lesson 23 working capital management (1)

7/29/2019 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)

306


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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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)

309

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



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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.


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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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:


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

313


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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


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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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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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


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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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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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


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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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



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


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


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:


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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l

l

l

l

l

theC 67% on 5%

l

l

l

323


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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


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)


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

326


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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


iv) No frequent sanction of ad hoc limits of borrowing from the banker327


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v)

i)

ii)

iii)

iv)

v)

75,000

328


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


32/33

l

l

329

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



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1.

2.

3.

4.

5.

6.


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.

lesson 23 working capital management (1)

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