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A Value-oriented Framework for Inventory Management

A Value-oriented Framework for Inventory Management The basic financial purpose of a firm is to maximize its value. An inventory management system should also contribute to the realization of this basic aim. Many current asset management models found in financial management literature were constructed with the assumption of book profit maximization as their basic aim. However these models could lack the means for realizing a different aim, i.e., the maximization of enterprise value. This article presents a modified value-based inventory management model. Keywords: inventory management, value-based management, free cash flow, working capital management, short-run financial management JEL: G32, G11, M11, D81, O16, P33, P34 DOI: 10.2478/v10033-009-0019-y 1. Introduction The basic financial aim of an enterprise is the maximization of its value. At the same time, research into the determinants in increasing firm value has considerable theoretical and practical significance. Most financial literature contains information about numerous factors influencing value. Among those factors are net working capital and the elements creating it, such as the level of cash tied in accounts receivable, inventories and operational cash balances. A large majority of classic financial model proposals related to optimum current assets management were constructed with net profit maximization in view. In order to make these models more suitable for firms that want to maximize their value, some of them must be reconstructed. In the sphere of inventory management, the estimation of the influence of changes in a firm's decisions is a compromise between limiting risk by having greater inventory and limiting the costs of inventory. It is the essential problem of corporate financial management. Current assets, i.e. the sum of inventories, accounts receivable, short-term investment (cash and equivalents) and short term accruals [Mueller 1953; Graber 1948; Khoury 1999; Cote 1999] are for the firm collateral/protection against risk [Merton 1999, p. 506; Lofthouse 2005; p. 27-28; Parrino 2008, p. 224-233, Poteshman 2005, p. 21-60] and at the same time an investment [Levy 1999, p. 6; Reilly 1992, p. 6; Fabozzi 1999, p. 214]. Current assets level is the result of a kind of production organization [Baumol 1952, Beck 2005, Beranek 1963, Emery 1988, Gallinger 1986, Holmstrom 2001, Kim 1998, Kim 1978, Lyn 1996, Tobin 1958, Stone 1972, Miller 1966, Miller 1996, Myers 1998, Opler 1999]. As a result, the firm maintains an adequate level of inventories and is linked with operational management rather than with financial decisions [Peterson 1979, p. 6769; Orlicky 1975, p.17-19; Plossl 1985, p. 421]. At the same time, current assets are the result of an active policy of gaining and holding the firm's clients. [Bougheas 2009] The firm offer should be suited to the demands and character of the firm clients. Inventory levels are also a result of this policy. The basic financial purpose of an enterprise is the maximization of its value. Inventory management should * Grzegorz Michalski Department of Corporate Finance and Value Management, Wroclaw University of Economics e-mail: Grzegorz.Michalski@ae.wroc.pl also contribute to the realization of this fundamental aim. Many of the current asset management models that are found in financial management literature assume book profit maximization as their basic financial purpose. These book profit-based models could be lacking with regard to another aim, i.e., the maximization of enterprise value. The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences for the recipient firm that can result from operating risk related to the delivery risk generated by suppliers. The present article offers a method using portfolio management theory to choose suppliers. When the entrepreneur chooses the tradesman, the entrepreneur should concentrate his or her attention not only on basic knowledge about the contracting party's individual shape parameters (i.e. the tradesman's financial situation), but also on information from inventory management models. The basic financial inventory management aim is to hold inventory to a minimally acceptable level in relation to costs. Holding inventory means using capital to finance inventory and links with inventory storage, insurance, transport, obsolescence, waste and spoilage costs. However, maintaining a low inventory level can, in turn, lead to other problems with regard to meeting supply demands. FCFFt = (CRt - CEt - NCE )× (1 - T ) + + NCE - Capex - NWCt (2) where CRt = cash revenues on sales; CEt = cash expenses resulting from fixed and variable costs in time t; NCE = non-cash expenses; T = effective tax rate; NWC = net working growth; and Capex = capital expenditure resulting from operational investments growth (money used by a firm to acquire or upgrade physical assets such as property, industrial buildings, or equipment). Similar conclusions about the results of a change in inventory management policy on firm value can be estimated on the basis of economic value added, which reveals the size of the residual profit (the added value) and enlargement of the firm's value in the period: EVA = NOPAT - k × ( NWC + OI ) , (3) where EVA = economic value added; NWC = net working capital; OI = long-term operating investments; and NOPAT = net operating profit after taxes, estimated on the basis of the formula: NOPAT = (CRt - CEt - NCE )× (1 - T ) (4) 2. Value based inventory management If advantages from holding inventory on a level defined by the firm are greater than the negative influence of opportunity costs from its holding, then the firm's value will grow. Change of inventory level affects the firm value. To measure that value, a formula can be used that is based on the assumption that the firm value is a sum of future free cash flows to the firm (FCFF) discounted by the cost of the capital financing the firm: The net working capital (NWC) is a part of current assets financed with fixed capital. The net working capital (current assets less current liabilities) results from the lack of synchronization of the formal rising receipts and the real cash receipts from each sale. Net working capital also results from divergence during a time of rising costs and from the real outflow of cash when a firm pays its accounts payable. NWC = CA - CL = AAR + INV + G - AAP (5) V p = t =1 FCFFt (1 + k )t (1) where Vp = firm value growth; FCFFt = future free cash flow growth in period t, and k = discount rate1. Future free cash flow is expressed: To estimate changes in accounts receivable levels, a discount rate equal to the average weighted cost of capital (WACC) is accepted. Such changes and their results are strategic and long term in character, although they refer to accounts receivable and short run area decisions (T.S. Maness 1998, s. 62-63). where NWC = net working capital; CA = current assets; CL = current liabilities; AAR = average level of accounts receivable; INV = inventory; G = cash and cash equivalents; and AAP = average level of accounts payable. During estimation of the free cash flows the holding and increasing of net working capital ties money used for financing it. If net working capital increases, the firm must tie money, thus decreasing free cash flows. Production level growth usually creates a necessity for the enlargement of cash levels, inventories, and accounts receivable. Part of this growth will be covered by current liabilities. Current liabilities also usually automatically increase alongside growth in production. The rest (which is noted as net working capital growth) will require other forms of financing. Inventory management policy decisions create the new inventory level in a firm. These decisions have influence on firm value. It is the result of opportunity costs of money tied in with inventory and the general costs of inventory management. Both the first and second involve the modification of future free cash flows, leading to changes in firm value. Figure 1 shows the influence of inventory management decisions on firm value. These decisions change the future free cash flows (FCFF). These decisions could also have influence on the life of the firm (t) (by the operational risk, which is the result of the possibility of a break in production cycles if the inventory level is too low), and the rate of the cost of capital financing of the firm (k). Changes to these three components have an influence on the creation of firm value (Vp). Influence on FCFF Influence on k Influence on t Inventory changes influences: · costs · NWC Inventory changes could influence cost of capital Inventory changes could influence period of life of the enterprise. 3. EOQ and VBEOQ The Economic Order Quantity Model is a model which maximizes the firm's income through total inventory cost minimization. Figure 2: EOQ and VBEOQ model Source: J. G. Kalberg, K. L. Parkinson, Corporate liquidity: Management and Measurement, IRWIN, Homewood 1993, p. 538. The EOQ model requires two equations: EOQ = FCFFt t 1 t =1 ( + k ) EVA = NOPAT - k × ( NWC + IO) V p = where FCFF = free cash flows to firm; NWC = net working capital growth; k = cost of the capital financing the firm; and t = the lifetime of the firm and the time required to generate single FCFF. Figure 1: Influence of inventory management decisions on firm value Source: own study. , (6) where EOQ = economic order quantity; P = demand for the product/inventory in period (year, month); Kz = cost per order; Ku = holding cost per unit in period (year, month); C = holding cost factor; and v = purchase cost per unit. The holding cost factor (Ku) is a result of the following costs2: · Opportunity costs (price of money tied-up in inventory) · Storage, insurance, transportation, obsolescence, waste and spoilage costs 2× P × Kz 2× P × Kz = C ×v Ku TCI = Inventory changes (resulting from changes in the inventory management policy of the firm) affect the net working capital level and the level of operating costs of inventory management in a firm as well. These operating costs are the result of storage, insurance, transport, obsolescence, waste and spoilage of inventory. (7) where TCI = total costs of inventory; Q = order quantity; and zb = minimal stock. Example 1. P = 220 000 kg; Kz = 31$; v = 2$ / 1kg; C = 25%. Effective tax rate, T = 19%. Cost of capital financing the firm WACC = k = 15%; zb = 300 kg. First EOQ is estimated: P Q × K z + + zb × v × C Q 2 , M. Sierpiska, D. Wdzki, Zarzdzanie plynnoci finansow w przedsibiorstwie, WN PWN, Warszawa 2002, s. 112. EOQ = 2 × 220 000 × 31 = 5 223 kg . 0,25 × 2 VBEOQ = 2 × (1 - 0,19 )× 31 × 220 000 = 3 959 kg ; 2 × (0,15 + 0,25 × (1 - 0,19 )) Next average inventory level is estimated: INVEOQ=5223 5 223 = + 300 = 2 912kg 2 INVEOQ=5223 = 2 912 × 2 = 5 824$ 220 000 × 31 + 5 223 5 223 + + 300 × 2 × 0,25 = 2 762$ 2 TCI VBEOQ=3959 = 220 000 × 31 + 3 959 TCI EOQ =5223 = 3 959 + + 300 × 2 × 0,25 = 2 862 $; 2 TCI Q =5223Q =3959 = 2 862 - 2 762 = 100 $; If 5 000 kg are ordered, the quantity EOQ = 5 223 kg, and the TCI are: 3 959 INVVBEOQ =3959 = 2 × + 300 = 4 559 $; 2 INVQ =5223Q =3959 = 4 559 - 5 824 = -1 265 $; TCI Q =5000 = 220 000 × 31 + 5 000 5 000 + + 300 × 2 × 0,25 = 2 764$. 2 VQ =5223Q =3959 = 1 265 - 100 × (1 - 0,19) = 725 $; 0,15 EVAQ =5223Q =3959 = (1 - 0,19) × (-100) - 0,15 × (-1265) = 109 $. Both V and EVA are greater than before if the firm's order of 3 959 kg is marked by VBEOQ. In fact it is the best known possibility. TCI will be greater, but if its influence on firm value is checked, it will be seen that if the decision is made to order less than EOQ suggests, this will increase the firm value: TCI Q =5223Q =5000 = 2 764 - 2 762 = 2 $, 4. POQ and VBPOQ A production order quantity model (POQ) is an EOQ modification that can be used when production possibilities exceed the market's capacity. 5 000 INVQ =5000 = 2 × + 300 = 5 600 $, 2 INVQ =5223Q =5000 = 5 600 - 5 824 = -224 $, NWC = INV, VQ =5223Q =5000 = 224 - EVAQ =5223Q =5000 2 × (1 - 0,19) = 213,2 $; 0,15 = NOPAT - k × (NWC + OI ) = (1 - 0,19) × (-2) - 0,15 × (-224) = 32 $. Because both V and EVA are greater than 0, it can bee seen that it will be profitable for the firm to order 5000 kg, not 5223 kg as suggested by EOQ. The EOQ model minimizes operational inventory costs, but in firm management there are also the opportunity costs of holding inventories. These costs dictate that the order will be less than that suggested by EOQ so as to maximize the firm value. With this in mind the VBEOQ model can be used: Figure 3: POQ and VBPOQ Source: Z. Sariusz-Wolski, Sterowanie zapasami w przedsibiorstwie, PWE, Warszawa 2000, p. 162. VBEOQ = (8) where k = cost of capital financing the firm (WACC); and VBEOQ = value based economic order quantity. For Alfa data: 2 × (1 - T )× K Z × P v × (k + C × (1 - T )) POQ could be estimated as3: POQ = 2× Kz × P , P<m P C × k × 1 - m (9) Z. Sariusz-Wolski, Sterowanie zapasami w przedsibiorstwie, PWE, Warszawa 2000, s. 162 where POQ = production order quantity; Kz = switch on production cost (setup cost per setup); P = demand intensity (how much can be sold annually); v = cost per unit; m = maximum annual production ability; and C = holding cost factor. INVPOQ =570 = 800 × INV570 = 800 × 2 500 570 × 1 - 10 000 = 171 000$, 2 NWC = (- FCFF0 ) = ZAPQ =633Q =570 = 171 000 - 189 600 = (-18 600)$. VQ =633Q =570 = +18 600 + EVAQ =633Q =570 TCI = (10) where Q = production quantity; and TCI = total cost of inventories. Q P P × 1 - × v × C + × K z 2 m Q - 514 × (1 - 0,19) 0,15 = +15 824$, INV = Q P × 1 - 2 m (11) Where INV = average inventory level. Example 2. Maximum demand, P = 2 500 tons, m = 10 000 tons annually. WACC = k = 15%, C = 25%, T = 19%. Kz = 12 000 $, v = 0,8$. First POQ is estimated: . = (1 - 0,19) × (-514) - 0,15 × (-18600) = 2373,66$ This shows that if production is less than the quantity POQ additional value will be created. VBPOQ can be determined from the following table: Q 483 482 481 480 479 478 477 TCI 98337 98391 98445 98500 98555 98612 98668 TCI INV 144900 144600 144300 144000 143700 143400 143100 INV EVA -44700 -45000 -45300 -45600 -45900 -46200 -46500 2 × 12 000 × 2 500 POQ = = 633 tons. 2 500 800 × 0,25 × 1 - 10 000 TCI POQ =633 2 500 633 = × 1 - 10 000 × 800 × 0,25 + 2 + 2 500 × 12 000 = 94 868$. 633 Table 1: VBPOQ Source: own study INV POQ =633 = 633 2 500 × 1 - 10 000 = 237 (1000) kg . 2 237 × 800 = 189 600$ The following check the influence of firm value on the change of production quantity to 90% POQ, 633 × 0,9 = 570 tons: TCI POQ =570 = 2 500 570 × 1 - 10 000 × 800 × 0,25 + 2 + 2 500 × 12 000 = 95 382$, 570 QVBPOQ = From this it was found that VBPOQ gives 479 tons. Table 1 also shows that the costs TCI for VBPOQ will be greater than for POQ, but that VBPOQ ties up less cash in inventories than the POQ, which is the source of benefits in lower opportunity costs. To estimate VBPOQ the following equation could also be used: 2 × P × K z × (1 - T ) (12) ,P<m QVBPOQ = P v × 1 - × [k + C × (1 - T )] m 2 × 2 500 × 12 000 × (1 - 0,19 ) = 479tons. 2500 × [0,15 + 0,25 × (1 - 0,19 )] 800 × 1 - 10 000 - FCFF1... = TCI Q=633Q =570 0,81 = 95 382 - 94 868 = 514$. Knowing VBPOQ, the firm can better manage inventories and bring the firm closer to realizing its basic financial aim ­ firm value maximization. A Value-oriented Frame V ework for Inventory M Management COTE J.M., C.K Latham, The Mer K. rchandising Ratio: A Comprehensive Measure of Work Capital Strate Issues in Accou king egy, unting Education, vol. , 14, no. 2, May 1999, p. 255-267. EMERY G.W., Positive Theories o Trade Credit, Ad of dvances in Workin ng Capital Manage ement, JAI Press, v 1, 1988, p. 115vol. -130. GALLINGER G A. J. Ifflander, M G., Monitoring Accounts Receivable Usin ng Variance Analys Financial Management, 1986, 69sis -76. GRABER P.J., A Assets, The Accoun nting Review, vol. 23, no. 1, Jan. 194 p. 48, 12-16. HOLMSTROM B., J. Tirole, LAPM a liquidity-based asset pricing mo M M: d odel, Journal of Finan 2001, vol. 56, p. 1837-1867 {WP6673, National Bureau nce, of Economic Re esearch, Cambridg 1998}. ge, KALBERG J. G., K. L. Parkinson, C Corporate liquidity Management and y: d Measurment, IRW Homewood 1993. WIN, KHOURY N.T., K.V. Smith, P.I. Ma , acKay, Comparing Working Capital Practices in Cana the United Sta and Australia, Revue Canadienn ada, ates ne des Sciences de l'Administration, vol. 16, no. 1, Mar 1999, p. 53-57. e r. KIM C-S., D. C. Mauer, A. E. Sher rman, The Determinants of Corporat te Liquidity: Theor and Evidence, Jo ry ournal of Financia and Quantitative al e Analysis, vol. 33 nr 3, 1998. 3, KIM Y. H., J. C. Atkins, Evaluating Investments in A . Accounts Receivab ble: A Wealth Maxim mizing Framework Journal of Financ vol. 33, nr 2, 19 k, ce, 978, p. 403-412. LEVY H., D. Gu unthorpe, Introduc ction do Investmen South-Western nts, n College Publish hing, Cincinnati 19 999. LOFTHOUSE S Investment Man S., nagement, Wiley, C Chichester 2005. LYN E. O., G. J Papaioannou, Liq J. quidity and the Financing Policy of the Firm: an Empiric Test, Advances in Capital Manag cal s gement, Londyn 19 996, vol. 3, p. 65-83. MERTON R.C, A.F. Perold, Theor of Risk Capital in Financial Firms, w: ry w D.H. Chew, The New Corporate Fin nance. Where Theory Meets Practice, McGraw-Hill, Bo oston 1999. MILLER M.H., D. Orr, A Model of the Demand for M f Money by Firms, Quarterly Journ of Economics, 1 nal 1966, nr 80, p. 413-435. MILLER T. W., B. K. Stone, The Value of Short-Term Cash Flow m Forecasting Sys stems, Advances in Working Capital Management, JAI n Press Inc., London 1996, vol. 3, p. 3-63. . MUELLER F.W Corporate Worki Capital and Liq W., ing quidity, The Journa of al Business of the University of Chic cago, vol. 26, no. 3, Jul. 1953, p. 157-172. MYERS S. C., R G. RAJAN, The Paradox of Liquidit Quarterly Journ of R. ty, nal Economics 113, nr 3, Cambridge, 1998, p. 733-771. , OPLER T., R. S STULZ, R. Williamso The determina on, ants and implicatio ons of corporate cas holdings, Journ of Financial Eco sh nal onomics, vol. 52, no. 1, n 1999, p. 3-46. ORLICKY J., M Material Requiremen Planning, McGraw-Hill, New York nts k 1975. PARRINO R., D Kidwell, Funda D.S. amentals of Corpor Finance, Wiley rate y, New York 2008. . PETERSON R., E.A. Silver, Decisio Systems for Inve , on entory Managemen nt and Production Planning, Wiley, N York 1979. New PIOTROWSKA M., Short-term fin A nancial decisions, W WUE, Wroclaw 199 97. PLOSSL G.W., Production and In nventory Control, Pr rinciples and Techniques, Prentice Hall, Englew wood Cliffs 1985. POTESHMAN A., R. PARRINO, M WEISBACH, Meas M. suring Investment Distortions when Risk-Averse Mana n agers Decide Whet to Undertake Risky ther R Project, Financia Management, vol. 34, Spring 2005 p. 21-60. al 5, REILLY F.K., In nvestments, The Dr ryden Press, Fort W Worth 1992. STONE B. K., T Use of Forecas and Smoothing in Control - Limit The sts g t Models for Cash Management, Financial Managem h ment, 1972, p. 72-84. TOBIN J., Liq quidity Preference as Behavior Toward Risk, Review of e w Economic Studi 1958 r. nr 25, p 65-86. ies, p. 5. Conclusions C Maximization of the owne M ers' wealth is the basic s financial goal in enterprise management Inventory n t. nagement tec chniques must contribute t this goal. t to man Mod difications to both the valu ue-based EOQ model and valu ue-based POQ model may be seen in this article. Q Inve entory manag gement decisio plex. Excess ons are comp cash tied up in i h inventory bur rdens the ente erprise with high costs of inve h entory service and opportun costs. By nity contrast, higher i inventory stoc helps incre ck ease income m from sales because customers have greater flexibility in mak king purchasin decisions and the firm de ng ecreases the risk of unplanned breaks in production Although n n. blems conne ected with o optimal econo omic order prob quantity and prod duction order quantity rema it can be ain, he d concluded that th value-based modifications implied by se s nagers make b better valuethes two models will help man crea ating decisions in inventory m s management. Lite erature BRIGHAM E.F., DA AVES P.R., Interm mediate Financial Management, l Thom mson, Mason 2004 4. FA ABOZZI F. J., G. FO ONG, Zarzdzanie portfelem inwesty finansowych ycji przyn noszcych staly dochód, WN PWN, W Warszawa 2000. FA ABOZZI F.J., Invest tment Manageme ent, Prentice Hall, Upper Saddle River 1999. r JAJ JUGA K., Zarzdza kapitalem, Wy anie ydawnictwo AE, Wroclaw 1993. LUENBERGER D. G., Teoria inwestycji fi finansowych, WN P PWN, Warszawa 2003 3. MA ANESS T.S., J.T. ZIE ETLOW, Short-Term Financial Manag m gement, Dryden Press Fort Worth 1998 s, 8. MICHALSKI G., Leks sykon zarzdzania finansami, CHB a Beck, Warszawa 2004 4. PIO OTROWSKA M., Fi inanse spólek. Kró ótkoterminowe dec cyzje finansowe, Wyda awnictwo AE, Wro oclaw 1997. PLUTA W., G. MICH HALSKI, Krótkoter rminowe zarzdza anie kapitalem, CHBe Warszawa 200 eck, 05. SA ARTORIS W., HILL N A Generalized C N., Cash Flow Approac to Short-Term ch Finan ncial Decisions, [in:] Pogue A., "Cash and Wo orking Capital Mana agement", The Jou urnal of Finance, M 1983, s. 349-360. May SCHERR F. C., Mode Working Capit Management. T ern tal Text and Cases, Prent Hall, Englewo Cliffs 1989. tice ood SIE ERPISKA M., W DZKI D., Zarzd dzanie plynnoci finansow w przed dsibiorstwie, WN P PWN Warszawa 20 005. BA AUMOL W.J., The Transactions Dema for Cash: An In and nventory Theo oretic Approach, Q Quarterly Journal o Economics", nr 6 Nov 1952, p. of 66, 545-5 556. BECK S.E., D.R. Stockman, Money as Re Options in a Ca eal ash-in-Advance Econ nomy, Economics Letters, 2005, vol. 87, p. 337-345. BERANEK W., Analysis for Financial De ecisions, R. D. IRWIN, Homewood 1963 3. BO OUGHEAS S., Mateu S., Mizen, P., Co ut orporate trade credi and it inven ntories: New eviden of a trade-off fr nce rom accounts paya and able receiv vable, Journal of B Banking & Finance vol. 33, no. 2, 200 p. 300-307. e, 09, http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png South East European Journal of Economics and Business de Gruyter

A Value-oriented Framework for Inventory Management

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Abstract

The basic financial purpose of a firm is to maximize its value. An inventory management system should also contribute to the realization of this basic aim. Many current asset management models found in financial management literature were constructed with the assumption of book profit maximization as their basic aim. However these models could lack the means for realizing a different aim, i.e., the maximization of enterprise value. This article presents a modified value-based inventory management model. Keywords: inventory management, value-based management, free cash flow, working capital management, short-run financial management JEL: G32, G11, M11, D81, O16, P33, P34 DOI: 10.2478/v10033-009-0019-y 1. Introduction The basic financial aim of an enterprise is the maximization of its value. At the same time, research into the determinants in increasing firm value has considerable theoretical and practical significance. Most financial literature contains information about numerous factors influencing value. Among those factors are net working capital and the elements creating it, such as the level of cash tied in accounts receivable, inventories and operational cash balances. A large majority of classic financial model proposals related to optimum current assets management were constructed with net profit maximization in view. In order to make these models more suitable for firms that want to maximize their value, some of them must be reconstructed. In the sphere of inventory management, the estimation of the influence of changes in a firm's decisions is a compromise between limiting risk by having greater inventory and limiting the costs of inventory. It is the essential problem of corporate financial management. Current assets, i.e. the sum of inventories, accounts receivable, short-term investment (cash and equivalents) and short term accruals [Mueller 1953; Graber 1948; Khoury 1999; Cote 1999] are for the firm collateral/protection against risk [Merton 1999, p. 506; Lofthouse 2005; p. 27-28; Parrino 2008, p. 224-233, Poteshman 2005, p. 21-60] and at the same time an investment [Levy 1999, p. 6; Reilly 1992, p. 6; Fabozzi 1999, p. 214]. Current assets level is the result of a kind of production organization [Baumol 1952, Beck 2005, Beranek 1963, Emery 1988, Gallinger 1986, Holmstrom 2001, Kim 1998, Kim 1978, Lyn 1996, Tobin 1958, Stone 1972, Miller 1966, Miller 1996, Myers 1998, Opler 1999]. As a result, the firm maintains an adequate level of inventories and is linked with operational management rather than with financial decisions [Peterson 1979, p. 6769; Orlicky 1975, p.17-19; Plossl 1985, p. 421]. At the same time, current assets are the result of an active policy of gaining and holding the firm's clients. [Bougheas 2009] The firm offer should be suited to the demands and character of the firm clients. Inventory levels are also a result of this policy. The basic financial purpose of an enterprise is the maximization of its value. Inventory management should * Grzegorz Michalski Department of Corporate Finance and Value Management, Wroclaw University of Economics e-mail: Grzegorz.Michalski@ae.wroc.pl also contribute to the realization of this fundamental aim. Many of the current asset management models that are found in financial management literature assume book profit maximization as their basic financial purpose. These book profit-based models could be lacking with regard to another aim, i.e., the maximization of enterprise value. The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences for the recipient firm that can result from operating risk related to the delivery risk generated by suppliers. The present article offers a method using portfolio management theory to choose suppliers. When the entrepreneur chooses the tradesman, the entrepreneur should concentrate his or her attention not only on basic knowledge about the contracting party's individual shape parameters (i.e. the tradesman's financial situation), but also on information from inventory management models. The basic financial inventory management aim is to hold inventory to a minimally acceptable level in relation to costs. Holding inventory means using capital to finance inventory and links with inventory storage, insurance, transport, obsolescence, waste and spoilage costs. However, maintaining a low inventory level can, in turn, lead to other problems with regard to meeting supply demands. FCFFt = (CRt - CEt - NCE )× (1 - T ) + + NCE - Capex - NWCt (2) where CRt = cash revenues on sales; CEt = cash expenses resulting from fixed and variable costs in time t; NCE = non-cash expenses; T = effective tax rate; NWC = net working growth; and Capex = capital expenditure resulting from operational investments growth (money used by a firm to acquire or upgrade physical assets such as property, industrial buildings, or equipment). Similar conclusions about the results of a change in inventory management policy on firm value can be estimated on the basis of economic value added, which reveals the size of the residual profit (the added value) and enlargement of the firm's value in the period: EVA = NOPAT - k × ( NWC + OI ) , (3) where EVA = economic value added; NWC = net working capital; OI = long-term operating investments; and NOPAT = net operating profit after taxes, estimated on the basis of the formula: NOPAT = (CRt - CEt - NCE )× (1 - T ) (4) 2. Value based inventory management If advantages from holding inventory on a level defined by the firm are greater than the negative influence of opportunity costs from its holding, then the firm's value will grow. Change of inventory level affects the firm value. To measure that value, a formula can be used that is based on the assumption that the firm value is a sum of future free cash flows to the firm (FCFF) discounted by the cost of the capital financing the firm: The net working capital (NWC) is a part of current assets financed with fixed capital. The net working capital (current assets less current liabilities) results from the lack of synchronization of the formal rising receipts and the real cash receipts from each sale. Net working capital also results from divergence during a time of rising costs and from the real outflow of cash when a firm pays its accounts payable. NWC = CA - CL = AAR + INV + G - AAP (5) V p = t =1 FCFFt (1 + k )t (1) where Vp = firm value growth; FCFFt = future free cash flow growth in period t, and k = discount rate1. Future free cash flow is expressed: To estimate changes in accounts receivable levels, a discount rate equal to the average weighted cost of capital (WACC) is accepted. Such changes and their results are strategic and long term in character, although they refer to accounts receivable and short run area decisions (T.S. Maness 1998, s. 62-63). where NWC = net working capital; CA = current assets; CL = current liabilities; AAR = average level of accounts receivable; INV = inventory; G = cash and cash equivalents; and AAP = average level of accounts payable. During estimation of the free cash flows the holding and increasing of net working capital ties money used for financing it. If net working capital increases, the firm must tie money, thus decreasing free cash flows. Production level growth usually creates a necessity for the enlargement of cash levels, inventories, and accounts receivable. Part of this growth will be covered by current liabilities. Current liabilities also usually automatically increase alongside growth in production. The rest (which is noted as net working capital growth) will require other forms of financing. Inventory management policy decisions create the new inventory level in a firm. These decisions have influence on firm value. It is the result of opportunity costs of money tied in with inventory and the general costs of inventory management. Both the first and second involve the modification of future free cash flows, leading to changes in firm value. Figure 1 shows the influence of inventory management decisions on firm value. These decisions change the future free cash flows (FCFF). These decisions could also have influence on the life of the firm (t) (by the operational risk, which is the result of the possibility of a break in production cycles if the inventory level is too low), and the rate of the cost of capital financing of the firm (k). Changes to these three components have an influence on the creation of firm value (Vp). Influence on FCFF Influence on k Influence on t Inventory changes influences: · costs · NWC Inventory changes could influence cost of capital Inventory changes could influence period of life of the enterprise. 3. EOQ and VBEOQ The Economic Order Quantity Model is a model which maximizes the firm's income through total inventory cost minimization. Figure 2: EOQ and VBEOQ model Source: J. G. Kalberg, K. L. Parkinson, Corporate liquidity: Management and Measurement, IRWIN, Homewood 1993, p. 538. The EOQ model requires two equations: EOQ = FCFFt t 1 t =1 ( + k ) EVA = NOPAT - k × ( NWC + IO) V p = where FCFF = free cash flows to firm; NWC = net working capital growth; k = cost of the capital financing the firm; and t = the lifetime of the firm and the time required to generate single FCFF. Figure 1: Influence of inventory management decisions on firm value Source: own study. , (6) where EOQ = economic order quantity; P = demand for the product/inventory in period (year, month); Kz = cost per order; Ku = holding cost per unit in period (year, month); C = holding cost factor; and v = purchase cost per unit. The holding cost factor (Ku) is a result of the following costs2: · Opportunity costs (price of money tied-up in inventory) · Storage, insurance, transportation, obsolescence, waste and spoilage costs 2× P × Kz 2× P × Kz = C ×v Ku TCI = Inventory changes (resulting from changes in the inventory management policy of the firm) affect the net working capital level and the level of operating costs of inventory management in a firm as well. These operating costs are the result of storage, insurance, transport, obsolescence, waste and spoilage of inventory. (7) where TCI = total costs of inventory; Q = order quantity; and zb = minimal stock. Example 1. P = 220 000 kg; Kz = 31$; v = 2$ / 1kg; C = 25%. Effective tax rate, T = 19%. Cost of capital financing the firm WACC = k = 15%; zb = 300 kg. First EOQ is estimated: P Q × K z + + zb × v × C Q 2 , M. Sierpiska, D. Wdzki, Zarzdzanie plynnoci finansow w przedsibiorstwie, WN PWN, Warszawa 2002, s. 112. EOQ = 2 × 220 000 × 31 = 5 223 kg . 0,25 × 2 VBEOQ = 2 × (1 - 0,19 )× 31 × 220 000 = 3 959 kg ; 2 × (0,15 + 0,25 × (1 - 0,19 )) Next average inventory level is estimated: INVEOQ=5223 5 223 = + 300 = 2 912kg 2 INVEOQ=5223 = 2 912 × 2 = 5 824$ 220 000 × 31 + 5 223 5 223 + + 300 × 2 × 0,25 = 2 762$ 2 TCI VBEOQ=3959 = 220 000 × 31 + 3 959 TCI EOQ =5223 = 3 959 + + 300 × 2 × 0,25 = 2 862 $; 2 TCI Q =5223Q =3959 = 2 862 - 2 762 = 100 $; If 5 000 kg are ordered, the quantity EOQ = 5 223 kg, and the TCI are: 3 959 INVVBEOQ =3959 = 2 × + 300 = 4 559 $; 2 INVQ =5223Q =3959 = 4 559 - 5 824 = -1 265 $; TCI Q =5000 = 220 000 × 31 + 5 000 5 000 + + 300 × 2 × 0,25 = 2 764$. 2 VQ =5223Q =3959 = 1 265 - 100 × (1 - 0,19) = 725 $; 0,15 EVAQ =5223Q =3959 = (1 - 0,19) × (-100) - 0,15 × (-1265) = 109 $. Both V and EVA are greater than before if the firm's order of 3 959 kg is marked by VBEOQ. In fact it is the best known possibility. TCI will be greater, but if its influence on firm value is checked, it will be seen that if the decision is made to order less than EOQ suggests, this will increase the firm value: TCI Q =5223Q =5000 = 2 764 - 2 762 = 2 $, 4. POQ and VBPOQ A production order quantity model (POQ) is an EOQ modification that can be used when production possibilities exceed the market's capacity. 5 000 INVQ =5000 = 2 × + 300 = 5 600 $, 2 INVQ =5223Q =5000 = 5 600 - 5 824 = -224 $, NWC = INV, VQ =5223Q =5000 = 224 - EVAQ =5223Q =5000 2 × (1 - 0,19) = 213,2 $; 0,15 = NOPAT - k × (NWC + OI ) = (1 - 0,19) × (-2) - 0,15 × (-224) = 32 $. Because both V and EVA are greater than 0, it can bee seen that it will be profitable for the firm to order 5000 kg, not 5223 kg as suggested by EOQ. The EOQ model minimizes operational inventory costs, but in firm management there are also the opportunity costs of holding inventories. These costs dictate that the order will be less than that suggested by EOQ so as to maximize the firm value. With this in mind the VBEOQ model can be used: Figure 3: POQ and VBPOQ Source: Z. Sariusz-Wolski, Sterowanie zapasami w przedsibiorstwie, PWE, Warszawa 2000, p. 162. VBEOQ = (8) where k = cost of capital financing the firm (WACC); and VBEOQ = value based economic order quantity. For Alfa data: 2 × (1 - T )× K Z × P v × (k + C × (1 - T )) POQ could be estimated as3: POQ = 2× Kz × P , P<m P C × k × 1 - m (9) Z. Sariusz-Wolski, Sterowanie zapasami w przedsibiorstwie, PWE, Warszawa 2000, s. 162 where POQ = production order quantity; Kz = switch on production cost (setup cost per setup); P = demand intensity (how much can be sold annually); v = cost per unit; m = maximum annual production ability; and C = holding cost factor. INVPOQ =570 = 800 × INV570 = 800 × 2 500 570 × 1 - 10 000 = 171 000$, 2 NWC = (- FCFF0 ) = ZAPQ =633Q =570 = 171 000 - 189 600 = (-18 600)$. VQ =633Q =570 = +18 600 + EVAQ =633Q =570 TCI = (10) where Q = production quantity; and TCI = total cost of inventories. Q P P × 1 - × v × C + × K z 2 m Q - 514 × (1 - 0,19) 0,15 = +15 824$, INV = Q P × 1 - 2 m (11) Where INV = average inventory level. Example 2. Maximum demand, P = 2 500 tons, m = 10 000 tons annually. WACC = k = 15%, C = 25%, T = 19%. Kz = 12 000 $, v = 0,8$. First POQ is estimated: . = (1 - 0,19) × (-514) - 0,15 × (-18600) = 2373,66$ This shows that if production is less than the quantity POQ additional value will be created. VBPOQ can be determined from the following table: Q 483 482 481 480 479 478 477 TCI 98337 98391 98445 98500 98555 98612 98668 TCI INV 144900 144600 144300 144000 143700 143400 143100 INV EVA -44700 -45000 -45300 -45600 -45900 -46200 -46500 2 × 12 000 × 2 500 POQ = = 633 tons. 2 500 800 × 0,25 × 1 - 10 000 TCI POQ =633 2 500 633 = × 1 - 10 000 × 800 × 0,25 + 2 + 2 500 × 12 000 = 94 868$. 633 Table 1: VBPOQ Source: own study INV POQ =633 = 633 2 500 × 1 - 10 000 = 237 (1000) kg . 2 237 × 800 = 189 600$ The following check the influence of firm value on the change of production quantity to 90% POQ, 633 × 0,9 = 570 tons: TCI POQ =570 = 2 500 570 × 1 - 10 000 × 800 × 0,25 + 2 + 2 500 × 12 000 = 95 382$, 570 QVBPOQ = From this it was found that VBPOQ gives 479 tons. Table 1 also shows that the costs TCI for VBPOQ will be greater than for POQ, but that VBPOQ ties up less cash in inventories than the POQ, which is the source of benefits in lower opportunity costs. To estimate VBPOQ the following equation could also be used: 2 × P × K z × (1 - T ) (12) ,P<m QVBPOQ = P v × 1 - × [k + C × (1 - T )] m 2 × 2 500 × 12 000 × (1 - 0,19 ) = 479tons. 2500 × [0,15 + 0,25 × (1 - 0,19 )] 800 × 1 - 10 000 - FCFF1... = TCI Q=633Q =570 0,81 = 95 382 - 94 868 = 514$. Knowing VBPOQ, the firm can better manage inventories and bring the firm closer to realizing its basic financial aim ­ firm value maximization. A Value-oriented Frame V ework for Inventory M Management COTE J.M., C.K Latham, The Mer K. rchandising Ratio: A Comprehensive Measure of Work Capital Strate Issues in Accou king egy, unting Education, vol. , 14, no. 2, May 1999, p. 255-267. EMERY G.W., Positive Theories o Trade Credit, Ad of dvances in Workin ng Capital Manage ement, JAI Press, v 1, 1988, p. 115vol. -130. GALLINGER G A. J. Ifflander, M G., Monitoring Accounts Receivable Usin ng Variance Analys Financial Management, 1986, 69sis -76. 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Stockman, Money as Re Options in a Ca eal ash-in-Advance Econ nomy, Economics Letters, 2005, vol. 87, p. 337-345. BERANEK W., Analysis for Financial De ecisions, R. D. IRWIN, Homewood 1963 3. BO OUGHEAS S., Mateu S., Mizen, P., Co ut orporate trade credi and it inven ntories: New eviden of a trade-off fr nce rom accounts paya and able receiv vable, Journal of B Banking & Finance vol. 33, no. 2, 200 p. 300-307. e, 09,

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South East European Journal of Economics and Businessde Gruyter

Published: Nov 1, 2009

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