Managing Inventory for Entrepreneurial Firms with Trade Credit and Payment Defaults

Abstract

This paper considers an entrepreneurial firm that periodically orders inventory to satisfy demand in a finite horizon. The firm offers trade credit to its customer while receiving one from its supplier. In addition to standard inventory-related costs, cash-related costs are incurred in each period. The cash-related cost is composed of a default penalty cost due to a cash shortage and an interest gain (negative cost) due to excess cash after inventory payments. The objective is to obtain an inventory policy that maximizes the working capital at the end of the horizon. We show that this problem is equivalent to that of minimizing the total inventory related cost and the cash-related cost in the horizon. The model with ample cash reduces to the traditional inventory model. For the general model, we prove that a state-dependent policy is optimal. To facilitate implementation and reveal insights, we consider a simplified model in which a myopic policy is optimal. A numerical study suggests that the myopic policy is effective for the original system. The myopic policy generalizes the classic base-stock policy and resembles practical working capital management under which firms make inventory decisions according to their working capital status. The policy parameters have closed-form expressions, which show the impact of demand and cost parameters on the inventory decision. Our study assesses the value of considering financial flows when the firm makes the inventory decision and reveals insights that are consistent with empirical findings in the literature.