Spotech Co.'s budgeted sales and budgeted cost of sales for the coming year are $212,000,000 and $132,500,000, respectively. Short-term interest rates are expected to average 5%. If Spotech could increase inventory turnover from its current eight times per year to 10 times per year, its expected cost savings in the current year would be:
The key to this problem is to determine how much inventory is reduced by the increased inventory turnover and the resulting savings in interest costs due to reduced working capital requirements. A company must either borrow funds to acquire working capital or give up the next best investment opportunity to fund working capital requirements (opportunity cost). Either way, it costs a company to hold inventory. Any reduction in inventory levels reduces that cost.The formula for inventory turns is annual cost of sales divided by inventory.
Solve for inventory by dividing annual cost of sales by inventory turns. Initially, Spotech has an inventory level of $16,562,500 ($132,500,000 divided by 8 turns). Spotech hopes to decrease the level to $13,250,000 by increasing inventory turns to 10 ($132,500,000 divided by 10 turns). Working capital is reduced by this change in inventory ($16,562,500 - $13,250,000 = $3,312,500). The interest avoided on the $3,312,500 represents a savings of $165,625 ($3,312,500 × 5%).