Lisa Pinto, vice president of finance at Roche Publishing Company, a rapidly growing publisher of college texts, is concerned about the firm's high level of short-term resource investment. She believes that the firm can improve the management of its cash and, as a result, reduce this investment. In this regard, she charged Arlene Bessenoff, the treasurer, with assessing the firm's cash management efficiency. Arlene decided to begin her investigation by studying the firm's operating and cash conversion cycles.
Arlene found that Roche's average payment period was 25 days, She consulted industry data, which showed that the average payment period for the industry was 40 days. Investigation of three similar publishing companies revealed that their average payment period was also 40 days. She estimated the annual cost of achieving a 40-day payment period to be $53,000.
Next, Arlene studied the production cycle and inventory policies. The average age of inventory was 120 days. She determined that the industry standard as reported in a survey done by Publishing World, the trade association journal, was 85 days. She estimated the annual cost of achieving an 85 day acerage age of inventory to be $150,000.
Further analysis showed Arlene that the firm's average collection period was 60 days. The industry average, derived from the trade association data and information on three similar publishing companies, was found to be 42 days-30% lower than Roche's. Arlene estimated that if Roche initiated a 2% cash discount for payment within 10 days of the beginning of the credit period, the firm's average collection period would drop from 60 days to the 42-day industry average. She also expected the following to occur as a result of the discount: Annual sales would increase from $13,750,000 to $15,000,000; bad debts would remain unchanged; and the 2% cash discount would be applied to 75% of the firm's sales. The firm's variable cost equal 80% of sales.
Roche Publishing Company is currently spending $12,000,000 per year on its operating-cycle investment, but it expects that initiating a cash discount will increase its operating-cycle investment to $13,100,000 per year. (Note: The operating -cycle investment per dollar of inventory, receivables, and payables is assumed to be the same.) Arlene's concern was whether the firm's cash management was as efficient as it could be. Arlene knew that the company paid 12% annual interest for its resource investment and therefore viewed this value as the firm's required return. For this reason, she was concerned about the resource investment cost resulting from any inefficiencies in the management of Roche's cash conversion cycle. (Note: Assume a 365-day year.)
a. Assuming a constant rate for purchases, production, and sales throughout the year, what are Roche's existing operating cycle (OC), cash conversion cycle (CCC), and resource investment need?
b. If Roche can optimize operations according to industry standards, what would its operating cycle (CO), cash conversion cycle (CCC), and resource investment need be under these more efficient conditions?
c. In terms of resource investment requirements, what is the annual cost of Roche's operational inefficiency?
d. Evaluate whether Roche's strategy for speeding its collection of accounts receivable would be acceptable. What annual net profit or loss would result from implementation of the cash discount?
e. Use your finding in part d, along with the payable and inventory costs given, to determine the total annual cost the firm would incur to achieve the industry level of operational efficiency.
f. Judging on the basis of your findings in parts c and e, should the firm incur the annual cost to achieve the industry level of operational efficiency? Explain why or why not.