If the firm where to be interested in maintaining a financial policy that is restrictive with it current assets, it might choose to; keep less cash on hand, not make any large investments in marketable securities, keep investments in inventory small, and minimizing credit sales, reducing accounts receivable.
Carrying costs are the opportunity costs that are associated with the current assets. Carrying costs rise as the level of investment in current assets increases. The rate of return on carrying costs is very low, when compared to other assets. Carrying costs can include interest lost on money invested in inventory, storage cost, taxes, insurance, and any other expense incurred from maintaining inventory. A reduction of current assets (or inventory) would typically decrease a firm's carrying costs.
Shortage costs occur when investments in current assets is low. Shortage costs fall as the level of investment in current assets increases. The two types of shortage costs are trading or order costs (costs for placing an order for more cash or inventory) and costs related to lack of safety reserves (lost sales, customer goodwill, missed production schedules, etc...).
The steps used to determine the optimal investment in current assets are to measure the trade-off between carrying and shortage costs. We must look at the costs measured in dollars and the amount of current assets. Carrying costs start at 0 when current assets are at 0, and grow as we add assets. Shortage costs start out high, and decline when we add current assets. The total costs of holding current assets, is the sum of the two. On a graph, where the point of the combined costs are at a...