Question 3 (30 marks)

a. (15 marks) The finance director of Hi-Quality Productions (Hi-Q) is reviewing the working capital management of the company. He is particularly concerned about the laxity in the accounts receivable collection process. The current credit terms of Hi-Q require customers to settle their bills within 30 days, but its customers are taking an average of 60 days to pay their bills. In addition, out of the total sales of $30m per year, the company suffers bad debts of $900,000 per year. The current administration costs for the credit department amounts to $600,000. The cost of fund for Hi-Q is 12% per year and the variable cost ratio is 70%. The finance director is reviewing a proposal which have been suggested to him by his assistant.

Proposal: Offering a discount of 2% for payments within 10 days. It is expected that the sales will increase to $33m per year. It is estimated that 50% of customers will take advantage of the discount, while the average time taken by the remaining customers to settle their bills will remain unchanged. Expand the credit department and apply a strict collection process. It is expected that bad debts will fall to 1% of sales per year and the administration costs will increase by $300,000.

Analyze the proposed changes and recommend the course of action to the finance director.

b. (15 marks) Clean Electronics is keen to source a customized computer microchip from a single supplier for its laptop computer. Each chip costs $200, and in addition it must pay its supplier a $1,000 setup fee on each order. Further, the minimum order size is 250 units; Cleans annual usage forecast is 5,000 units; and the carrying cost of this item is estimated to 20% of the average inventory value. You can use the formula for EOQ: .

Required:

(1) What is the EOQ for the microchips? What are the total inventory costs if the EOQ is ordered? (5 marks)

(2) Suppose it takes 2 weeks for the supplier to set up production, make, test and deliver the chips. At what inventory level should Clean reorder? (Assume certainty in delivery time and usage, and a 52-week year.) (2 marks)

(3) Due to uncertain delivery time and usage, the company carry a 200-unit safety stock to avoid running out of chip. What effect would this have on total inventory costs and what is the new reorder point? (4 marks)

(4) Now suppose Cleans supplier offers a discount of 1% on orders of 1,000 or more. Should Clean take the discount? Why or why not? (4 marks)