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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

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 74 percent, and accounts receivable turnover is four times. Assume income taxes of 20 percent and an increase in sales of $65,000. No other asset build-up will be required to service the new accounts.

c. Should Henderson liberalize credit if a 16 percent after-tax return on investment is required?

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 74 percent, and accounts receivable turnover is four times. Assume income taxes of 20 percent and an increase in sales of $65,000. No other asset build-up will be required to service the new accounts.

b. What would be Henderson’s incremental after-tax return on investment?

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.

In Problem 12, assume the term structure of interest rates becomes inverted, with short-term rates going to 11 percent and long-term rates 5 percentage points lower than short-term rates. If all other factors in the problem remain unchanged, what will earnings after taxes be?

Lear Inc. has \(840,000 in current assets, \)370,000 of which are considered permanent current assets. In addition, the firm has \(640,000 invested in fixed assets.

a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 8 percent. The balance will be financed with short-term financing, which currently costs 7 percent. Lear’s earnings before interest and taxes are \)240,000. Determine Lear’s earnings after taxes under this financing plan. The tax rate is 30 percent.

b. As an alternative, Lear might wish to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing and the balance with short-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $240,000. What will be Lear’s earnings after taxes? The tax rate is 30 percent.

c. What are some of the risks and cost considerations associated with each of these alternative financing strategies?

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