"Multinational Working Capital Management "- Inter. Fin-7

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Multinational Working Capital Management

A multinational corporation can be defined as an entity, which has branches, or subsidiaries spread over many countries. Since multinational corporations have operations in different countries, the financial transactions will also be denominated in multiple currencies. Hence, financial management of short-term assets and liabilities in an MNC is much more important and complex in nature. It involves management of current assets and current liabilities denominated in different currencies.

INTERNATIONAL CASH MANAGEMENT

International money managers attempt to attain on a worldwide basis the traditional domestic objectives of cash management: (1) bringing the company's cash resources within control as quickly and efficiently as possible and (2) achieving the optimum conservation and utilization of these funds. Accomplishing the first goal requires establishing accurate, timely forecasting and reporting systems, improving cash collections and disbursements, and decreasing the cost of moving funds among affiliates. The second objective is achieved by minimizing the required level of cash balances, making money available when and where it is needed, and increasing the risk-adjusted return on those funds that can be invested.

The principles of domestic and international cash management are identical. The latter is a more complicated exercise, however, and not only because of its wider scope and the need to recognize the customs and practices of other countries. When considering the movement of funds across national borders, a number of external factors inhibit adjustment and constrain the money manager. The most obvious is a set of restrictions that impedes the free flow of money into or out of a country. These regulations impede the free flow of capital and, thereby, hinder an international cash management program.

There is really only one generalization that can be made about this type of regulation: Controls become more stringent during periods of crisis, precisely when financial managers want to act. Thus, a large premium is placed on foresight, planning, and anticipation. Government restrictions must be scrutinized on a country-by-country basis to determine realistic options and limits of action.

Other complicating factors in international money management include multiple tax jurisdictions and currencies and the relative absence of internationally integrated interchange facilities—such as are available domestically in the United States and in other Western nations—for moving cash swiftly from one location to another. Despite these difficulties, however, MNCs may have significant opportunities for improving their global cash management. For example, multinationals can often achieve higher returns overseas on short-term investments that are denied to purely domestic corporations, and the MNCs can frequently keep a higher proportion of these returns after tax by taking advantage of various tax laws and treaties. In addition, by considering all corporate funds as belonging to a central reservoir or "pool" and managing it as such (where permitted by the exchange control authorities), overall returns can be increased while simultaneously reducing the required level of cash and marketable securities worldwide.

Multinational corporations, by virtue of their presence in different countries, have access to much wider international money markets. Hence, there is a need for the finance manager to develop a strategy to meet the actual requirement of the MNC which proposes either to mobilize the funds or to deploy the surplus cash in investments. The objective of cash management is (i) to maximize the return by proper allocation of short-term investments and (ii) to minimize the cost of borrowing by borrowing in different money markets.

To achieve the above objective the MNCs have to evolve a strategy by taking the following aspects into consideration:

i. The borrowing cost in a particular currency and the relationship between nominal interest rate between the currencies and anticipated exchange rates of the currencies (International Fisher effect).

ii. The exchange risk of the MNC consequent to the firm’s exposure in different currencies with regard to the receivables and payables.

iii. The level of risk acceptable to the management of the MNC.

iv. The availability of tools for hedging.

v. Tax structure prevailing in various countries

vi. Political environment and the consequent risk relating to various countries.

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Guest

Posted on 21 December 2009

Management of the Short-Term Investment Portfolio

A major task of international cash management is to determine the levels and currency denominations of the multinational group's investment in cash balances and money market instruments. Firms with seasonal or cyclical cash flows have special problems, such as spacing investment maturities to coincide with projected needs. To manage this investment properly requires (1) a forecast of future cash needs based on the company's current budget and past experience and (2) an estimate of a minimum cash position for the coming period. These projections should take into account the effects of inflation and anticipated currency changes on future cash flows.

Successful management of an MNC's required cash balances and of any excess funds generated by the firm and its affiliates depends largely on the astute selection of appropriate short-term money market instruments. Rewarding opportunities exist in many countries, but the choice of an investment medium depends on government regulations, the structure of the market, and the tax laws, all of which vary widely. Available money instruments differ among the major markets, and at times, foreign firms are denied access to existing investment opportunities. Only a few markets, such as the broad and diversified U.S. market and the Eurocurrency markets, are truly free and international.

Once corporate headquarters has fully identified the present and future needs of its affiliates, it must then decide on a policy for managing its liquid assets worldwide. This policy must recognize that the value of shifting funds across national borders to earn the highest possible risk-adjusted return depends not only on the risk-adjusted yield differential, but also on the transaction costs involved. In fact, the basic reason for holding cash in several currencies simultaneously is the existence of currency conversion costs. If these costs are zero and government regulations permit, all cash balances should be held in the currency having the highest effective risk-adjusted return net of withdrawal costs.

Given that transaction costs do exist, the appropriate currency denomination mix of an MNC's investment in money and near-money assets is probably more a function of the currencies in which it has actual and projected inflows and outflows than of effective yield differentials or government regulations. The reason why is simple: Despite government controls, it would be highly unusual to see an annualized risk-adjusted interest differential of even 2%. Although seemingly large, a 2% annual differential yields only an additional 0.167% for a 30-day investment or 0.5% extra for a 90-day investment. Such small differentials can easily be offset by foreign exchange transaction costs. Thus, even large annualized risk-adjusted interest spreads may not justify shifting funds for short-term placements.

Where Surplus Cash Should Be Held?

In a multinational corporation with production and selling subsidiaries spread around the world, cash inflows and outflows occur in diverse currencies. Apart from cost and return considerations, several other factors influence the choice of currencies and locations for holding cash balances.

The bid-ask spreads in exchange rate quotations represent transaction costs of converting currencies into one another. There may of course be other costs such as telephone calls, telexes, other paperwork, etc. Minimising transaction costs would require that funds be kept in the currency in which they are received if there is possibility that they might be needed later in the same currency. A related but distinct consideration is that of liquidity, viz. funds should be held in a currency in which they are most likely to be needed. This may not be the same as the currency in which the cash comes in. Militating against these factors is the political risk dimension. The parent firm may want to hold all surplus cash in its home currency to minimise the risk of its assets being frozen by a foreign government. This factor is likely to be of some importance only in the case of politically highly unstable countries.

Availability of investment vehicles and their liquidity is another important factor. Major money market centers such as London and New York offer a wide variety of highly liquid money market instruments so that the firm does not need to hold practically any idle cash balances.

Finally, withholding taxes may influence the choice. If balances are held in interest bearing assets in; a country which has a withholding tax on non-resident interest income, and the tax rate exceeds the parent's home country tax rate, the parent cannot get full credit for the foreign tax paid and such a location may therefore become unattractive for holding funds.

Investing Surplus Funds

Once the treasurer has identified the cash flows and determined how much surplus funds are available in which currencies and for what durations, he or she must choose appropriate investment vehicles so as to maximise

Guest

Posted on 21 December 2009

the interest income while at the same time minimising currency and credit risks and ensuring sufficient liquidity to meet any unforeseen cash requirements.

The major investment vehicles available for short-term placement of funds are (1) short-term bank deposits (2) fixed-term money market deposits such as CDs and (3) financial and commercial paper. The main considerations in choosing an investment vehicle can be summarised as follows:

1. Yield: Total return on the investment including interest income and any capital gain or loss. Very often, security and liquidity considerations may take precedence over yield.

2. Marketability: Since liquidity is an important consideration, the ease with which the investment can be unwound is important. Instruments like CDs have well developed secondary markets while CPs and trade related paper have limited liquidity.

3. Exchange Rate Risk: If funds eventually required in currency A are invested in currency B, there is exchange rate risk. If covered, then as we saw above, there is no advantage to switching currencies.

4. Price Risk: If a fixed-term investment such as a CD or a T-bill has to be liquidated before maturity, there is the risk of capital loss if interest rates have moved up in the meanwhile.

5. Transactions Costs: Brokerage commissions and other transactions costs can significantly lower the realised yield particularly on short-term investments.

Money-market investments are often available in fixed minimum sizes and maturities which may not match the size of the available surplus and the duration for which it is available. For instance consider the case of a treasurer who has a surplus of USD 180,000 for 90 days. 90-day USD CDs are an attractive instrument offering 10% return but the denomination is USD 100,000 per CD. The treasurer can purchase one CD and invest 80,000 dollars in a bank deposit earning 6% or borrow USD 20,000 via an overdraft facility at 13% and purchase two CDs. Which course of action is preferable?

Let us cast the problem in more general terms. Let M denote the minimum size of the investment instrument, S the surplus funds, i the interest on the instrument, d the interest rate on the bank deposit and b the interest rate on borrowing or overdraft. Then the breakeven size of excess funds is given by

M x i - (M - S*) x b = S* x d

i.e. S* = M [(b - i) l (b - d)

If excess funds on hand exceed S*, money should be borrowed to invest in the money market instrument; otherwise the excess funds should be left in a bank deposit.

In the example at hand, M = 100000, i = 0.10, d = 0.06 and b = 0.13. The breakeven size of surplus funds is

100000 [(0.13 - 0.10) / (0.13 - 0.06)] = 42,857.14

Since the treasurer has USD 80000 excess, it is preferable to borrow USD 20,000 and purchase two CDs.

A similar problem arises when the duration for which surplus funds are available does not match the term of a money market investment. Suppose a treasurer has DEM 250,000 available for 10 days. A 30-day fixed deposit is paying 7% p.a.. Thus the gap is 20 days. The money can be placed in a current account earning 2% p.a. Overdraft facility can be availed of for 20 days at a cost of 9% p.a. Here we can define a 'breakeven' gap such that if the actual gap exceeds the breakeven, money should be borrowed to take advantage of the higher return on the fixed deposit. We leave this as an exercise for the reader.

Financing Short – Term Deficits

Just as judicious management of short-term surplus funds can earn extra income for the firm, careful handling of short-term deficits can lead to significant savings. The treasurer's objective in this regard should be to minimise the overall borrowing requirement consistent with the firm's liquidity needs and to fund these at the minimum possible all-in cost.

One of the cheapest ways of covering short-term deficits is internal funds. In a multinational firm with several subsidiaries, it often happens that while one division has a short-term funds requirement, another has surplus funds. While the former may have to take an expensive bank loan or overdraft facility, the latter may not have

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Posted on 21 December 2009

very attractive investment opportunities beyond bank deposits. A centralized cash management system with cash pooling described below can efficiently allocate internal surpluses so as to optimize interest earnings net of interest costs for the corporation as a whole. However cross-border inter-company loans are a complex area. There are issues related to differences in tax regimes, existence of double taxation treaties, differences in accounting norms, and exchange risk. Specialist advice is usually necessary to exploit these opportunities in an optimal fashion.

External sources of short-term funding consist of overdraft facilities, fixed-term bank loans and advances and instruments like commercial paper, trade and bankers' acceptances. Apart from the all-in cost of funding, considerations such as collateral or security requirements, flexibility in terms of repayment schedule, speed with which a new facility can be arranged, effect on firm's credit rating and so forth also play a role in evaluating the funding options. The size and maturity mismatch problems arise here too. For instance, suppose a treasurer determines that he has a requirement of USD 60,000 for 30 days. An overdraft facility would cost him 12% while a 30-day term loan is available at 9% but the minimum amount is USD 100,000. Surplus funds can be kept in a deposit earning 5%. The problem again is to determine the "breakeven" size of funding requirement such that if the actual need is larger than this, it is preferable to go in for the term loan rather than an overdraft facility. In another case, an amount of USD 100,000 is needed for 18 days whereas a term loan is for a minimum of 30 days. Once again the reader can determine the breakeven gap above which it is preferable to take the loan and place the funds in a deposit during the days they are not needed.

All-in cost must be determined on a post-tax basis. Withholding taxes, deductibility of interest, fees and other charges related to a funding facility, tax treatment of inter-subsidiary interest payments and tax treatment of exchange gains and losses if funding is availed of in a different currency, are among the issues which must be carefully analysed.

Centralized Cash Management System

MNCs will have divisions/subsidiaries in different countries. Each of the subsidiary or division will have cash positions, receivables and payables in the same currencies or different currencies. The composition of receivables and payables and cash can be in any combination. One division may have huge receivables in the US dollar and hedged with a short position while another division which has a huge dollar payable, might have hedged with a long position with the same maturity. Similarly, one division may be having a surplus cash position while another division in another country may be having a cash deficit and borrowing at a high cost. These type of situations warrant proper cash management systems. To overcome these type of problems for cash management, MNCs resort to centralized cash management system.

Advantages

i. Netting: In large MNC’s, intra-corporate transactions among various subsidiaries of the parent company or subsidiaries with parent corporate are a common feature. As a consequence there will be receivables and payables among the group subsidiaries resulting in cash inflows and outflows in different currencies. At times the inflows and outflows between two subsidiaries may have matching maturities or may have maturity mismatches. If the receivables and payables are of different currencies, the transaction costs can be higher.

In a centralized cash management system all cash transactions of group companies are settled through a single point.

In such circumstances, netting is possible whereby the receivables are netted out against payables and net cash flows are settled among the group subsidiaries.

When we are considering the transactions between the subsidiaries, leading and lagging of receivables/ payables is possible to enable matching of maturities. Netting with other corporate entities is also possible.

ii. Management of currency exposure: Another advantage of centralized cash management system is exchange risk management. In a centralized cash management system, the parent can evolve a corporate strategy for exchange risk management keeping overall position of receivables and payables in different currencies of the various subsidiaries in mind. This strategy will reduce the transaction cost of the hedging which otherwise would be incurred by each subsidiary individually.

iii. Pooling of cash: Each of the subsidiary will maintain certain amount of liquid position. Some of the subsidiaries may have surplus cash whereas some others may have a deficit. In a centralized cash management system, the center may pool up the cash from surplus subsidiaries for transfer to the deficit units. This will eliminate borrowing cost to the deficit units. The existence of cash pooling center will reduce the burden of cash management at the subsidiary level.

Guest

Posted on 21 December 2009

Problems involved in Centralized Cash Management System

1. Cash requirement in domestic currency for a subsidiary is quite unpredictable. A centralized cash pooling system sometimes may cause hardships to the subsidiary if unforeseen expenditure is to be met by the subsidiary. The parent should evolve a centralized cash pooling system which enables the subsidiary to meet urgent cash requirements.

2. Even the transfer of funds involves cost. Hence centralized cash management system should ensure that fund transfer events are not too many by the pooling center and the system is cost effective in nature.

3. Even in these days of electronic fund transfer systems; delays in fund transfers and making cash available to the subsidiary are possible.

4. Exchange control regulations of the country where the subsidiary is located will have a serious impact on cash inflows and outflows from subsidiaries to other group corporates or to the parent company.

5. Tax structure in the countries where the subsidiaries are located will be another important factor in centralized cash management system. Cash management system should ensure that the transfer of funds from one subsidiary to another should be cost effective even if the total borrowing cost inclusive of withholding tax at cash surplus center is taken into consideration.

6. A decentralized cash management system can benefit from the proximity of various subsidiaries to major financial centers in the world. A centralized cash management system is generally located at the same place as the parent company, which may not be near any major financial center. This may act as a drawback.

Optimal Worldwide Cash Levels

Centralized cash management typically involves the transfer of an affiliate's cash in excess of minimal operating requirements into a centrally managed account, or cash pool. Some firms have established a special corporate entity that collects and disburses funds through a single bank account.

With cash pooling, each affiliate need hold locally only the minimum cash balance required for transactions purposes. All precautionary balances are held by the parent or in the pool. As long as the demands for cash by the various units are reasonably independent of each other, centralized cash management can provide an equivalent degree of protection with a lower level of cash reserves.

Another benefit from pooling is that either less borrowing need be done or more excess funds are available for investment where returns will be maximized. Consequently, interest expenses are reduced or investment income is increased. In addition, the larger the pool of funds, the more worthwhile it becomes for a firm to invest in cash management expertise. Furthermore, pooling permits exposure arising from holding foreign currency cash balances to be centrally managed.

Taking over control of an affiliate's cash reserves can create motivational problems for local managers unless some adjustments are made to the way in which these managers are evaluated. One possible approach is to relieve local managers of profit responsibility for their excess funds. The problem with this solution is that it provides no incentive for local managers to take advantage of specific opportunities that only they may be aware of.

An alternative approach is to present local managers with interest rates for borrowing or lending funds to the pool that reflect the opportunity cost of money to the parent corporation. In setting these internal interest rates (IIRs), the corporate treasurer, in effect, is acting as a bank, offering to borrow or lend currencies at given rates. By examining these IIRs, local treasurers will have a greater awareness of the opportunity cost of their idle cash balances, as well as an added incentive to act on this information. In many instances, they will prefer to transfer at least part of their cash balances (where permitted) to a central pool in order to earn a greater return. To make pooling work, managers must have access to the central pool whenever they require money.

ACCOUNTS RECEIVABLE MANAGEMENT

Firms grant trade credit to customers, both domestically and internationally, because they expect the investment in receivables to be profitable, either by expanding sales volume or by retaining sales that otherwise would be lost to competitors.' Some companies also earn a profit on the financing charges they levy on credit sales.

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Posted on 21 December 2009

The need to scrutinize credit terms is particularly important in countries experiencing rapid rates of inflation. The incentive for customers to defer payment, liquidating their debts with less valuable money in the future, is great. Furthermore, credit standards abroad are often more relaxed than in the home market, especially in countries lacking alternative sources of credit for small customers. To remain competitive, MNCs may feel compelled to loosen their own credit standards. Finally, the compensation system in many companies tends to reward higher sales more than it penalizes an increased investment in accounts receivable. Local managers frequently have an incentive to expand sales even if the MNC overall does not benefit.

The effort to better manage receivables overseas will not get far if finance and marketing don't coordinate their efforts. In many companies, finance and marketing work at cross purposes. Marketing thinks about selling, and finance thinks about speeding up cash flows. One way to ease the tensions between finance and marketing is to educate the sales force on how credit and collection affect company profits. Another way is to tie bonuses for salespeople to collected sales or to adjust sales bonuses for the interest cost of credit sales. Forcing managers to bear the opportunity cost of working capital ensures that their credit, inventory, and other working-capital decisions will be more economical.

Credit Extension

Two key credit decisions to be made by a firm selling abroad are the amount of credit to extend and the currency in which credit sales are to be billed. Nothing need be added here to Chapter 9's discussion of the latter decision except to note that competitors will often resolve the currency-of-denomination issue.

The easier the credit terms are, the more sales are likely to be made. Generosity is not always the best policy. Balanced against higher revenues must be the risk of default, increased interest expense on the larger investment in receivables, and the deterioration (through currency devaluation) of the dollar value of accounts receivable denominated in the buyer's currency. These additional costs may be partly offset if liberalized credit terms enhance a firm's ability to raise its prices.

The bias of most personnel evaluation systems is in favor of higher revenues, but another factor often tends to increase accounts receivable in foreign countries. An uneconomic expansion of local sales may occur if managers are credited with dollar sales when accounts receivable are denominated in the local currency. Sales managers should be charged for the expected depreciation in the value of local currency accounts receivable. For instance, if the current exchange rate is LC 1 =$0.10, but the expected exchange rate 90 days hence (or the three-month forward rate) is $0.09, managers providing three-month credit terms should be credited with only $0.90 for each dollar in sales booked at the current spot rate.

Whether judging the implications of inflation, devaluation, or both, it must be remembered that when a unit of inventory is sold on credit, a real asset has been transformed into a monetary asset. The opportunity to raise the local currency selling price of the item to maintain its dollar value is lost. This point is obvious, but is frequently disregarded.

Assuming that both buyer and seller have access to credit at the same cost and reflect in their decisions anticipated currency changes and inflation, it should normally make no difference to a potential customer whether it receives additional credit or an equivalent cash discount. However, the MNC may benefit by revising its credit terms in three circumstances:

1. The buyer and seller hold different opinions concerning the future course of inflation or currency changes, leading one of the two to prefer term/price discount trade-offs (that is, a lower price if paid within a specified period).

2. The MNC has a lower risk-adjusted cost of credit than does its customer because of market imperfections. In other words, the buyer's higher financing cost must not be a result of its greater riskiness.

3. During periods of credit restraint in a country, the affiliate of an MNC may have access to funds (because of its parent) that local companies do not have and may, thereby, gain a marketing advantage over its competitors. Absolute availability of money, rather than its cost, may be critical.

The following five-step approach enables a firm to compare the expected benefits and costs associated with extending credit internationally:

1. Calculate the current cost of extending credit.

2. Calculate the cost of extending credit under the revised credit policy.

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Posted on 21 December 2009

3. Using the information from steps 1 and 2, calculate incremental credit costs under the revised credit policy.

4. Ignoring credit costs, calculate incremental profits under the new credit policy.

5. If, and only if, incremental profits exceed incremental credit costs, select the new credit policy.

INVENTORY MANAGEMENT

Inventory in the form of raw materials, work in process, or finished goods is held (i) to facilitate the production process by both ensuring that supplies are at hand when needed and allowing a more even rate of production and (2) to make certain that goods are available for delivery at the time of sale.

Although, conceptually, the inventory management problems faced by multinational firms are not unique, they may be exaggerated in the case of foreign operations. For instance, MNCs typically find it more difficult to control their overseas inventory and realize inventory turnover objectives. There are a variety of reasons: long and variable transit times if ocean transportation is used, lengthy customs proceedings, dock strikes, import controls, higher duties, supply disruption, and anticipated changes in currency values.

Production Location and Inventory Control

Many U.S. companies have eschewed domestic manufacturing for offshore production to take advantage of both low-wage labor and a grab bag of tax holidays, low-interest loans, and other government largess. But a number of firms have found that low manufacturing cost isn't everything. Aside from the strategic advantages associated with U.S. production, such as maintaining close contact with domestic customers, onshore manufacturing allows for a more efficient use of capital. In particular, because of the delays in international shipment of goods and potential supply disruptions, firms producing abroad typically hold larger work-in-process and finished goods inventories. The result is higher inventory-carrying costs.

Advance Inventory Purchases

In many developing countries, forward contracts for foreign currency are limited in availability or are nonexistent. In addition, restrictions often preclude free remittances, making it difficult, if not impossible, to convert excess funds into a hard currency. One means of hedging is to engage in anticipatory purchases of goods, especially imported, items. The trade-off involves owning goods for which local currency prices may be increased, thereby maintaining the dollar value of the asset even if devaluation occurs, versus forgoing the return on local money market investments.

For example, suppose that Volkswagen do Brasil is trying to decide how many months' worth of components to carry in inventory. The present price of a component is DM 100, and this price is rising at the rate of 0.5% monthly. The Deutsche mark holding cost is estimated at 1 % monthly, including insurance, warehousing, and spoilage, but excluding the opportunity cost of funds. Under these circumstances, where holding costs exceed anticipated cost increases by 0.5% monthly, Volkswagen should maintain the minimum parts inventory necessary to achieve its targeted output in Brazil.

Assume now that Volkswagen has excess cruzeiro balances in Brazil on which it is earning a nominal monthly rate of 2%. However, under Brazil's system of mini-devaluation, the cruzeiro is expected to devalue against the Deutsche mark by 3% in each of the next three months, 2% in the fourth month, and 1% thereafter. Since other investment opportunities are limited or nonexistent because of currency and financial market controls, VW's opportunity cost of funds in Deutsche marks (the 2% nominal rate it earns on cruzeiros less the expected devaluation) for the next six months, month by month, equals

Month	Opportunity Cost of Funds (%)
1	-1
2	-1
3	-1
4	0
5	1
6	1

Adding this opportunity cost of funds to the previously given monthly holding costs of 1 % yields the total monthly individual and cumulative DM costs of carrying inventory for the next six months:

Beginning Month	Total Monthly Carrying Cost (%)	Cumulative Carrying Cost (5 mos.)	Cumulative Price Increase (%)
1	0	0	0.0
2	0	0	0.5
3	0	0	1.0
4	1	1	1.5
5	2	3	2.0
6	2	⁵	2.5

Based on the cumulative carrying costs and price increases, it is now apparent that the existence of anticipated cruzeiro devaluations, unmatched by correspondingly higher nominal interest rates—that is, the international Fisher effect is not expected to hold—should lead Volkswagen do Brasil to hedge a portion of its cash balances by purchasing four months' worth of inventory at today's prices (and at today's DM : cruzeiro exchange rate). In other words, it will pay Volkswagen to purchase this amount of inventory in advance in order to minimize losses in the real value of its cruzeiro cash balances.

Inventory Stockpiling

Because of long delivery lead times, the often limited availability of transport for economically sized shipments, and currency restrictions, the problem of supply failure is of particular importance for any firm that is dependent on foreign sources These conditions may make the knowledge and execution of an optimal stocking policy, under a threat of a disruption to supply, more critical in the MNC than in the firm that purchases domestically.

The traditional response to such risks has been advance purchases. Holding large amounts of inventory can be quite expensive, though. In fact, the high cost of inventory stockpiling—including financing, insurance, storage, and obsolescence—has led many companies to identify low inventories with effective management. In contrast, production and sales managers typically desire a relatively large inventory, particularly when a cutoff in supply is anticipated.

Some firms do not charge their managers’ interest on the money tied up in inventory. A danger is that managers in these companies may take advantage of this situation by stockpiling sufficient quantities of material or goods before a potential cutoff in order to have close to a zero stock-out probability. Such a policy, established without regard to the trade-offs involved, can be very costly. For example, "In Singapore possible curtailment in shipments of air conditioners led to such heavy advance ordering that for the next two years the market was completely saturated because the warehouses were full of air conditioners. Such an asymmetrical reward structure will distort the trade-offs involved. The profit performances of those managers who are receiving the benefits of additional inventory on hand should be adjusted to reflect the added costs of stockpiling.

It is obvious that as the probability of disruption increases or as holding costs go down, more inventories should be ordered. Similarly, if the cost of a stock-out rises or if future supplies are expected to be more expensive, it will pay to stockpile additional inventory. Conversely, if these parameters move in the opposite direction, fewer inventories should be stockpiled.

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