Download - Lesson 23 Working Capital Management (1)
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Accounting and Finance for
Managers
304
23.0 Aims and Objectives
23.1 Introduction
23.2 Objectives of the Working Capital Management
23.3 Approaches of the Working Capital
23.4 Determinants of Working Capital
23.5 Working Capital Policies
23.6 Estimation of Working Capital Requirement
23.7 Cash Management
23.7.1 Motives of Holding Cash
23.7.2 Objectives of Cash Management
23.7.3 Basic Problems of Cash Management
23.8 Management of Inventories
23.8.1 Meaning of Inventory
23.8.2 Why Inventory is to be Controlled?
23.8.3 Major Benefits of Inventory Control
23.8.4 Centralised Stores
23.8.5 Decentralised Stores
23.8.6 Central Stores and Sub Stores
23.8.7 Recording Level
23.8.8 Minimum Level/Safety Level
23.8.9 Maximum Level
23.8.10 Danger Level
23.8.11 Average Stock Level
23.8.12 Economic Ordering Quantity
23.8.13 ABC Analysis
23.8.14 VED Analysis
23.9 Receivables Management
23.9.1 Concept of Receivables Management
23.9.2 Objectives of Accounts Receivables
23.9.3 Cost of Maintaining the Accounts Receivables
23.9.4 Factors Affecting the Accounts Receivables
23.9.5 Management of Accounts Payable/Financing the Resources
23.10 Various Committee Reports on Working Capital
23.10.1 Dheja Committee Report 1969
Contd...
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(i)
(ii)
23.10.2 Tandon Committee Working Capital Management
23.10.3 Chore Committee Report 1979
23.10.4 Marathe Committee Report 1984
23.11 Let us Sum up
23.12 Lesson-end Activity
23.13 Keywords
23.14 Questions for Discussion
23.15 Suggested Readings
After studying this lesson you will be able to:
describe the objectives of working capital management
know how to analyse the needs of working capital
(iii) describe how to manage receivables and payables
(iv) explain how inventory is managed in a company.
The working capital is the amount revolving capital to meet the day today requirements
of the firm. The other facets of the working capital is circulating capital, floating capital
and moving capital which are required to meet the immediate requirements of the firm.
The "working capital" means the funds available for day today operations of the enterprise.
It also represents the excess of current assets over the current liabilities which include
the short-term loans.
Accounting standards Board, The institute of Chartered Accountant of India note the
ASB has used the term working capital and not Net working capital.
The working capital requirements are normally estimated to the tune of production policies,nature of the business, length of manufacturing process, credit policy and so on.
The requirement of the working capital should be met
with the help of long term and shot term resources. The permanent and temporary
working capital requirements should be met out of long term and short term financial
resource respectively.
The approaches of the working capital are classified into two categories viz the hedging
approach and conservative approach:Under this approach, the maturity of the financial resources
are matched with the nature of assets to be financed.305
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(i)
(ii)
(i)
(ii)
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Accounting and Finance for
ManagersPermanent working capital are financed by the long-term financial resources and theseasonal working capital requirements are met out through short term financial resources.
Acc to this approach, all requirement of the funds should met
out long-term sources. The short-term resources should be only for emergency requirements.
Following are the major determinants of the working capital:
The nature of the business should be considered for the
determination of working capital only to the tune of i) cash nature of business ii) sale of
services rather than commodities:
These are things considered only on the basis of stock , book volume of debts and so on.
The need of the working capital is determined on the basis of duration
of the production cycle. The time duration taken by the manufacturing process should be
considered from the stage of raw materials to the stage of finished goods. If the duration
is lengthier may require the firm to keep more amount of working capital to meet out the
requirements and vice versa.
The cycle of the business should be relatively considered for the need
of working capital. The upswing of the business cycle requires the business venture to
invest more amount of working capital due more volume of sales, results out of huge
volume of stock, book debts and so on. During the downswing of the business require
the business to have only lesser volume of working capital due lesser volume of business
and so on.
The working capital requirement is determined on the basis of
production policy of the firm. Normally the production policy of the firm is classified on
the basis of two methodologies:
The firm produces the goods then and there to the tune of immediate needs of themarket. This may require the firm to meet adversities due to lack of working capital
to meet out, due to in adequate planning. During the peak season, it requires
enormous working capital which may disturb working conditions of the business
venture.
The steady production policy by considering the futuristic demands, which will not
disturb the long-term prospects of the business venture due to effective planning.
The credit policy of the firm is another determinant for the determination
of the working capital. There are two different credit policies viz liberal and stringent
credit policies
The liberal credit policy may lead to have greater volume ofbook debts, greater credit period, huge amount required for the built of stock; require
the firm to have greater amount of working capital
Would not require that much of working capital like the
earlier segment.
The growth and expansion prospects of the firm should be
appropriately determined in order to identify the volume of working capital required
during the future, unless otherwise that will badly affect the future development of the
firm.
If the shortage of raw materials is acute,
the firm is required to keep sufficient volume of working capital to have smooth flow ofproduction process without any interruptions. In such cases the firm should have additional
volume of working capital not only to avoid interruptions during the production process
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iii)
i)
ii)
iii)
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due lack of supply of raw materials, but also to enjoy greater trade discounts during the
bulk purchase in order to bring down the purchase cost of the raw materials.
It is one of the major sources of working capital and practically speaking it is
one of the sources of cash from operations. To maintain the liquidity, the net profit
earning capacity should be maintained forever.
The cash dividend payment leads to greater amount of cash outflows
which are more essential to the value of the firm to be maintained. The value of the firm
could also be alternately maintained by either through the declaration of bond dividend or
stock dividend or property dividend. The later specified methodologies facilitate the firm
to postpone the cash out flow which normally evade the immediate cash requirement.
The depreciation policy of the firm not only facilitates to bring
down the taxable liability but also brings down the profit which enhances the liquidity of
the firm on the other side.
The price level changes require the firm to keep more amount of
working capital to go hand in hand with the price changes which normally affect the
firm's liquidity position. During the per iods of inflation, the firm is required to anticipate
the price level changes which drastically affect the working capital position of the firm.
The working capital has to be adequately managed by the firm , neither more nor lessthan its requirement to meet out the needs. If the working capital is more than therequirement means that the firm is expected to unnecessarily keep short-term assetsidle in state and vice versa. The maintaining of the working capital management is mainlydepending upon three major influences of the organizations
Working Capital Management
i)
ii)
Profitability
Liquidity and
Structural health of the organisation
Why the study of Management of working capital is required ?
If the working capital is less than the requirement means that the volume of current
assets are inadequate to meet the short term obligations of the firm on time, which maylead to disrepute the name and fame of the organisation.
Contradictorily to the above, if the firm keeps more working capital that means more
volume of current assets are maintained in the investment structure to meet out the shortterm obligations of the firm which poses more liquidity but on the other hand it hurdles
the righteous opportunity to invest in the fixed assets to earn more income. The excessivevolume of current assets drastically affects the profitability of the firm due to excessliquidity out of more amount of current assets.
As a firm should always maintain the righteous volume of working capital not only to
maintain the liquidity of the firm but also to earn adequately from the investment volumeof fixed assets.
The working capital management policies are studied in the following context viz
Concerned with profitability, liquidity and risk of the firm
Concerned with the composition of the current assets
Concerned with the composition of the current liabilities
There are two major types of working capital policies
Conservative policy of working capital:
Under this policy, the firm minimizes risk by maintaining a higher level of current assets
in meeting the liquidity of the firm.
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Accounting and Finance for
ManagersAggressive policy of working capital:
Under this policy , the firm enhances the risk by way of reducing the working capital in
order to earn more and more profits.
The following is the proforma of the working capital requirement
Statement of working capital required
i)
ii)
iii)
iv)
v)
Cash
Debtors
Stocks
Advanced payments
Others
XXXX
XXXX
XXXX
XXXX
XXXX
Creditors XXXX
ii)
iii)
Lag in payment of expenses
Outstanding expenses if any
XXXX
XXXX
Working capital (Current assets-Current liabilities) XXXX
Add: Provision for contingencies
Net working capital required
X X X X
XXXX
Prepare an estimate of working capital requirement from the following data of the XYZ
Ltd.
Projected annual sales volume
Selling price
2,00,000 units
Rs.10 per unit
c) % of net profit on sales
Average credit period allowed to customers
Average credit period allowed by suppliers
Average holding period of the inventories
25%
8 weeks
4 weeks
12 weeks
Allow 10% for contingencies
Debtors (8 weeks)Rs.15,00,000 8/52(At cost)
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i)
a)
b)
d)
e)
f)
g)
eks) Rs.15,00,000 12/52
Less Current liabilities
Creditors (4 weeks) Rs15,00,000 4/52
Net working capital
Add: 10% contingencies
2,30,769.23
3,46,153.38
1,15,384.61
4,61,538.0
46,153.8
308 Working capital required 5,07,691.8
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1.
2.
(i)
(ii)
(a)
(b)
(a)
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The recent release of the finance minister during the budget session on thespecial excise duty on the cement industry.
How the construction industry is affected ? In what way? Which factor of
influence affects the firm?
The management of cash resources should not be only in a position to afford liquidity but
also it should not require the firm to keep the cash resources simply idle; which should be
invested in the marketable securities to earn some rate of return whenever the firm feel
excessive holding of cash resources.
If the cash outflows are more than that of the cash inflows, the
firms are expected to maintain the cash resources.Some times the firm may be required to meet out the contingent
needs which could not be foreseen during its life span; warrants the adequate maintenance
of working capital.
It is a motive holding the cash resources by the firm to exploit the
opportunities available in the market. If the vendor of raw materials announces that
there is a greater discount towards the bulky purchase of raw materials, may lead the
firm to bring down the cost of purchase. For which, the cash resources are required and
made use of to the tune of announcements.
Banks provide certain services to the firms only on the basis of
the certain amount of balances in the accounts. That is the motive holding cash resourcesto avail services from the banker viz compensation motive.
Meeting of cash requirements on time which
normally involves in the maintenance of the goodwill of the firm. The firm should
keep the adequate cash balances to meet the requirement which are greater in
importance.
The funds locked up in the
form of cash resources should be more, but it should only to the tune of the requirement.
(i)
Through the preparation of the budget, the
cash requirement could be identified which would normally facilitate the firm
to trim off the excessive cash in holding.
The separate amount
should be maintained for the purpose to meet out the discrepancies which are
not easily foreseen.
(ii)
The amount of collection from the local branches
are normally deposited in a particular account of the firm, as soon as the
Working Capital Management
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Accounting and Finance for
Managersdeposit has reached the certain limit , the amount in the respective branch
account will be transferred to the account at where the firm maintains in the
head office. This process of transfer is normally taking place only through
telegraphic transfer during the early days but on now a days the anywhere
banking is facilitated to transfer the amount of deposit instantaneously.
The process of collection is carried out with the help of
local post offices only in order to avoid the postal delays in the transit . Thissystem enhances the speed of the collection at rapid and finally the local
branch messenger collects the cheques from the parties through specified
post box allocated for the process of collection.
(iii)
The centralizing the process of
payment may facilitate the enterprise to take advantage of time in settling the
payments i.e., reduces the need of immediate cash requirements.
It is another methodology to avail the
maximum possible credit period to postpone the payment by making use of
the cash resources most effectively.
(iv)
Identify the excessive cash
resources which are kept simply idle more than the requirement.
After identifying
the various investment opportunities , the excessive cash resources should be
invested to earn appropriate rate of return during the slack season at when
the firm does not require greater volume of working capital and vice versa.
Explain the modern instruments available in the financial market to entertain
the cash management strategies.
2. 1. Cash means
a) Cash in hand b) Cash in hand and at bank
Cash in hand, at bank and near d) None of the above
cash i.e marketable securities
To avail the trade discount at the moment of bulk purchase is
Transaction motive
Compensating motive
Stretching cash payment is
Controlling the cash inflow
Speculative motive
Precautionary motive
Controlling cash outflows
c) a) & b) d) None of the above
The inventory includes the following :
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(b)
(a)
(b)
(a)
(b)
1.
c)
2.
a) b)
c) d)
3.
a) b)
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It means that the value of the raw materials stored for
the purpose of production in the storage yard. The stock of raw materials can be
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classified normally into two categories viz opening stock and closing stock of raw
materials.
During the production process, the firm usually stores
the semi finished goods which are neither a raw materials nor finished goods. The
purpose of the storage of work in progress in order to shorten the time duration to
manufacture the finished goods. The value of the semi finished / work in progress
stored in the storage house may be classified into two categories viz opening stockand closing stock. The finalizing the value of the stock of the work in progress is
inevitable process in transfer pricing. The value of the work in progress normally
expressed in two different ways viz on the basis of prime cost and works cost.
This is the stage at which the goods are readily available
for selling in the market. The value of the stock of the goods is computed on the
basis of cost of production.
Stock of Stores supplies, components and accessories.
Working Capital Management
The ultimate purpose of controlling the inventory arises only due to the conflicting and
heterogeneous objectives of the various functional departments of the organizations.
How inventory influences the various department of the organization ?
Normally, the inventory influences on the following departments viz Production Purchase,
Finance and Sales department How it influences the various departments at a time
together.
The manager production frequently insists the
organisation to maintain the continuous and uninterrupted supply to have smooth flow
production. This requires the production manager to build ample stock of raw materials.This is routed through the purchase requisition by the manager production to the purchase
manager.
Due to the influence from the production manager,
the purchase department is demanded to procure the requirements. As per the requisition
of the production department, meeting the requirements is not tough task but the
department should know about the financial intricacies of the organisation through the
finance department which is especially meant for the purpose.
Lesser the quantum of purchase will lead to lesser financial commitment but expected toloose the benefits out of the bulk procurement. Not advisable for the materials which
are in scarcity.
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Accounting and Finance for
ManagersDue to the market pressure/greater demand of the products
require the sales department to supply the goods in time as well as to meet the needs and
demands of the intermediaries and consumers. To supply them in time, the sales manager
need not wait for the production cycle to be completed to produce the finished goods. To
save time, the sales manager must be given ample facility to store the finished goods in
the depot not only to meet the needs but also traps and drags the existing customers and
consumers.
On/of the Finance department : Due to influence from the department of the production,
purchase and sales departments, the finance department is required to concentrate on
the various angles.
It is the only department bearing a difference of opinion in maintaining more volume of
inventory in the firm; which certainly slashes the earning capacity of the firm due to least
volume of assets deploy on the productive purpose.
For e.g. The famous MNC Jindal Corporation Ltd. has wound up its operations at
industrial site in Bangalore due to the cost of raw materials cost. The transportation cost,
acquisition cost of copper ore gone up due to escalated cost in the biz market. They
were neither to store nor to transport more and more which led to the winding up of
operations of the enterprise at Bangalore.
The following diagram will obviously facilitate the Inventory Control:
PurchaseDepartment
FinanceDepartment
Production
Department
SalesDepartment
Inventory control means that maintenance of desired level of inventoryby way of taking into the economic interest of the firm.
The economic interest of the firm differs from one functional dept. to another due to the
heterogeneous objectives. The economic desired benefits of the dept. are illustrated to
the tune of the preceding illustrated diagrams.
Benefits towards less production cost through mass production.
Benefits towards discounts, carrying cost and so on.
Timely supply of the goods to the requirements, facilitates the firm
to earn greater volume of earning. To reduce the operating cycle in duration in order to
realize the economic benefits as early as possible.
Benefits towards the carrying cost, storage cost of the entire312 inventory.
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b)
c)
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It leads to effective utilization of funds only through an appropriate investment on
inventory
It facilitates to obtain the economic supply of raw materials
It possess the firm comfortably to meet the needs and wants of the consumers in
time
It neither allows the firm to undergo the practices of overstocking nor understocking.
It leads to effectiveness in the material handing which reduces the wastage, pilferage
and so on.
Before discussing the methods of inventory control, every one must obviously understand
the organization of the stores department. The stores department is the only department
which applies all the techniques of inventory control.
The organization of the inventory control are various in dimensions . The organization of
differs from one industry to another industry, one firm to another within the same industry,from one nature to another, from volume to another. They are as follows:
Working Capital Management
a) Centralised stores
Decentralised stores
Central and Sub stores
Under this type, the materials are received by and issued at one central place by thedepartment to the requirements of the other functional departments.
The following diagram will facilitate to understand the organisation structure of the
centralized stores of the manufacturing department. The materials are continuously
received by the stores dept. through the purchase department and the received material
are distributed to the various assisting departments.
This type of organization of stores control has its own advantages and disadvantages in
application
The major advantages are following:
It requires less space
It facilitates to minimize the stock investment
The centralization leads to lower administrative and maintenance cost of stores
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Accounting and Finance for
ManagersIn addition to the advantages, the present organization suffers with its own limitation
while in applications; which are following:
The centralization of stores leads to enhance the cost of transportation as well as
handling cost of materials.
The centralized system leads to lot of inconvenience and delay to other department
due to distance
There is a greater risk of calamity loss of materials which are stored under one
roof
The success is subject to the effectiveness of the transportation
Under this method, the separate stores are maintained by the departments on their own
as well as run by the exclusive store keeper. It ensures the smooth flow material to the
tune of requirements and reduces the time involved in the transit of materials from the
stores to the respective departments. The following diagram will facilitate to have an
insight on the organization of the stores.
This is a method which attempts to discard the bottlenecks of the above mentioned as
well as brings forth unique organization of stores. Under this method, each department is
given separate sub store which is within easier access and shorter in distance to supply
the material requirements through the store keeper. The sub store keeper should have to
make requisition to central stores where all the materials are centrally procured and
supplied then and there to the tune of the individual departments.
C e n t r a l S t o r e
S u b S t o r e
W e l d in g D e p t
S u b S t o r e
P l a n n i n g D e p t
P r o d u c t i o n D e p t
The role of the store keeper is most inevitable in controlling the stores. While controlling
the stores, the store keeper should neither disturb the production process nor undergo
the practices of overstocking. By earmarking the above enlisted objectives, every store
keeper is led by the various methods of inventory valuation in addition to various methods
of requisitioning of material.
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First we will discuss, the various methods of requisitioning of materials.
This is the level at which the firm should go for fresh purchase requisition of material
through the store keeper to meet the requirements. The reordering level which takes
into consideration of minimum level of consumption of raw material during the course of
production process as well as the amount material required by the firm during period ofpurchase and goods in transit immediately after the order.
Reordering Level
Working Capital Management
Minimum Level
Amount of materials required
during the periods of consumption
Reordering level=Minimum level of stock for uninterrupted flow of production process
+
Amount of materials required during the periods of consumption
Or
Lead time stock level
Alternate method is available by using the maximum consumption and maximum re-order period
Re ordering level= Maximum consumption Maximum Re- order period
This method registers the maximum consumption of the firm during the production as
well as the maximum time period required for the supply of required materials.
Under this alternate approach, the firm at any moment will not face any difficulties due
to short supply or insufficient amount of materials.
The firm should at always maintain minimum amount of material in its hands to facilitate
the flow of production process as unaffected .due to short fall in the quantum of materials.
The following points are most important in designing the minimum level of stock:
Lead time should be predominantly considered to determine the time lag in between
the materials ordered and received. The firm should find out the practical difficulty
of the vendor in supplying the material for the determination for minimum level of
stock.
Amount of consumption of the material during the lead time
Minimum stock level=Reordering level- (Normal level consumption Normal Reorder
period)
Minimum level = Reorder level + (Average level of consumption Average Reorderperiod)
Average and normal level of consumption are synonymous with each other. If normal or
average consumption is not given, the formula is as follows
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Accounting and Finance for
Managers Average consumption = Minimum level consumption + Maximum level consumption
2
This is the level at which the firm holds maximum quantity of materials as stock during
the process. The ultimate aim of fixing the level of maximum level is that to avoid the
overstocking. If the stock level of the firm exceeds the maximum level already fixed is
known as overstocking level of the firm, more than the requirement.
Why over stocking is considered not advisable ?
It leads to excessive investment on inventory more than the requirement
It leads to unnecessary wastage of the materials due to excessive stock
The excessive storage of materials may certainly affect the price of the product
Maximum stock level= Reordering level+ Reordering quantity - (Minimum consumption
Minimum Reordering period)
At this level, the firm should not further issue any materials to the various functional
departments .At the danger level, the purchase department is vested with greater
responsibility to immediately arrange the supply of raw materials in order to maintain the
flow of production as uninterrupted.
The consumption level of the materials is getting varied from one time period to another.
During the specified period , there may be maximum consumption and minimum
consumption, which should be averaged to find the mid point in between the two, in
order to either fulfill the minimum consumption or maximum consumption to the extent
possible.
Why the maximum reorder period is taken into consideration?The purpose of considering is that the greater period taken by the supplier to supply the
required materials
Danger Level= Average consumption Maximum reorder period
Average stock level =Minimum stock level + of the reorder quantity
The ordering of materials usually tagged with three different component of costs viz:
Acquisition cost of materialsOrdering cost of materials
Carrying cost of materials
The ordering quantity of materials may be either larger or meager in volume, whichcarries its own advantages and disadvantages.
If the quantity ordered is larger in volume, the following are some of the importantadvantages:
The bulk purchase order reduces the ordering cost of the materials. The greaterthe size of the order which leads to reduce the number of the orders in procuringthe materials.
The discount can be classified into two categories viz Tradediscount and Cash discount .
316l What is trade discount ?
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=
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Trade discount is the discount granted by the supplier to the buyer of materials at themoment of bulk purchase. This % of discount is greatly possible only during the periodsof greater volume of purchase; which reduces the over all cost of the acquisition.
If the quantity is procured in meager volume, the following are construed as advantages:
The carrying cost will come down in the case of lesser inventories
The cost of storage is lesser as far as the meager quantities of materials
Loss due to deterioration, obsolescence, wastage will be minimum
Insurance cost is less due to meager volume of materials
Working Capital Management
Economic Ordering Quantity =2AO
1
A = Annual requirement in units
O = Ordering cost
I = Cost of storing per year or cost of carrying the inventory
Total cost
Rupees
Cost of carrying
Ordering cost
Units per orderInsert the picture anpve
Annual Requirement =20,000 units
Ordering cost= Rs.100 per order
Cost per unit =Rs.4
Carrying cost =16%
Determine the EOQ of the firm and finally justify the EOQ
Economic Ordering Quantity (EOQ)=2AQ
I
2 20,000 Rs.100
0.16% on Rs.4
= 2,500 units
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Accounting and Finance for
ManagersThe following Table 23.1 illustrates the justification of the EOQ at the 2,500 units level
Annual requirement of 20,000 units
Particulars
Size of the Orders
Number of order to placed
1
20,000
1
2
10,000
2
3
5000
4
4
2,500
8
5
500
40
= Total Annual Need
Size of the order
Average stock 10,000 5,000 2,500 1,250 250
= Size of the order
2
Average stock value 40,000 20,000 10,000 5,000 1,000
=Average stock cost per unit RsCarrying cost 6,400 3,200 1,600 800 160
= Average Stock value 16% Rs
Ordering cost Rs
Total cost Rs
100
6,500
200
3,500
400
2,000
800
1,600
4,000
4,160
Calculate EOQ
Annual Requirement -1600 units
Cost of materials per unit Rs.40
Cost placing and receiving -Rs.50
Annual carrying cost of inventory -10% on value
Economic Ordering Quantity (EOQ)=2AO
1
EOQ =2 1600
Rs.50
10% on Rs.40
= 200 units
Consumption during the year -600 units
Ordering cost Rs. 12 per order
Carrying cost 20%
Price per unit Rs. 20
Economic Ordering Quantity (EOQ)=2AO
1
B.Com. (Punjab)
EOQ =2 600 Rs.12
20% on Rs.20
= 60 units
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318
A manufacturer purchases certain machinery from outside suppliers Rs.60 per unit.
Total annual needs are 800 units. The following are the additional information
Annual return on investments 10%
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=
=
a)
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Rent, insurance, taxes per unit per year Rs 2
Cost of placing an order Rs.200
Determine the economic order unit
First step to find out the earnings= 10% Rs.60= Rs.6 to be earned from the investment
The amount of rent , insurance , taxes per unit year =Rs 2
I= 10% on Rs.60 + Rs.2= Rs.8
Working Capital Management
Economic Order Quantity (EOQ) =2AO
1
2 800 Rs.200
10% on Rs.60 +Rs.2
= 200 units
Given the annual consumption of material is 1,800 units , ordering costs are Rs.2 per
order, price per order price per unit of material is 32 paise and storage costs are 25% per
annum of stock value , find the economic order quantity.
(B.Com. Calicut)
Economic Order Quantity (EOQ) =2 AO
1
2 1,800 Rs.2
25% on 32 paise
= 300 units
Find out the Re ordering level from the following information
Minimum stock 1000 units b) Maximum stock 2000 units c) Time required for
receiving the material 20 days d) Daily consumption of material 100 units
Reordering level = Minimum level + Lead time stock level
The first step is to find out the Lead time stock level
Lead time stock level is nothing but the amount of stock level required by the firm, till the
next fresh receipt of goods, subject to the time normally taken by the supplier to supply.
Lead time stock level= Time required for receiving the material Daily consumption
Lead time stock level= 20 days 100 units per day= 2000 units
Reordering level= 1,000 + 2,000 units= 3,000 units
Calculate maximum level , minimum level and reordering level from the following data
Reorder quantity
Reorder period
Maximum consumption
2,000 units
8 to 12 weeks
800 units per week
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Accounting and Finance for
ManagersNormal consumption
Minimum consumption
600 units per week
500 units per week
Reordering level = Minimum level + Lead time stock level
Or
= Maximum consumption Maximum lead time
Minimum level= Reordering level (Average consumption Average lead time )
Maximum level= Reorder level + Reorder quantity (Mini consumption Mini Leadtime)
First step is to find out the Re ordering level
Reordering level = 800 units per week 12 weeks= 9,600 units
The next step is to find out the Maximum level
Maximum level = 9,600 units + 2,000 units - (500 units 8 weeks)
= 11,600 units- 4,000 units =7,600 unitsThe next step is to find out the minimum level . For that Average consumption has to be
found out. The average consumption is nothing but normal consumption. The normal
lead time period is the average of minimum and maximum re order period of the firm in
getting the supply of the materials from the suppliers
Minimum level = 9,600 units (600 units 20/2)
= 9,600 units 6,000 units= 3,600 units
Two components A and B are used as follows
Normal usage
Minimum usage
Maximum usage
Re order quantity
Re order period
50 units per week each
25 units per week each
75 units per week each
A: 300 units
B: 500 units
A: 4 to 6 weeks
B: 2 to 4 weeks
Calculate for each component
(B.Com., Madras)
(a) Re order level (b) Minimum level (c) Maximum level and (d) Average stock level
First step is to find out the Reorder level for both A and B components
The maximum usage is common for both A and B components but the reorder period are
different from each other
Reorder level = Maximum consumption /usage Maximum Reorder period
(A)= 75 units 6 weeks= 450 units
(B)=75 units 4 weeks= 300 units
The next step is to determine the Maximum level of both Components A and B
Maximum level = Reordering level + Reordering quantity (Mini Consumption Mini
Lead time)
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(A)= 450 units + 300 units ( 25 units 4 weeks) = 650 units
(B)=300 units + 500 units (25 units 2 weeks) = 750 units
Working Capital Management
Minimum Level = Reordering level ( Average consumption Average lead time)
= 450 unit (50 unit(4 + 6))
2
= 450 units 250 units = 200 units
(B) = 300 unit (50 unit(2 + 4))
2
=300 units ( 150 units )=150 units
Average stock level = Minimum stock level + Re order quantity(A)= 2 00 units + 300 units = 350 units
(B)=150 units+ 500 units = 400 unit
The following information is available in respect of components of R 100
Maximum stock level 10,000 units
Budgeted consumption
Estimated delivery period
Maximum 3,000 units per month
Minimum 1,600 units per month
Maximum 4 months
Minimum 2 months
You are required to calculate
(i)
(ii)
Re-order level
Re-order quantity
Re order level = Maximum consumption maximum lead time
= 3,000 units 4 months=1,200 Units
The Reordering quantity could be found out with the help of Maximum level equation
Let us assume Re ordering quantity =X
Maximum level = Re-ordering level + Re-ordering quantity - (Minimum
consumption Mini Re order period)
= 1,200 units+ (X)-(1,600 units 2 months)
(-X)
X
= 1,200 units-3,200 Units
= 2000 units
= 2,000 units
In the stores control , there are two important documents viz Bin card system and stores ledger.
Bin card is a record prepared by the store keeper at the moment of issuing
and receiving the materials. It is maintained by the store keeper for physical verification
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(A)
321
with accuracy and effectiveness. The inventory control can be accessed through physical
verification then and there, whenever the situation warrants.
The bin card system is adopted by many firms for their inventory control either in the
form of bin tag or stock card hanging outside the rack in order to portray the information
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322
Accounting and Finance for
Managersimmediately to facilitate the store keeper to understand the stock position of the store
room.
The bin card system is available in two major categories viz:
Under this system two different bins are used. As soon as the
goods or materials received by the store keeper, that should be recorded in terms of
quantities. One among the two should be maintained for Re order level and minimum
level another for Maximum stock level.
To alarm the firm neither to store more than the maximum level nor to issue less than the
minimum level of the stock. If the firm once reaches the maximum level, it should
immediately caution the implications due to the overstocking. The same firm, if reaches
the minimum level of stock, it should not go for further issue of materials to functional
department or otherwise, the firm's production may be disturbed due to the poor stocking.
It is an extension of the early method, which incorporates the
lead time stock level in addition to the other level viz Maximum, Reorder and Minimum
level of the stock. Among the three , two cards are exclusively used by the firm in order
to maintain the appropriate stock level, i.e., for maximum stock level and minimum stock
level. The firm should neither to store beyond the maximum level nor to issue less than
the Minimum level. In between, a separate bin card is used only for the Reorder level
and Lead time stock level at which the firm should go for the placement of an order to
get fresh delivery of materials and facilitate the firm to undergo production without any
interruption by considering the time taken by the supplier to supply the ordered materials.
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Some other methods of the inventory control
There are few models exercise the inventory control , which facilitates the firm to avoid
either under or over stocking.
ABC Analysis
VED Analysis
Normally the materials are classified on the basis of the following covenants viz:
Working Capital Management
l
l
Volume and
Value
Based on the basis the materials are classified into three categories:
Lesser percentage in volume and Greater percentage in Value-
Greater percentage in volume and Lesser percentage in Value - and
Percentage in volume and Percentage in value are more or less -
This will be explained with the help of following example for insight.
A store has 4,000 items of consumption and a monthly consumption of Rs 20,00,000. 320
items will have a consumption of Rs. 15,00,000. 500 items will account for Rs 4,00,000
and 2,680 items consume material worth Rs.1,00,000 only.
A
B
320
1000
8%
25%
15,00,000
4,00,000
75%
20%
The importance of2,680analysis is exercising the control1,00,000the inventory.
Total 4,000 100% 20,00,000
How the control of the inventory is being exercised ?
Group A items are high valued items among the other items of the enterprise,
require greater monitoring and controlling.
Group B items are comparatively lesser in value among the three items given next
to the Group A, require less rigid control and monitoring.
Group C items are the major volume of items among the 4000 items of the enterprise
which are least in value, need very little control and monitoring.
The following of control of inventory on A, B and C items of the enterprise:
A
B
C
320
1000
2,680
Rigid Control
Moderate Control
Very little Control
8%
25%
67%
15,00,000
4,00,000
1,00,000
75%
20%
5%
From the above table, it is obviously understood that the items which have greater %
(75%) in the total value requires rigid control than any other quantity of materials. The
Group C items are bearing 67% of total consumption amounted which 5% of total value
of the items procured by the enterprise.
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theC 67% on 5%
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Accounting and Finance for
Managers
Level of Control
Order frequency
Rigid control
Frequent ordering-
Moderate control
Once in 2 months
Very little control
Once in 6 months
weeks, Fortnights
Lead time problem To be cut off drastically
To be reducedmoderately
Lead time problemdue to clerical should
cut off
Safety stock level Due to greater value-least volume safety
stock to be
Due to moderatevalue-lesser safety
stock is required
Due to lower value-High safety stock is
required
maintained
System of Purchase Higher value demandscentralized system of
procurement
Moderate valuerequires centralized
and decentralized
Lower value needsdecentralized system
of purchase
system of purchase
Supervision By Senior officers By Middle level By clerical staff
managers
It guides the management to exercise the control based on the value of goods to
the total composition.
Systematic inventory control can be exercised through this analysis on the basis of
value of the materials. The high value materials of Group A are rigidly controlledwhich finally led to lesser investments.
Scientific system facilitates to lessen the storage cost of the inventory.
VED analysis is applied for the inventory control of the manufacturing enterprise.
V-Vital
E-Essential and
D-Desirable
The spare parts are classified into vital, essential and desirable to the crucially to theproduction.
The non availability of certain spares for short time leads high cost stock out known as
vital spares.
The non availability of spares cannot be tolerated even for few hours or one day and the
cost of lost production is enormous, known as Essential spares to production.
The absence of spares even more than one week, not affecting the flow production,
known as desirable spares.
1) Inventory means
a) Stock of Cash b) Stock of Raw materials, work in
progress and Finished goods324
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c)
(3)
(2)
(1)
Stock of spares d) Both b) & c) only
Contd...
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2)
a) b)
c) d)
3)
a)
c)
4)
a)
5)
i)
ii)
iii)
Inventory control is for the maintenance of
High level of inventory
Low level of inventory
Excessive inventory holding is
Better for the firm
Neither better nor worse for the firm
the firm
The purpose of inventory control is
To minimize the excessive stock b)
consumer
Optimum level of inventory
Average level of inventory
b) Worse for the firm
d) Either better or worse for
To meet the needs of the
Working Capital Management
c) To maintain liquidity d) a),b) & c)
Inventory control is in relevance with
a)
c)
Storage cost
Ordering cost
b)
d)
Carrying cost
(a), (b) and (c)
The receivables are normally arising out of the credit sales of the firm.
It is an asset owed to the firm by the buyer out of the credit sales with the terms and
conditions of repayment on an agreed time period.
The receivables out of the credit sales
crunch the availability of the resources to meet the day today requirements. The acute
competition requires the firm to sustain among the other competitors through more volume
of credit sales and in the intention of retaining the existing customers. This requires the
firm to sell more through credit sales only in order to encourage the buyers to grab the
opportunities unlike the other competitors they offer in the market.
Achieving the growth in the volume of sales
Increasing the volume of profits
Meeting the acute competition
Due to in sufficient amount of working capital with reference to more
volume of credit sales which drastically affects the existence of the working capital of
the firm. The firm may be required to borrow which may lead to pay certain amount of
interest on the borrowings . The interest which is paid by the firm due to the borrowings
in order to meet the shortage of working capital is known as capital cost of receivables.
Cost of maintaining the receivables.
Whatever the cost incurred for the collection of the receivables are
known as collection cost.
This may arise due to defaulters and the cost is in other words as cost
of bad debts and so on. 325
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i)
ii)
iii)
i)
ii)
iii)
iv)
i)
ii)
iii)
Accounting and Finance for
Managers
The volume of sales is the best indicator of accounts receivables.
It differs from one firm to another.
The credit policies are another major force of determinant in
deciding the size of the accounts receivable. There are two types of credit policiesviz lenient and stringent credit policies.
Enhances the volume of the accounts receivable due to
liberal terms of the trade which normally encourage the buyers to buy more and
more.
It curtails the motive buying the goods on credit due stiff
terms of the trade put forth by the supplier unlike the earlier.
The terms of the trade are normally bifurcated into two categoriesviz credit period and cash discount
Higher the credit period will lead to more volume of receivables, on theother side that will lead to greater volume of debts from the side of buyers.
If the discount on sales is more , that will enhance the volume of sales
on the other hand that will affect the income of the enterprise.
It is more important at par with the management of receivable, in order to avail the short
term resources for the smooth conduct of the firm.
The following committees were especially appointed for the purpose to administer theworking capital
Dheja Committee Report 1969
Tandon Committee Report 1975
Chore Committee Report 1980
Marathe Committee Report 1984
The various committee report implications are the following:
"The study carried out on the credit need of the industry and trade and how that needs
inflated and such trends were checked" by the under the chairmanship of Dheja
Committee.
General tendency was found among the firms to avail the bank credit more than
their requirements
Another tendency was among them that the short term credit was generally made
use of by thee for the acquisition of the long term assets
The lending through cash credit should be done on the basis of security in order toassess the financial position of the firm
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i)
ii)
iii)
i)
ii)
iii)
iv )
i)
ii)
iii)
i)
ii)
iii)
Appraisal should be done by the bankers on the present and future performance of
the firms
The total dealings are segmented into two categories viz core and short-term needs
The committee suggested the firms to maintain only one account with the one
banker For huge amount of borrowing, consortium was suggested among thebankers to lend the corporate borrowers
The next committee was appointed Tandon Committee 1975, in an intention of granting
loans and advances to the industry on the need basis through the study of the development
proceeds only in order to improve the weaker section of the people.
The bank should not reveal this much only to lent to the requirements of the firm in
accordance with lending policy, in spite of that the banks were expected to lend tothe tune of firm's requirement
It should be treated as supplementary source of finance but not as major source offinance
Loans were lent only in accordance on the basis of the securities produced by theborrower but not on basis of level of operations
Security compliance wont provide any safety to the banks but the periodical followup only should facilitate the banker to get back the amount of loans and advanceslent
It reached the land mark in studying the need of the industries
towards the requirements of the working capital. The committee has submitted its report
on 9th Aug , 1975 by studying the lending policies.
Necessary information about the future operations are to be supplied
The supporting current assets should be shown to the banker at the moment of
borrowing
The bank should understand that the bank credit is only for the purposes to meet
out the needs of the borrower but not for any other.
This committee especially constituted only for the purpose to study the sanctionable
limits of the banker and the extent of the loan amount utilization of the borrower. Theanother purpose of the committee to appoint that to provide the alternate ways and
means to afford credit facility to the industries to enhance the productive activities in the
country.
Continuance of the existing three system of credits by the banker viz cash credit,
loans and bills
No need to bifurcate the cash credit accounts of the borrower for the implementation
of the differential rate of interest
According to the specifications of the borrower, the banker should come to one
conclusion which in normal peak level and non peak level of operations only to the
tune of operations
Working Capital Management
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v)
i)
ii)
iii)
iv)
v)
75,000
328
Accounting and Finance for
ManagersThe overdependence on the bank credit should be lessened among the practices of
the industrialists through emphasizing the need of term finance.
The fourth committee is Marathe committee which was instituted by the Reserve bank
of India and it submitted the report on 1983. The recommendations were implemented
by the Government of India from April 1,1984.
Reasonability of the projection statements are to be studied by the banks more
carefully
Current assets and liabilities are to be classified in accordance with the norms
issued by the Reserve bank of India
Maintenance of the current assets ratio 1.33:1
Timely supply the information stipulated by the bankers
Apt supply of annual accounting information
ABC Ltd. decides to liberalise credit to increase its sales . The liberalized credit policy
will bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales and
there will be 10% risk for non-payment and 5% collection cost .Will the company benefit
from the new credit policy ?
Additional sales volume
(-) Variable cost
Additional revenue
(-)Non payment risk 10% on additional sales volume
(-) 5% on collection
3,00,000
1,80,000
1,20,000
30,000
15,000
Additional revenue from increased sales due to liberal credit policy
The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenuethrough the volume of incremental sales.
The "working capital" means the funds available for day today operations of the enterprise.
It also represents the excess of current assets over the current liabilities which include
the short term loans". The working capital requirements are normally estimated to the
tune of production policies, nature of the business, length of manufacturing process,
credit policy and so on. The need of the working capital is determined on the basis of
duration of the production cycle. The time duration taken by the manufacturing process
should be considered from the stage of raw materials to the stage of finished goods. The
cycle of the business should be relatively considered for the need of working capital.
The credit policy of the firm is another determinant for the determination of the working
capital. There are two different credit policies viz liberal and stringent credit policies.
The management of cash resources should be not only in a position to afford liquidity but
also it should not require the firm to keep the cash resources simply idle; which should be
invested in the marketable securities to earn some rate of return whenever the firm feel
excessive holding of cash resources. Banks provide certain services to the firms only on
the basis of the certain amount of balances in the accounts. That is the motive holding
cash resources to avail services from the banker viz compensation motive. Timely supply
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of the goods to the requirements, facilitates the firm to earn greater volume of earning.
Reordering Level is the level at which the firm should go for fresh purchase requisition
of material through the store keeper to meet the requirements. There are few models
exercise the inventory control, which facilitates the firm to avoid either under or over
stocking
ABC Analysis
VED Analysis
Discuss inventory management as applicable in an industry of your choice.
The short term asset meant for day today or immediate financial
commitments
Current assets - current liabilities
Which are of immediate importance
Which are regular in feature
coins, notes, currencies and near cash i.e., marketable securities
maintain the adequate cash resource and excessive resources
should be invested in the marketable securities
Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods
and Stock of Spares but not Stock of Loose tools.
Economic Order Quantity of materials to be ordered/procured
Cost is incurred for carrying the materials from the place of purchase to
place of production centre/profit centre
Cost incurred at the moment of placing the order of goods or materials
e.g. Administration costs, cost of communication and so on.
The stock level of the firm should not be more than the determined
level
The further issues should not be done below the level of the stock of
the firms
At this level, the firm should place an order for the materials to the
requirement
This is level required by all the firms to maintain the stock till the
next delivery from the supplier
Analysis of exercising the control on the inventory on the basis of value.
Always Better Control Analysis; A- High control for high value goods; B-Moderate
control for lesser value goods and C- Little control on the least value goods
Vital, Essential and Desirable Analysis Designed for Spares and
accessories
Card or Tag used to illustrate the level of the stock position of the certain
materials at the stores
It is a official record of receipt and issuance of materials or goods in
terms of quantities with value of them
Working Capital Management
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1.
2.
3.
4.
5.
6.
Accounting and Finance for
ManagersIt is an asset arises at the moment of credit sales, owed to the firm
Cost of collection incurred by the firm due to collection of receivables
Agency charges, brokerage charges for collection
Cost due to bad debts
Define the working capital management.
Explain the objectives of working capital management.
Explain the various components of working capital management.
Write detailed note on cash management.
Elucidate the various practices of Inventory management.
Highlight the importance of the receivable management through various strategies.
R.L. Gupta and Radhaswamy, Advanced Accountancy.
V.K. Goyal, Financial Accounting, Excel Books, New Delhi.
Khan and Jain, Management Accounting.
S.N.Maheswari, Management Accounting.
S. Bhat Financial Management, Excel Books, New Delhi.
Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw
Hill, New Delhi (1994).I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.