Question 3 (20 Marks)

GTG Ltd is considering making the following changes in the area of working capital management:

Inventory management

It has been suggested that the order size for Product GTG5 should be determined using the economic order quantity model (EOQ).

GTG Ltd forecasts that demand for Product GTG5 will be 160 000 units in the coming year and it has traditionally ordered 10% of annual demand per order. The ordering cost is expected to be N$400 per order while the holding cost is expected to be N$5,12 per unit per year. A buffer inventory of 5 000 units of Product GTG5 will be maintained, whether orders are made by the traditional method or using the economic order quantity model.

Receivables management

GTG Ltd could introduce an early settlement discount of 1% for customers who pay within 30 days and at the same time, through improved operational procedures, maintain a maximum average payment period of 60 days for credit customers who do not take the discount. It is expected that 25% of credit customers will take the discount if it were offered.

It is expected that administration and operating cost savings of N$753 000 per year will be made after improving operational procedures and introducing the early settlement discount.

Credit sales of GTG Ltd are currently N$87,6 million per year and trade receivables are currently N$18 million. Credit sales are not expected to change because of the changes in receivables management. The company has a cost of short-term finance of 5,5% per year.

Required:

3.1 Calculate the cost of the current ordering policy and the change in the costs of inventory management that will arise if the economic order quantity is used to determine the optimum order size for Product GTG5.

(5)

3.2 Calculate and comment on whether the proposed changes in receivables management will be acceptable. If only 25% of customers take the early settlement discount, what is the maximum early settlement discount that could be offered? (7)

3.3 Discuss the factors that should be considered in formulating working capital policy on the management of trade receivables. (8)