Current Asset Management

Objective:
To determine the appropriate mix of the current assets components (cash, marketable
securities, accounts receivables and inventories), considering safety and liquidity, as well as
profitability.

Cash Conversion Cycle

It is the length of time it takes for the initial cash outflows for goods and services
(materials, labor, etc.) to be realized as cash inflows from sales (cash sales and collection of
accounts receivable).

Determination of Cash Conversion Cycle:

purchases credit sales collection

average age of inventories + average age of A/R
90 days 72 days

162 days
operating cycle

60 days
average age of A/P 102 days
payment cash conversion cycle

A. Cash Management
Cash is the most liquid asset of all and is vital for existence of any business firm. Its
efficient management is crucial to the solvency of the business because as we all know cash is the
focal point of the funds flows in a business.
The goal of cash management is to reduce the amount of cash that is being used within the
firm so as to increase profitability, but without reducing business activities or exposing the firm to
undue risk in its financial obligations.

Objective of Cash Management

The financial manager must know as to why the cash management is a necessity. The cash
management strategies are generally built around two goals:
 to provide cash needed to meet the obligations, and
 to minimize the idle cash held by the firm.
The financial manager has to strike an acceptable balance between holding too much cash
and too little cash. This is the focal point of the cash risk-return trade-off. A large cash investment
minimizes the chances of default but penalizes the profitability of the firm. A small cash balance
target may free the excess cash balance for investment in marketable securities and thereby
enhancing the profitability as well as value of the firm, but increases simultaneously the chances
of running out of cash. The risk-return trade-off of any firm can be reduced to two prime
objectives for the firm's cash management system, as follows:
 meeting the cash outflow
 minimizing the cash balance
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Motives for Holding Cash
1. Transaction Motive
Firms are in existence to create products or provide services. The providing of services
and creating of products results in the need for cash inflows and outflows. Firms hold cash in
order to satisfy the cash inflow and cash outflow needs that they have.
2. Precautionary Motive
Holding cash as a precaution serves as an emergency fund for a firm. If expected cash
inflows are not received as expected cash held on a precautionary basis could be used to satisfy
short-term obligations that the cash inflow may have been bench marked for.
3. Compensating Motive
Banks provide a variety of services to business firms, such as clearance of check, supply
of credit, etc., for which a minimum balance is required to be kept with the bank, this balance is to
compensate banks for services rendered.
4. Speculative Motive
One economist described this reason for holding cash as creating the ability for a firm to
take advantage of special opportunities that if acted upon quickly will favor the firm. An example
of this would be purchasing extra inventory at a discount that is greater than the carrying costs of
holding the inventory.

Ways to Manage Cash

1. Accelerating cash collection as soon as possible

How to accelerate cash collection?

 decentralized collections
 lock-box system
 prompt payment by customers
 early conversion of payment into cash

Ways to improve cash collection:

 changing customer paying habits
 improve the delivery system (reduce the negative float)
 bypass the problem (factoring of receivable)

Concept of Lock-box System

A lock-box system is a procedure in which customers mail payments to a post office box
that is emptied regularly by the firm’s bank, which processes the payments and deposits them in
the firm’s account. This system speeds up collection time by reducing processing time as well as
mail and clearing time.
 Advantage:
o receive remittances sooner which reduces processing float
 Disadvantage
o additional cost of creating and maintaining a lock-box system;
generally, not advantageous for small remittances

Lock-box process
1. customers are instructed to mail their remittances to the lock-box location
2. bank picks up remittances several times daily from the lockbox

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 3. bank deposits remittances in the customers account and provides a deposit slip with a list
of payments
4. company receives the list and any additional mailed items

2. Decelerating cash payment as soon as possible

How to decelerate cash payment?

 playing the float
 control of disbursement
o payable through draft (PTD)
o payroll and dividend disbursement
o zero balance account (ZBA)
 remote and controlled disbursement

Concept of Float
Float refers to funds that have been sent by the payer but are not yet usable funds to the
payee. Float is important in the cash conversion cycle because its presence lengthens both the
firm’s average collection period and its average payment period. However, the goal of the firm
should be to shorten its average collection period and lengthens its average payment period. Both
can be accomplished by managing float.
Float has three components parts:
1. Mail float is the time delay between when payments are placed in the mail and when it is
received.
2. Processing float is the time between receipt of the payment and its deposit into the firm’s
account.
3. Clearing float is the time between deposit of the payment and when spendable funds
become available to the firm. This component of float is attributable to the time required
for a check to clear the banking system.

Diagrammatic presentation of the three components of float:

checks checks checks checks

are mailed are received are deposited are cleared

Processing Float Clearing Float

Mail Float

Deposit Float

Collection Float

Types of Float
1. Negative Float
It exists when book balance exceeds the bank balance, which means that there is more
cash tied up in the collection cycle and it earns a 0% rate of return.

2. Positive Float
It exists when the firm’s bank balance exceeds its book balance, e.g. checks written or
issued by the firm that have not yet cleared.
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Note: good cash management dictates that negative float must be minimized, if not eliminated; and positive float
must be maximized.

Determining the Optimum Cash Balance

Two models:
1. Baumol’s Model (optimum cash balance under certainty)
This model considers cash management similar to an inventory management’s problem.
An EOQ-type model which can be used to determine the optimal cash balance where the cost of
maintaining and obtaining cash are at minimum.
Such cost are:
o cost of securities transactions or cost of obtaining a loan
o opportunity cost of holding cash which includes the return foregone by not
investing in marketable securities or the cost of borrowing cash

Assumptions of Baumol’s model:

 the firm is able to forecast it cash need with certainty
 the firms cash payments occur uniformly over a period of time
 the opportunity cost of holding cash is known and it does not change over a period of time
 the firm will incur the same transaction cost whenever it converts its securities to cash

Limitations of Baumol’s model:

It does not allow the cash flows to fluctuate. Firms in practice do not use their cash
balance uniformly nor they are able to predict daily cash inflows and outflows.

Formula:

where:
OCB= OCB= optimal cash balance (peso)
t= transaction cost which is fixed amount per transaction.
2td It includes the cost of securities transactions or cost of
i obtaining a loan (cost per transaction)
Average OCB= OCB/2 i= interest rate on marketable securities or the cost of
Opportunity cost= Ave. OCBx rate of return borrowing cash (rate)
Transaction cost= d/OCB x cost per transaction* d= total demand for cash over a period of time (peso)
*cost per transaction is also known as cost per converting marketable securities to cash
Total Cost= total transaction cost+ total opportunity cost

For example:
For the coming year, the expected cash disbursements total P432,000. The interest rate on
marketable securities is 5% per annum. The fixed cost of selling marketable securities is P8 per
transaction. Compute the optimal cash balance to minimize total cost.

OCB= 2x 8x 432,000
0.05
= P11,757.55

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 Optimal Cash Balance
P12,000 P11,757.5 P10,000
5
Transaction cost 288.00 293.94 345.60
Opportunity 300.00 293.94 250.00
cost
Total Cost 588.00 587.88 595.60

Note: The OCB using the Baumol’s model would provide the lowest total cost. We can know that the OCB will
provide the lowest total cost if the transaction cost is equal to the opportunity cost.

2. Miller-Orr Model (optimum cash balance under certainty)

The Miller-Orr Model overcomes the shortcomings present in the Baumol’s model. It assumes
that net cash flows are normally distributed with a zero value of mean & standard deviation. The MO
model provides for two control limits –the upper control limit & the lower control limit as well as the
return point .If the firm’s cash flow fluctuate randomly and hit the upper limit, then it buys sufficient
marketable securities to come back to a normal level of cash balance (return point). Similarly, when
the firm’s cash flows wander and hit the lower limit, it sells sufficient marketable securities to bring
the cash balance back to the normal level (return point).
Formula:
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RP = + L

where: FC = transaction cost of buying or selling securities

V = variance of daily cash flows
r = daily return on short-term investments
L = minimum cash requirement

Example:  
Given are the following: 
Fixed cost of a securities transaction = 50
Variance of daily net cash flows = 2500
Daily interest rate on securities = 0.0003 (10% per annum, so 10%/360 days = 0.0003 daily)
Minimum balance required by the company = 1000

Answer: RP= 1,678.60

The upper limit for the cash account (U) is determined by the equation:
U = 3RP - 2L
where:
RP = Return Point
L = Lower limit
In the previous example:
U = 3 (1,678.60) - 2(1000) = 3,035.81

B. Marketable Securities Management

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Marketable Securities
These are short-term money market instruments that can easily be converted to cash

Types of Short-Term Investment Opportunities

 Treasury bills
These are short-term government securities. Usually, they are sold at a discount and
redeemed at par. The difference is the return on security. They can be bought & sold any time;
thus they have liquidity. Also, they do not have the default risk.
 Commercial papers:
These are short-term, unsecured securities issued by highly creditworthy large companies.
They are issued with a maturity of three months to one year.
 Certificates of deposits:
Do banks acknowledging fixed deposits for a specific period of time issue papers? They
are negotiable instruments that make them marketable securities.
 Bank deposits
A firm can deposit its temporary cash in a bank for a fixed period of time. The interest rate
depends on the maturity period.

Reasons for Holding Marketable Securities

1. Marketable securities serve as substitute for cash (transaction, precautionary, and
speculative) balances.
2. Marketable securities as a temporary investment that yields return while funds are idle.
3. Cash is invested in marketable securities to meet known financial obligations such as tax
payments and loan amortization.

Decision Criteria for Marketable Securities

1. Risk
 Default risk- refers to chances that the issuer may not be able to pay the
interest or principal on time or at all.
 Interest rate risk- refers to fluctuations in securities’ price caused by
changes in market interest rates.
 Inflation risk- refers to the risk that inflation will reduce the real value of
the investment.

2. Marketability
This refers to how quickly a security can be sold before maturity without a significant
price concession.

3. Term to Maturity
Maturity dates of marketable securities held should coincide, when possible, with the date
at which the firm needs cash, or when the firm will no longer have cash to invest.

C. Accounts Receivable Management

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 Accounts Receivable Management is the formulation and administration of plans and
policies related to sales on account and ensuring the maintenance of receivables at predetermined
level and their collectibility as planned.

Objective of Accounts Receivable Management

To have both the optimal amount of receivables outstanding and the optimal amount of
bad debts. This balance requires the trade-off between the benefit of more credit sales, and the
costs of accounts receivable such as collection, interest, and bad debts. In addition, in order to
collect accounts receivable as quickly as possible withoul losing sales from high-pressure
collection techniques.

Ways of Accelerating Collection of Receivables

 shorten credit terms
 offer special discounts to customers who pay their accounts within a specified period
 speed up the mailing time of payments from customers to the firm
 minimize float, that is, reduce the time during which payments received by the firm
remian uncollected funds

Factors in Determining Accounts Receivable Policy

1. Credit Selection and Standards
Credit selection involves application of techniques for determining which customers
should receive credit. This process involves evaluating the customer’s creditworthiness and
comparing it to the firm’s credit standards, its minimum requirements for extending credit to a
customer.

Five C’s of Credit

This provides a framework for in-debt credit analysis.
 Character: The applicant’s record of meeting past obligations
 Capacity: the applicant’s ability to repay the requested credit, as judged in terms of
financial statement analysis focused on cash flows available to repay debt obligations.
 Capital: The applicant’s debt relative to equity.
 Collateral: the amount of assets the applicant has available for use in securing the credit.
The larger the amount of available assets, the greater the chance that a firm will recover
funds if the applicant defaults.
 Conditions: current general and industry-specific economic conditions and any unique
conditions surrounding a specific transaction.

Cost of maintaining receivables:

 additional fund requirement for the company
 administrative cost
 collection cost
 default cost

Computation of Net Benefit of Marginal Investment in A/R (relaxation of credit selection and
standards):
Net Benefit of Marginal Increase in Cost of Marginal Cost of Marginal
Investment in A/R = Contribution Margin - Investment in A/R - Bad Debts
(relaxation) A B C

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A= increase in sales- increase in variable cost
B= (ave.investment in A/R under the proposed system- ave. invenstment in A/R under the present system) x required
rate of return or (increase in receivable on existing sales+ increase in receivable on new sales) x variable cost
ratio x required rate of return
C= bad debts under the propsed system- bad debts under the present system or increase in sales x bad debts
percentage on sales
 ave. investment in A/R= total variable cost of annual net credit sales/ accounts receivable turnover
 increase in receivable on existing sales= (proposed credit term- present credit term) x ( annual present
sales/ 360 days)
 increase in receivable on new sales= amount of new sales x (credit term/ 360 days)

Example:
Company XYZ would like to relax its credit selection and standards which would result to
the following:
Present System Proposed System
Units to be sold for the year 60,000 63,000
Selling price per unit P10 P10
Variable cost per unit P6 P6
Fixed cost P100,000 P100,000
Average collection period 30 days 45 days
Bad debts percentage based on net 1% 2%
sales
Required rate of return 15% 15%
How much is the net benefit of relaxing the company’s credit selection and standards?

Solution:
Increase in contribution margin
(63,000- 60,000)x (P10- 6) P12,000
Cost of marginal investment in A/R
Ave. investment under the proposed system
(P6x 63,000)/ (360/45) P47,250
Ave. investment under the present system
(P6x 60,000)/ (360/30) 30,000
Marginal investment in A/R P17,250
x Required rate of return 0.15 (2,587.50)
Cost of marginal bad debts
Bad debts under the proposed system
(63,000x P10)x 2% P12,600
Bad debts under the present system
(60,000x P10)x 1% 6,000 (6,600.00)
Net benefit (cost) of relaxing credit selection and standards 2,812.50

2. Credit Terms
The credit period refers to the length of time allowed to customers to pay for their
purchases. Terms of net 30 mean the customer had 30 days from the befinning of the credit period
to pay the full invoice amount. Some firms offer cash discounts, percentage deductions form the
purchase price for paying within a specified time. For example, terms of 2/10 net 30 mean the
customer can take a 2% discunt from the invoice amount if the payment is made within 10 days of
the beginning of the credit period or can pay the full amount of the invoice within 30 days without
discount.

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Note: Credit period is the number of days after the beginning of the credit period until full payment of the account is
due; e.g. n/30.

Computation of Net Benefit of Marginal Investment in A/R (extending credit period):

Net Benefit of Marginal Increase in Cost of Marginal Cost of Marginal
Investment in A/R = Contribution Margin - Investment in A/R - Bad Debts
(extension) A B C

A= increase in sales- increase in variable cost

B= (ave.investment in A/R under the proposed system- ave. invenstment in A/R under the present system) x required
rate of return or (increase in receivable on existing sales+ increase in receivable on new sales) x variable cost
ratio x required rate of return
C= bad debts under the propsed system- bad debts under the present system or increase in sales x bad debts
percentage on sales
 ave. investment in A/R= total variable cost of annual net credit sales/ accounts receivable turnover
 increase in receivable on existing sales= (proposed credit term- present credit term) x ( annual present
sales/ 360 days)
 increase in receivable on new sales= amount of new sales x (credit term/ 360 days)

Example:
The XYZ Company’s existing sales are P1,800,000. It is currently extending a credit
period of n/30 its customers. The company is contemplating to increase it sales by P160,000 by
lengthening the existing credit period to n/45. The bad debt losses on additional sales are expected
to be 5 percent. The variable cost ratio is 80% and the required rate of return is 15%. Should the
company extend the credit period or not?
Solution:
Increase in contribution margin
P160,000x (1- 0.80) P32,000
Cost of marginal investment in A/R
Increase in receivable on existing sales
(45- 30)x (1,800,000/360)x 0.80 P60,000
Increase in receivable on new sales
P160,000x (45/360)x 0.80 16,000
Marginal investment in A/R P76,000
x Required rate of return 0.15 (11,400)
Cost of marginal bad debts
P160,000x 0.05 ( 8,000)
Net benefit (cost) of extending credit period 12,600

Cash Discount
Including a cash discount in the credit terms is a popular wasy to achive the goal of
speeding up collections without putting pressure on customers. The cash discount provides an
incentives for customers to pay sooner. By speeding collections, the discount decreases the firm’s
investment in account receivable, but it also decreases the per-unit profit. Additionally, initiating a
cash discount should reduce bad debts because customers will pay sooner.

Computation of Net Benefit of Offering Cash Discount:

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 Net Benefit (Cost) of Increase in Cost Savings from Cost of Cash
Offering Cash Discount = Contribution Margin + Reduction of A/R - Discount
A B C

Cost Savings from

+ Reduction in Bad Debts
D
C

A= increase in sales- increase in variable cost

B= (ave.investment in A/R under the present system- ave. invenstment in A/R under the proposed system) x required
rate of return
C= cash discount percentage x estimated percentage of customers who will take the discount x number of units to be
sold x selling price per unit
D= bad debts under the present system- bad debts under the proposed system
 ave. investment in A/R= total variable cost of annual net credit sales/ accounts receivable turnover
 increase in receivable on existing sales= (proposed credit term- present credit term) x ( annual present
sales/ 360 days)
 increase in receivable on new sales= amount of new sales x (credit term/ 360 days)
Example:
Company XYZ would like to initiate a cash discount of 2/10, which would result to the
following:
Present System Proposed System
Units to be sold for the year 1,000 1,050
Selling price per unit P3,000 P3,000
Variable cost per unit P2,300 P2,300
Fixed cost P100,000 P100,000
Average collection period 30 days 25 days
Bad debts percentage based on ave. 1% 1%
A/R
Required rate of return 15% 15%
How much is the net benefit from initiation of proposed cash discount?
Solution:
Increase in contribution margin
(1,050- 1,000)x (P3,000- 2,300) P35,000
Cost savings form reduction of investment in A/R
Ave. investment under the present system
(P2,300x 1,000)/ (360/30) P191,667
Ave. investment under the proposed system
(P2,300x 1,050)/ (360/25) 167,708
Marginal investment in A/R P 23,959
x Required rate of return 0.15 3,594
Cost of cash discount
(0.02x 0.80x 1,050x P3,000) (50,400)
Cost savings from reduction of bad debts
Bad debts under the present system
(P2,300x 1,000)/ (360/30)x 1% P 1,917
Bad debts under the proposed system
(P2,300x 1,050)/ (360/25)x 1% 1,677 240
Net benefit (cost) of the proposed cash discount (11,566)

3. Credit Monitoring

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 It is the ongoing review of the frim’s accounts receivable to determine whether customers
are paying according to the stated credit terms. If they are not paying in a timely manner, credit
monitoring will alert the firm to the problem. Two frequently used techniques for credit
monitoring are average collection period and aging of account receivable.

D. Inventory Management
Inventory management is the formulation and administration of plans and policies to
efficiently and satisfactorily meet production and merchandising requirements and minimize costs
relative to inventories.

Objective of Inventory Management

To maintain inventory at a level that best balances the estimates of actual savings, the cost
of carrying additional inventory, and the efficiency of inventory control.
Firms should always avoid a situation of over-investment or under-investment in
inventories. The major dangers of over investment are:
 unnecessary tie-up of the firm's funds and loss of profit,
 excessive carrying costs, and
 risk of liquidity.
The consequences of underinvestment in inventories are:
 production hold-ups
 failure to meet delivery commitments. Inadequate raw materials and work-in-process
inventories will result in frequent production interruptions.

There are three general motives for holding inventories:

1. Transactions motive emphasizes the need to maintain inventories to facilitate smooth
production and sales operations. For uninterrupted and proper running of any firm it is
necessary to have an appropriate level of inventory.
2. Precautionary motive necessitates holding of inventories to guard against the risk of
unpredictable changes in demand and supply forces and other factors.
3. Speculative motive influences the decision to increase or reduce inventory levels to take
advantage of price fluctuations.

Inventory Management Techniques

1. Inventory Planing
It is the determination of the quality and quantity and location of inventory, as well as the
time of ordering, in order to meet future business requirements.
 Econimic Order Quantity (EOQ) Model
 Reorder Point
 Just-in-Time (JIT)
The Just-in-Time (JIT) system is used to minimize inventory investment. The philosophy
is that materials should arrive at exactly the time they are needed for production. Ideally, the firm
would have only work-in-process inventory. Because its objective is to minimize inventory
investment, a JIT system uses no, or very little, safety stocks.

2. Inventory Control
It is the regulation of inventory within predetermined level; adequate stocks should be
available to meet business requirements, but the investment in inventory should minimum.
 Fixed Order Quantity System: an order for a fixed quantity is placed when the inventory
level reaches the reorder point.
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  Fixed Reorder Cycle System (periodic review or replacement): orders are made after a
review of inventory levels has been done at regular intervals.
 Optional Replacement System
 ABC Classifiacation System: inventories are classified for selectibe control
o A items: high value items requiring highest possible control
o B items: medium cost items requiring normal control
o C items: low cost items requiring the simplest possible control

3. Modern Inventory Management

It is often applied in the context of automated manufacturing
 Materials Requirement Planning (MRP): designed to plan and control raw
materials used in production. The demand for materials, which is assumed to be dependent
on some factors, is programmed into a computer.
 Manufacturing Resource Planning (MRP-II): closed loop system that integrates all
facets of a business, including inventories, production, sales, and cash flows.
 Enterprise Resource Planning (ERP): integrates the information systems of the
whole enterprise. All organizational operations are connected and the organization itself is
connected with its customers and suppliers.

The Economic Order Quantity (EOQ) Model

One of the most common techniques for determining the optimal order size for inventory
items is the economic order quantity (EOQ) model. The EOQ model considers various costs of
inventory and then determines what order sixe minimizes total inventory cost. EOQ assumes that
the relevant costs of inventory can be divided into order costs and carrying costs.
 Ordering cost: (peso/order)
o requisitioning
o order placing
o transportation
o receiving and inspecting
o clerical and staff
 Carrying cost: (peso/unit/year)
o warehousing
o handling
o clerical and staff
o insurance
o deterioration and obsolescence
o opportunity cost

Order costs decrease as the size of the order increases. Carrying costs, however, increase with
incresases in the order size. The EOQ model analyzes the trade-off between order costs and carrying
costs to determine the order quantity that minimizes the total inventory cost.

Assumption of EOQ model:

 demand occurs at a constant rate throughout the year
 lead time on the receipt of the orders is constant
 the entire quantity ordered is received at one time

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  the unit costs of the items ordered are constant; thus, there can be no quantity
discounts
 there are no limitations on the size of the inventory

Formula:
where:
EOQ= EOQ= order size (units)
o= ordering cost per order (peso)
2o d= annual demand in units (units)
dc c= carrying cost per unit per year (peso)

Average inventory= EOQ/2

Total order cost= (d/EOQ)x ordering cost per order
Total carrying cost= average inventory x carrying cost per unit per year
Total inventory cost= total order cost + total carrying cost

Example:
XYZ Company has been buying product A in lots of 1,250 units which represents a three
months supply. The cost per unit is P220. the order cost is P900 per order; and the annual
inventory carrying cost per one unit is P25. Assume that the units will be required evenly
throughout the year, compute the EOQ.
Solution:

EOQ= 2x 1,250x 4x 900

25
= 600 units

Order Size
700 units 600 units 500 units
Ordering 6,428.57 7,500.00 9,000.00
cost
Carrying cost 8,750.00 7,500.00 6,250.00
Total cost 15,178.5 15,000.00 15,250.00
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Note: The order size using the EOQ model would provide the lowest total inventory cost. We can know that the order
size (EOQ) will provide the lowest total inventory cost if the transaction cost is equal to the carrying cost.

When applied to manufacturing operations, the EOQ formula may be used to compute the
Economic Lot Size (ELS).
Formula:
where:
ELS=
EOQ= order size (units)
s= cost per set-up (peso)
2s d= annual demand in units (units)
dc c= carrying cost per unit per year (peso)

Re-order Point
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 We have now solved the problem of “how much to order” by determining the economic
order quantity, we have yet to seek the answer to the second problem, “when to order”. This is a
problem of determining the re-order point.
The re-order point is that inventory level at which an order should be placed to replenish
the inventory.
To determine the re-order point, we should know:
 lead time,
 average usage
 economic orders quantity
Under such a situation, re-order point is simply that inventory level which will be
maintained for consumption during the lead-time. That is:

Reorder point = lead time in days x daily usage

Lead-time
It is the period between the time the order is placed and the order is received. By certainty
we mean that usage and lead-time do not fluctuate.

Safety stock
The demand for material may fluctuate from day to day or from week to week. Similarly,
the actual delivery time may be different from the normal lead-time. If the actual usage increases
or the delivery of inventory is delayed, the firm can face a problem of stock-out, which can prove
to be costly for the firm. Therefore, in order to guard against the stock-out, the firm may maintain
a safety-stock (some minimum or buffer inventory as cushion against expected increased usage
and/or delay in delivery time).

Total safety stock= safety stock (time) + safety stock (increase in demand/usage)
Safety stock (time)= (maximum lead time- normal lead time) x average daily usage
Safety stock (demand/usage)= (maximum daily usage/demand- average daily usage/demand) x
normal lead time
Normal lead time usage= normal lead time x average daily usage
Re-order point (no safety stock)= normal lead time usage
Re-order point (with safety stock)= normal lead time usage x safety stock or
maximum lead time x average daily usage

Re-order point illustrated:

ave. daily usage= 5 units
normal lead time= 10 days
maximum lead time= 15 days

maximum lead time (15 days)

safety stock-time
normal lead time (10 days) (25 units)
re-order point- no safety
stock (50 units)
re-order point- with safety
stock (75 units)

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