Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

Clean Wash Ltd. manufactures and markets automatic washing machines. Among the hundreds of components which it purchases each year from external suppliers for assembling into the finished articles are drive belts, of which it uses 400,000 units per annum. It is considering converting its purchasing, delivery and stock control of this item to a Just-In-Time (JIT) system. This will raise the number of orders placed but lower the administrative and other costs of placing and receiving orders. If successful, this will provide the model for switching most of its inwards supplies into this system.

Details of current and proposed ordering and carrying costs are given below:

Ordering cost per order Current
Sh.10,000 Proposed
Sh.2,500
Purchase cost per item Sh.25 Sh.25
Inventory holding cost (as a percentage of the purchase cost) 20% 20%

To implement new arrangements will require a one-off reorganization costs estimated at Sh.140,000 which will be treated as revenue item for tax purposes. The rate of corporation tax is 32.5% and Clean Wash Ltd. can obtain finance at an effective cost of 18%. The life span of the new system is 8 years.

Required
(a) (i)The economic order quantity with current and proposed arrangements.

(ii) New Present Value (NPV) of the new arrangement. Is the new arrangement worthwhile?

(b) Briefly explain the nature and objectives of JIT purchasing arrangements concluded between components users and suppliers.
ANSWER

(ii) Implementation of the new system will affect both the total ordering costs per annum and stock holding cost under the existing system these are as follows:


(b) JIT represents a complete management philosophy and is more than just a collection of techniques. It aims to manufacture to order for each customer and to eliminate idle resources in all areas of the company. It is a technique which enables management to order and buy what it requires at that particular point in time.

In terms of purchasing, a JIT system aims to ensure that components are delivered just immediately prior to the need to use then in the production process. It therefore requires a close relationship to be built up between customer and supplier, the later being required to deliver quality assured components to match production schedules. Suppliers in turn should benefit it from fair long-term sales as the purchaser reduces its number of sources. This should allow the supplier to achieve scale economies and improve production planning. The customer should achieve a reduction in ordering costs and n stock levels and associated carrying costs.

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