1. Which of the following would cause average inventory holdings to decrease, other things held
constant?
a. The purchase price of inventory items decreases by 50 percent.
b. The carrying price of an item decreases (as a percent of purchase price).
c. The sales forecast is revised downward by 10 percent.
d. Interest rates fall.
e. Fixed order costs double.
Reason: Inventory turnover is one measures company’s performance and financial health.
Low inventory turnover generally means a company is holding too much inventory compared
to its sales. Decreasing inventory turnover often means sales are decreasing below expected
levels. For example: if the cost of goods sold was $10,000 for the quarter and average
inventory was $5000… $10,000 divided by $5000 would equal an inventory turn ratio of 2.
Two inventories per quarter means a company takes one and half months to use and replenish
on hand inventory. When the company has planned and produced a certain level of inventory
based on sales forecast that don’t materialize, extra inventory is the result. Decreasing turn
over can also be the result of returns from a prior period, extra production to create safety
stock against future potential sales increases or fulfillment of a contractual stocking
agreement with a customer.
2. During times of inflation, which of these inventory accounting methods is best for cash flow?
a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher
cost of goods sold and a lower reported net income.
b. Specific identification, because it correctly identifies the actual item sold and so the actual
cost is recorded on the income statement.
c. Weighted average, because it smoothes the reported cost of goods sold over time.
d. It doesn't matter which you use since cash flow is unaffected by the choice of inventory
identification method.
e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of
goods sold and higher reported net income.
Reason: Specific identification provides the most precise matching of costs and revenues and
assumes that a company bought three identical units of a given product at different prices.
One unit cost $2,000 the second cost $2,100 and the third cost $2,200. The company sold one
unit for 2,800. The units are alike, so the customer does not care which of the identical units
the company ships. However, the gross margin on the sale could be $800, $700, or $600
depending on which unit the company ships. So this method is best during inflation,
3. Which of the following is true of the Baumol model? Note that the optimal cash transfer
amount is C*.
a. If the total amount of cash needed during the year increases by 20%, then C* will increase by
20%.
b. If the average cash balance increases by 20%, then the total holding costs will increase by
20%.
c. If the average cash balance increases by 20% the total transactions costs will increase by 20%.
d. The optimal transfer amount is the same for all companies.
e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by
20%, then C* will increase by 20%.
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Reason: As the demand for cash, ‘C’ increases, the holding cost will also increase and the
transaction cost will reduce because of a decline in the number of transactions. From this
time, it can be said that there is a relationship between the holding cost and the transaction
cost.
The optimum cash balance, C* is obtained when the total cost is minimum.
Optimum cash balance (C*) = Ö2cT/k
Where, C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash balances.
With the increase in the cost per transaction and total funds required, the optimum cash
balance will increase. However, with an increase in the opportunity cost, it will decrease.
4. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will
be called EOQ.
a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.
b. If the average inventory increases by 20%, then the total carrying costs will increase by
20%.
c. If the average inventory increases by 20% the total order costs will increase by 20%.
d. The EOC is the same for all companies.
e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.
Reason: As per EOQ model, Carrying cost represents the costs incurred on holding inventory
in hand, that include the opportunity cost of money held up in the inventories, storage costs,
and spoilage costs. So as the inventory increases then total carrying will also increase.
As the order size increases, fewer orders are required, causing the ordering cost to decline,
whereas the average amount of inventory on hand will increase, resulting in an increase in
carrying costs
EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)
5. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed
for cash payments made during the next year. Each time Halliday deposits money in its account,
a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities
that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit
charge, what is the total cost for one year of holding the minimum cost cash balance according to
the Baumol model?
a. $7,483
b. $187
c. $3,741
d. $374
e. $748
Reason: Formula:
C = Optimum Balance
A= Annual cash distribution
F = Fixed cost per transaction
O = Opportunity cost of holding
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