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Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory?

Short Answer

Expert verified

The safety stock helps an organization against the risk of loss of sales, and the increase in safety stock increases the carrying cost of inventory.

Step by step solution

01

Reason for keeping safety stock

An organization should maintain safety stock to ensure that they have enough stock at a given time which will protect it against the risk of losing prospective sales which will affect the organization’s income. The safety stock will ensure that the organization is able to meet all the deliveries even when there is an unforeseeable delay like equipment breakdown, production delay, etc.

02

Impact of safety stock on carrying cost

The safety stock will result in an increase in the carrying cost of inventory. If an organization keeps a large safety stock, then it will lead to high carrying costs, and even small safety stock will result in a small increase in the inventory carrying cost.

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Most popular questions from this chapter

Bombs Away Video Games Corporation has forecasted the following monthly sales:

January

\(100,000

February

\)93,000

March

\(25,000

April

\)25,000

May

\(20,000

June

\)35,000

July

\(45,000

August

\)45,000

September

\(55,000

October

\)85,000

November

\(105,000

December

\)123,000

Total annual sales

\(756,000

Bombs Away Video Games sells the popular Strafe and Capture video game. It sells for \)5 per unit and costs \(2 per unit to produce. A level production policy is followed. Each month’s production is equal to annual sales (in units) divided by 12.

Of each month’s sales, 30 percent are for cash and 70 percent are on account. All accounts receivable are collected in the month after the sale is made.

b. Prepare a monthly schedule of cash receipts. Sales in the December before the planning year are \)100,000. Work part b using dollars.

Esquire Products Inc. expects the following monthly sales:

January

\(28,000

February

\)19,000

March

\(12,000

April

\)14,000

May

\(8,000

June

\)6,000

July

\(22,000

August

\)26,000

September

\(29,000

October

\)34,000

November

\(42,000

December

\)24,000

Total annual sales

\(264,000

Cash sales are 40 percent in a given month, with the remainder going into accounts receivable. All receivables are collected in the month following the sale. Esquire sells all of its goods for \)2 each and produces them for \(1 each. Esquire uses level production, and average monthly production is equal to annual production divided by 12.

b. Determine a cash receipts schedule for January through December. Assume that dollar sales in the prior December were \)20,000. Work part b using dollars.

In Problem 18, what long-term interest rate would represent a break-even point between using short-term financing as described in part a and long-term financing? (Hint: Divide the interest payments in 18a by the amount of total funds provided for the six months and multiply by 12.)

In the second year, Fisk Corporation finds that it can reduce ordering costs to \(2 per order but that carrying costs stay the same at \)1.60 per unit. Also, volume remains at 49,000 units per year.

c. What will the average inventory be?

Mervyn’s Fine Fashions has an average collection period of 50 days. The accounts receivable balance is $95,000. What is the value of its credit sales?

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