A

Total cost

Carrying costs Shortage costs

Amount of current assets (CA)

Total cost

Carrying costs Shortage costs

Amount of current assets (CA)

A flexible policy is most appropriate when carrying costs are low relative to shortage costs.

B. Restrictive policy

Dollars

" Minimum point

" Minimum point

CA*

Amount of current assets (CA)

A restrictive policy is most appropriate when carrying costs are high relative to shortage costs.

© The McGraw-Hill Companies, 2002

Edition, Alternate Edition

CHAPTER 19 Short-Term Finance and Planning 651

current assets are zero and then climb steadily as current assets grow. Shortage costs start out very high and then decline as we add current assets. The total cost of holding current assets is the sum of the two. Notice how the combined costs reach a minimum at CA*. This is the optimal level of current assets.

Optimal current asset holdings are highest under a flexible policy. This policy is one in which the carrying costs are perceived to be low relative to shortage costs. This is Case A in Figure 19.2. In comparison, under restrictive current asset policies, carrying costs are perceived to be high relative to shortage costs, resulting in lower current asset holdings. This is Case B in Figure 19.2.

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