lesson-23 working capital management

304

Accounting and Finance forManagers LESSON

23WORKING CAPITAL MANAGEMENT

CONTENTS

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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Working Capital Management

23.0 AIMS AND OBJECTIVES

After studying this lesson you will be able to:

(i) describe the objectives of working capital management

(ii) 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.

23.1 INTRODUCTION

The working capital is the amount revolving capital to meet the day today requirementsof the firm. The other facets of the working capital is circulating capital, floating capitaland 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 includethe short-term loans.

Accounting standards Board, The institute of Chartered Accountant of India note theASB has used the term “working capital” and not “Net working capital”.

23.2 OBJECTIVES OF THE WORKING CAPITALMANAGEMENT

Estimating the working capital requirements

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.

Sources of the working capital: The requirement of the working capital should be metwith the help of long term and shot term resources. The permanent and temporaryworking capital requirements should be met out of long term and short term financialresource respectively.

23.3 APPROACHES OF THE WORKING CAPITAL

The approaches of the working capital are classified into two categories viz the hedgingapproach and conservative approach:

The hedging approach: Under this approach, the maturity of the financial resourcesare matched with the nature of assets to be financed.

23.10.2 Tandon Committee

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

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Accounting and Finance forManagers

Permanent working capital are financed by the long-term financial resources and theseasonal working capital requirements are met out through short term financial resources.

The conservative approach: Acc to this approach, all requirement of the funds should metout long-term sources. The short-term resources should be only for emergency requirements.

23.4 DETERMINANTS OF WORKING CAPITAL

Following are the major determinants of the working capital:

General nature of Business:The nature of the business should be considered for thedetermination of working capital only to the tune of i) cash nature of business ii) sale ofservices rather than commodities:

These are things considered only on the basis of stock , book volume of debts and so on.

Production cycle:The need of the working capital is determined on the basis of durationof the production cycle. The time duration taken by the manufacturing process should beconsidered from the stage of raw materials to the stage of finished goods. If the durationis lengthier may require the firm to keep more amount of working capital to meet out therequirements and vice versa.

Business cycle:The cycle of the business should be relatively considered for the needof working capital. The upswing of the business cycle requires the business venture toinvest more amount of working capital due more volume of sales, results out of hugevolume of stock, book debts and so on. During the downswing of the business requirethe business to have only lesser volume of working capital due lesser volume of businessand so on.

Production policy: The working capital requirement is determined on the basis ofproduction policy of the firm. Normally the production policy of the firm is classified onthe basis of two methodologies:

(i) 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 capitalto meet out, due to in adequate planning. During the peak season, it requiresenormous working capital which may disturb working conditions of the businessventure.

(ii) The steady production policy by considering the futuristic demands, which will notdisturb the long-term prospects of the business venture due to effective planning.

Credit policy: The credit policy of the firm is another determinant for the determinationof the working capital. There are two different credit policies viz liberal and stringentcredit policies

(i) Liberal credit policy: The liberal credit policy may lead to have greater volume ofbook debts, greater credit period, huge amount required for the built of stock; requirethe firm to have greater amount of working capital

(ii) Stringent credit policy: Would not require that much of working capital like theearlier segment.

Growth and Expansion:The growth and expansion prospects of the firm should beappropriately determined in order to identify the volume of working capital requiredduring the future, unless otherwise that will badly affect the future development of thefirm.

Acute shortage of the raw materials supply: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 additionalvolume of working capital not only to avoid interruptions during the production process

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Working Capital Managementdue lack of supply of raw materials, but also to enjoy greater trade discounts during thebulk purchase in order to bring down the purchase cost of the raw materials.

Net profit: It is one of the major sources of working capital and practically speaking it isone of the sources of cash from operations. To maintain the liquidity, the net profitearning capacity should be maintained forever.

Dividend policy: The cash dividend payment leads to greater amount of cash outflowswhich are more essential to the value of the firm to be maintained. The value of the firmcould also be alternately maintained by either through the declaration of bond dividend orstock dividend or property dividend. The later specified methodologies facilitate the firmto postpone the cash out flow which normally evade the immediate cash requirement.

Depreciation policy:The depreciation policy of the firm not only facilitates to bringdown the taxable liability but also brings down the profit which enhances the liquidity ofthe firm on the other side.

Price level changes:The price level changes require the firm to keep more amount ofworking capital to go hand in hand with the price changes which normally affect thefirm's liquidity position. During the periods of inflation, the firm is required to anticipatethe price level changes which drastically affect the working capital position of the firm.

23.5 WORKING CAPITAL POLICIES

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

i) Profitability

ii) Liquidity and

iii) 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 currentassets 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 morevolume 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 hurdlesthe 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 tomaintain 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

i) Concerned with profitability, liquidity and risk of the firm

ii) Concerned with the composition of the current assets

iii) 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 assetsin meeting the liquidity of the firm.

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Aggressive policy of working capital:

Under this policy , the firm enhances the risk by way of reducing the working capital inorder to earn more and more profits.

23.6 ESTIMATION OF WORKING CAPITALREQUIREMENT

The following is the proforma of the working capital requirement

Statement of working capital required

Current Assets:

i) Cash XXXX

ii) Debtors XXXX

iii) Stocks XXXX

iv) Advanced payments XXXX

v) Others XXXX

Less:

Current liabilities

i) Creditors XXXX

ii) Lag in payment of expenses XXXX

iii) Outstanding expenses if any XXXX

Working capital (Current assets-Current liabilities) XXXX

Add: Provision for contingencies XXXX

Net working capital required XXXX

Prepare an estimate of working capital requirement from the following data of the XYZLtd.

a) Projected annual sales volume 2,00,000 units

b) Selling price Rs.10 per unit

c) % of net profit on sales 25%

d) Average credit period allowed to customers 8 weeks

e) Average credit period allowed by suppliers 4 weeks

f) Average holding period of the inventories 12 weeks

g) Allow 10% for contingencies

Statement of working capital requirements

Current Assets Rs

Debtors (8 weeks)Rs.15,00,000 × 8/52(At cost) 2,30,769.23 Stock (12 weeks) Rs.15,00,000 × 12/52 3,46,153.38 Less Current liabilities Creditors (4 weeks) Rs15,00,000 × 4/52 1,15,384.61 Net working capital 4,61,538.0 Add: 10% contingencies 46,153.8 Working capital required 5,07,691.8

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Working Capital ManagementCheck Your Progress

1. The recent release of the finance minister during the budget session on thespecial excise duty on the cement industry.

2. How the construction industry is affected ? In what way? Which factor ofinfluence affects the firm?

23.7 CASH MANAGEMENT

The management of cash resources should not be only in a position to afford liquidity butalso it should not require the firm to keep the cash resources simply idle; which should beinvested in the marketable securities to earn some rate of return whenever the firm feelexcessive holding of cash resources.

23.7.1 Motives of holding cash

Transaction Motive: If the cash outflows are more than that of the cash inflows, thefirms are expected to maintain the cash resources.

Precautionary Motive:Some times the firm may be required to meet out the contingentneeds which could not be foreseen during its life span; warrants the adequate maintenanceof working capital.

Speculative Motive:It is a motive holding the cash resources by the firm to exploit theopportunities available in the market. If the vendor of raw materials announces thatthere is a greater discount towards the bulky purchase of raw materials, may lead thefirm to bring down the cost of purchase. For which, the cash resources are required andmade use of to the tune of announcements.

Compensation motive:Banks provide certain services to the firms only on the basis ofthe certain amount of balances in the accounts. That is the motive holding cash resourcesto avail services from the banker viz compensation motive.

23.7.2 Objectives of Cash Management

(i) Meeting the cash requirement:Meeting of cash requirements on time whichnormally involves in the maintenance of the goodwill of the firm. The firm shouldkeep the adequate cash balances to meet the requirement which are greater inimportance.

(ii) Minimising the funds locked up in the cash balances:The funds locked up in theform of cash resources should be more, but it should only to the tune of the requirement.

23.7.3 Basic Problems of Cash Management

(i) Controlling level of cash

(a) Preparing the cash budget: Through the preparation of the budget, thecash requirement could be identified which would normally facilitate the firmto trim off the excessive cash in holding.

(b) Providing room for unpredictable discrepancies: The separate amountshould be maintained for the purpose to meet out the discrepancies which arenot easily foreseen.

(ii) Controlling of inflows of cash

(a) Concentration banking: The amount of collection from the local branchesare normally deposited in a particular account of the firm, as soon as the

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deposit has reached the certain limit , the amount in the respective branchaccount will be transferred to the account at where the firm maintains in thehead office. This process of transfer is normally taking place only throughtelegraphic transfer during the early days but on now a days the anywherebanking is facilitated to transfer the amount of deposit instantaneously.

(b) Lock box system: The process of collection is carried out with the help oflocal 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 localbranch messenger collects the cheques from the parties through specifiedpost box allocated for the process of collection.

(iii) Controlling of cash outflows

(a) Centralizing of disbursing the payments: The centralizing the process ofpayment may facilitate the enterprise to take advantage of time in settling thepayments i.e., reduces the need of immediate cash requirements.

(b) Stretching payment schedule: It is another methodology to avail themaximum possible credit period to postpone the payment by making use ofthe cash resources most effectively.

(iv) Investing the excessive cash surplus

(a) Determine the need of the surplus cash: Identify the excessive cashresources which are kept simply idle more than the requirement.

(b) Determination of the various avenues of investment:After identifyingthe various investment opportunities , the excessive cash resources should beinvested to earn appropriate rate of return during the slack season at whenthe firm does not require greater volume of working capital and vice versa.

Check Your Progress

1. Explain the modern instruments available in the financial market to entertainthe cash management strategies.

2. 1. Cash means

a) Cash in hand b) Cash in hand and at bank

c) Cash in hand, at bank and near d) None of the abovecash i.e marketable securities

2. To avail the trade discount at the moment of bulk purchase is

a) Transaction motive b) Speculative motive

c) Compensating motive d) Precautionary motive

3. Stretching cash payment is

a) Controlling the cash inflow b) Controlling cash outflows

c) a) & b) d) None of the above

23.8 MANAGEMENT OF INVENTORIES

23.8.1 Meaning of Inventory

The inventory includes the following :

l Stock of raw materials:It means that the value of the raw materials stored forthe purpose of production in the storage yard. The stock of raw materials can be

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Working Capital Managementclassified normally into two categories viz opening stock and closing stock of rawmaterials.

l Stock of work in progress:During the production process, the firm usually storesthe semi finished goods which are neither a raw materials nor finished goods. Thepurpose of the storage of work in progress in order to shorten the time duration tomanufacture the finished goods. The value of the semi finished / work in progressstored 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 isinevitable process in transfer pricing. The value of the work in progress normallyexpressed in two different ways viz on the basis of prime cost and works cost.

l Stock of finished goods:This is the stage at which the goods are readily availablefor selling in the market. The value of the stock of the goods is computed on thebasis of cost of production.

l Stock of Stores supplies, components and accessories.

23.8.2 Why inventory is to be controlled ?

The ultimate purpose of controlling the inventory arises only due to the conflicting andheterogeneous 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 timetogether.

On/of the Production department: The manager production frequently insists theorganisation to maintain the continuous and uninterrupted supply to have smooth flowproduction. 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 purchasemanager.

Less the stock of raw materials and accessories - Risk of Lock out due toinsufficient quantities and vice versa

On/of the Purchase department: Due to the influence from the production manager,the purchase department is demanded to procure the requirements. As per the requisitionof the production department, meeting the requirements is not tough task but thedepartment should know about the financial intricacies of the organisation through thefinance 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 whichare in scarcity.

Lesser the quantum of purchase - Greater will be cost of procurement andlesser will the economic benefits and vice versa

Inventory

Raw materials Work in progress Finished goods

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On/of the Sales department: Due to the market pressure/greater demand of the productsrequire the sales department to supply the goods in time as well as to meet the needs anddemands of the intermediaries and consumers. To supply them in time, the sales managerneed not wait for the production cycle to be completed to produce the finished goods. Tosave time, the sales manager must be given ample facility to store the finished goods inthe depot not only to meet the needs but also traps and drags the existing customers andconsumers.

More the stock of the finished goods - Better the position for the firm to meetthe needs of the biz environment and more the cost of storage and investmenton the current assets and vice versa

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 onthe various angles.

It is the only department bearing a difference of opinion in maintaining more volume ofinventory in the firm; which certainly slashes the earning capacity of the firm due to leastvolume of assets deploy on the productive purpose.

Lesser the inventory - Higher the risk in meeting the needs of production,purchase and sales - but better the return of the firm.

For e.g. The famous MNC Jindal Corporation Ltd. has wound up its operations atindustrial 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. Theywere neither to store nor to transport more and more which led to the winding up ofoperations of the enterprise at Bangalore.

The following diagram will obviously facilitate the Inventory Control:

Inventory control: 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 theheterogeneous objectives. The economic desired benefits of the dept. are illustrated tothe tune of the preceding illustrated diagrams.

Production department: Benefits towards less production cost through mass production.

Purchase department: Benefits towards discounts, carrying cost and so on.

Sales department: Timely supply of the goods to the requirements, facilitates the firmto earn greater volume of earning. To reduce the operating cycle in duration in order torealize the economic benefits as early as possible.

Finance department: Benefits towards the carrying cost, storage cost of the entireinventory.

PurchaseDepartment

FinanceDepartment

ProductionDepartment

SalesDepartment

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Working Capital Management23.8.3 Major Benefits of Inventory Control

l It leads to effective utilization of funds only through an appropriate investment oninventory

l It facilitates to obtain the economic supply of raw materials

l It possess the firm comfortably to meet the needs and wants of the consumers intime

l It neither allows the firm to undergo the practices of overstocking nor understocking.

l It leads to effectiveness in the material handing which reduces the wastage, pilferageand so on.

Before discussing the methods of inventory control, every one must obviously understandthe organization of the stores department. The stores department is the only departmentwhich applies all the techniques of inventory control.

The organization of the inventory control are various in dimensions . The organization ofdiffers 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

b) Decentralised stores

c) Central and Sub stores

23.8.4 Centralised 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 thecentralized stores of the manufacturing department. The materials are continuouslyreceived by the stores dept. through the purchase department and the received materialare distributed to the various assisting departments.

This type of organization of stores control has its own advantages and disadvantages inapplication

The major advantages are following:

l It requires less space

l It facilitates to minimize the stock investment

l The centralization leads to lower administrative and maintenance cost of stores

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In addition to the advantages, the present organization suffers with its own limitationwhile in applications; which are following:

l The centralization of stores leads to enhance the cost of transportation as well ashandling cost of materials.

l The centralized system leads to lot of inconvenience and delay to other departmentdue to distance

l There is a greater risk of calamity loss of materials which are stored under oneroof

l The success is subject to the effectiveness of the transportation

23.8.5 Decentralised Stores

Under this method, the separate stores are maintained by the departments on their ownas well as run by the exclusive store keeper. It ensures the smooth flow material to thetune of requirements and reduces the time involved in the transit of materials from thestores to the respective departments. The following diagram will facilitate to have aninsight on the organization of the stores.

23.8.6 Central stores and Sub stores

This is a method which attempts to discard the bottlenecks of the above mentioned aswell as brings forth unique organization of stores. Under this method, each department isgiven separate sub store which is within easier access and shorter in distance to supplythe material requirements through the store keeper. The sub store keeper should have tomake requisition to central stores where all the materials are centrally procured andsupplied then and there to the tune of the individual departments.

The role of the store keeper is most inevitable in controlling the stores. While controllingthe stores, the store keeper should neither disturb the production process nor undergothe practices of overstocking. By earmarking the above enlisted objectives, every storekeeper is led by the various methods of inventory valuation in addition to various methodsof requisitioning of material.

C e n t r a l S t o r e

S u b Sto re S u b Sto re

W e ld ing D ep t P lan nin g D ept

P ro d u ct ion D ep t

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Working Capital ManagementFirst we will discuss, the various methods of requisitioning of materials.

23.8.7 Reordering Level

This is the level at which the firm should go for fresh purchase requisition of materialthrough the store keeper to meet the requirements. The reordering level which takesinto consideration of minimum level of consumption of raw material during the course ofproduction 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 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 aswell 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 dueto short supply or insufficient amount of materials.

23.8.8 Minimum Level/Safety level

The firm should at always maintain minimum amount of material in its hands to facilitatethe 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:

l Lead time should be predominantly considered to determine the time lag in betweenthe materials ordered and received. The firm should find out the practical difficultyof the vendor in supplying the material for the determination for minimum level ofstock.

l Amount of consumption of the material during the lead time

Minimum stock level=Reordering level- (Normal level consumption × Normal Reorderperiod)

Minimum level = Reorder level + (Average level of consumption × Average Reorderperiod)

Average and normal level of consumption are synonymous with each other. If normal oraverage consumption is not given, the formula is as follows

Minimum LevelAmount of materials required

during the periods of consumption

Reordering Level

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Accounting and Finance forManagers Average consumption = Minimum level consumption + Maximum level consumption

2

23.8.9 Maximum Level

This is the level at which the firm holds maximum quantity of materials as stock duringthe process. The ultimate aim of fixing the level of maximum level is that to avoid theoverstocking. If the stock level of the firm exceeds the maximum level already fixed isknown as overstocking level of the firm, more than the requirement.

Why over stocking is considered not advisable ?

l It leads to excessive investment on inventory more than the requirement

l It leads to unnecessary wastage of the materials due to excessive stock

l 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)

23.8.10 Danger level

At this level, the firm should not further issue any materials to the various functionaldepartments .At the danger level, the purchase department is vested with greaterresponsibility to immediately arrange the supply of raw materials in order to maintain theflow 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 minimumconsumption, which should be averaged to find the mid point in between the two, inorder to either fulfill the minimum consumption or maximum consumption to the extentpossible.

Why the maximum reorder period is taken into consideration?

The purpose of considering is that the greater period taken by the supplier to supply therequired materials

Danger Level= Average consumption × Maximum reorder period

23.8.11 Average Stock LevelAverage stock level =Minimum stock level + ½ of the reorder quantity

23.8.12 Economic Ordering QuantityThe ordering of materials usually tagged with three different component of costs viz:

l Acquisition cost of materials

l Ordering cost of materials

l 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:

l 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.

l Quantity discounts: The discount can be classified into two categories viz Tradediscount and Cash discount .

l What is trade discount ?

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Working Capital ManagementTrade 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:

l The carrying cost will come down in the case of lesser inventories

l The cost of storage is lesser as far as the meager quantities of materials

l Loss due to deterioration, obsolescence, wastage will be minimum

l Insurance cost is less due to meager volume of materials

2AOEconomic Ordering Quantity =

1

A = Annual requirement in units

O = Ordering cost

I = Cost of storing per year or cost of carrying the inventory

Illustration 1

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

I

2AQ (EOQ)Quantity Ordering Economic =

2 20,000 Rs.100

0.16% on Rs.4

× ×=

= 2,500 units

Graph of EOQ:

Total cost Rupees

Cost of carrying Ordering cost Units per order Insert the picture anpve

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The following Table 23.1 illustrates the justification of the EOQ at the 2,500 units level

Illustration 2

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

2AOEconomic Ordering Quantity (EOQ)=

1

2 1600 Rs.50EOQ = = 200 units

10% on Rs.40

× ×

Illustration 3

Consumption during the year -600 units

Ordering cost Rs. 12 per order

Carrying cost 20%

Price per unit Rs. 20 B.Com. (Punjab)

2AOEconomic Ordering Quantity (EOQ)=

1

2 600 Rs.12EOQ =

20% on Rs.20

× ×

= 60 units

Illustration 4

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%

Annual requirement of 20,000 units

Particulars 1 2 3 4 5

Size of the Orders 20,000 10,000 5000 2,500 500

Number of order to placed = Total Annual Need Size of the order

1 2 4 8 40

Average stock = Size of the order 2

10,000 5,000 2,500 1,250 250

Average stock value =Average stock × cost per unit Rs

40,000 20,000 10,000 5,000 1,000

Carrying cost = Average Stock value × 16% Rs

6,400 3,200 1,600 800 160

Ordering cost Rs 100 200 400 800 4,000

Total cost Rs 6,500 3,500 2,000 1,600 4,160

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Working Capital ManagementRent, 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

2AOEconomic Order Quantity (EOQ) =

1

2 800 Rs.200=

10% on Rs.60 +Rs.2

200 units

× ×

=

Illustration 5

Given the annual consumption of material is 1,800 units , ordering costs are Rs.2 perorder, price per order price per unit of material is 32 paise and storage costs are 25% perannum of stock value , find the economic order quantity.

(B.Com. Calicut)

2 A OEconomic Order Quantity (EOQ) =

1

2 1,800 Rs.2=

25% on 32 paise

= 300 units

× ×

Illustration 6

Find out the Re ordering level from the following information

a) Minimum stock 1000 units b) Maximum stock 2000 units c) Time required forreceiving 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 thenext 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

Illustration 7

Calculate maximum level , minimum level and reordering level from the following data

Reorder quantity 2,000 units

Reorder period 8 to 12 weeks

Maximum consumption 800 units per week

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Normal consumption 600 units per week

Minimum consumption 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 units

The next step is to find out the minimum level . For that Average consumption has to befound out. The average consumption is nothing but normal consumption. The normallead time period is the average of minimum and maximum re order period of the firm ingetting 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

Illustration 8

Two components A and B are used as follows

Normal usage 50 units per week each

Minimum usage 25 units per week each

Maximum usage 75 units per week each

Re order quantity A: 300 units

B: 500 units

Re order period 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 levelFirst 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 aredifferent 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 × MiniLead time)

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Working Capital Management(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)

2

6))(4 unit (50– unit 450

+×=

(A) = 450 units – 250 units = 200 units

(B)2

4))(2 unit (50– unit 300

+×=

=300 units – ( 150 units )=150 units

Average stock level = Minimum stock level + ½ Re order quantity

(A)= 2 00 units + ½ 300 units = 350 units

(B)=150 units+ ½ 500 units = 400 unit

Illustration 9

The following information is available in respect of components of R × 100

Maximum stock level 10,000 units

Budgeted consumption Maximum 3,000 units per month

Minimum 1,600 units per month

Estimated delivery period Maximum 4 months

Minimum 2 months

You are required to calculate

(i) Re-order level

(ii) 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 - (Minimumconsumption× Mini Re order period)

= 1,200 units+ (X)-(1,600 units × 2 months)

(-X) = 1,200 units-3,200 Units

= –2000 units

X = 2,000 units

In the stores control , there are two important documents viz Bin card system and stores ledger.

Bin Card: Bin card is a record prepared by the store keeper at the moment of issuingand receiving the materials. It is maintained by the store keeper for physical verificationwith accuracy and effectiveness. The inventory control can be accessed through physicalverification then and there, whenever the situation warrants.

The bin card system is adopted by many firms for their inventory control either in theform of bin tag or stock card hanging outside the rack in order to portray the information

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immediately to facilitate the store keeper to understand the stock position of the storeroom.

The bin card system is available in two major categories viz:

Two Bin card system: Under this system two different bins are used. As soon as thegoods or materials received by the store keeper, that should be recorded in terms ofquantities. One among the two should be maintained for Re order level and minimumlevel another for Maximum stock level.

To alarm the firm neither to store more than the maximum level nor to issue less than theminimum level of the stock. If the firm once reaches the maximum level, it shouldimmediately caution the implications due to the overstocking. The same firm, if reachesthe minimum level of stock, it should not go for further issue of materials to functionaldepartment or otherwise, the firm's production may be disturbed due to the poor stocking.

Three Bin Card system: It is an extension of the early method, which incorporates thelead time stock level in addition to the other level viz Maximum, Reorder and Minimumlevel of the stock. Among the three , two cards are exclusively used by the firm in orderto maintain the appropriate stock level, i.e., for maximum stock level and minimum stocklevel. The firm should neither to store beyond the maximum level nor to issue less thanthe Minimum level. In between, a separate bin card is used only for the Reorder leveland Lead time stock level at which the firm should go for the placement of an order toget fresh delivery of materials and facilitate the firm to undergo production without anyinterruption by considering the time taken by the supplier to supply the ordered materials.

Bin card for Mini and Reorderlevel

Bin card for Maximum Level

Maximum Level

Maximum LevelReorder Level

Reorder level

Minimum stock level Lead time stock level Maximum stock level

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Working Capital ManagementSome other methods of the inventory control

There are few models exercise the inventory control , which facilitates the firm to avoideither under or over stocking.

l ABC Analysis

l VED Analysis

23.8.13 ABC analysis

Normally the materials are classified on the basis of the following covenants viz:

l Volume and

l Value

Based on the basis the materials are classified into three categories:

l Lesser percentage in volume and Greater percentage in Value- Category A

l Greater percentage in volume and Lesser percentage in Value - Category B and

l Percentage in volume and Percentage in value are more or less - Category C

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. 320items will have a consumption of Rs. 15,00,000. 500 items will account for Rs 4,00,000and 2,680 items consume material worth Rs.1,00,000 only.

Table of Items and value

The importance of the analysis is exercising the control on the inventory.

How the control of the inventory is being exercised ?

l Group A items are high valued items among the other items of the enterprise,require greater monitoring and controlling.

l Group B items are comparatively lesser in value among the three items given nextto the Group A, require less rigid control and monitoring.

l Group C items are the major volume of items among the 4000 items of the enterprisewhich 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:

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. TheGroup C items are bearing 67% of total consumption amounted which 5% of total valueof the items procured by the enterprise.

Group No. of Items Level of Control % of Items

Value Rs % of Value

A 320 Rigid Control 8% 15,00,000 75%

B 1000 Moderate Control 25% 4,00,000 20%

C 2,680 Very little Control 67% 1,00,000 5%

Group No. of Items % of Items Value Rs % of Value

A 320 8% 15,00,000 75%

B 1000 25% 4,00,000 20%

C 2,680 67% 1,00,000 5%

Total 4,000 100% 20,00,000

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The Unique features of the ABC analysis:

Advantages

(1) It guides the management to exercise the control based on the value of goods tothe total composition.

(2) Systematic inventory control can be exercised through this analysis on the basis ofvalue of the materials. The high value materials of Group A are rigidly controlledwhich finally led to lesser investments.

(3) Scientific system facilitates to lessen the storage cost of the inventory.

23.8.14 VED analysis

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 asvital spares.

The non availability of spares cannot be tolerated even for few hours or one day and thecost 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.

Check Your Progress

1) Inventory means

a) Stock of Cash b) Stock of Raw materials, work inprogress and Finished goods

c) Stock of spares d) Both b) & c) only

Contd...

Nature A Group of Items B Group of Items C Group of Items

Level of Control Rigid control Moderate control Very little control

Order frequency Frequent ordering-weeks, Fortnights

Once in 2 months Once in 6 months

Lead time problem To be cut off drastically

To be reduced moderately

Lead time problem due to clerical should cut off

Safety stock level Due to greater value- least volume safety stock to be maintained

Due to moderate value-lesser safety stock is required

Due to lower value-High safety stock is required

System of Purchase Higher value demands centralized system of procurement

Moderate value requires centralized and decentralized system of purchase

Lower value needs decentralized system of purchase

Supervision By Senior officers By Middle level managers

By clerical staff

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Working Capital Management2) Inventory control is for the maintenance of

a) High level of inventory b) Optimum level of inventory

c) Low level of inventory d) Average level of inventory

3) Excessive inventory holding is

a) Better for the firm b) Worse for the firm

c) Neither better nor worse for the firm d) Either better or worse forthe firm

4) The purpose of inventory control is

a) To minimize the excessive stock b) To meet the needs of theconsumer

c) To maintain liquidity d) a),b) & c)

5) Inventory control is in relevance with

a) Storage cost b) Carrying cost

c) Ordering cost d) (a), (b) and (c)

23.9 RECEIVABLES MANAGEMENT

23.9.1 Concept of Receivables Management

The receivables are normally arising out of the credit sales of the firm.

What is meant by the accounts receivable?

It is an asset owed to the firm by the buyer out of the credit sales with the terms andconditions of repayment on an agreed time period.

Meaning of the receivables management: The receivables out of the credit salescrunch the availability of the resources to meet the day today requirements. The acutecompetition requires the firm to sustain among the other competitors through more volumeof credit sales and in the intention of retaining the existing customers. This requires thefirm to sell more through credit sales only in order to encourage the buyers to grab theopportunities unlike the other competitors they offer in the market.

23.9.2 Objectives of Accounts Receivables

i) Achieving the growth in the volume of sales

ii) Increasing the volume of profits

iii) Meeting the acute competition

23.9.3 Cost of Maintaining the Accounts Receivables

Capital cost: Due to in sufficient amount of working capital with reference to morevolume of credit sales which drastically affects the existence of the working capital ofthe firm. The firm may be required to borrow which may lead to pay certain amount ofinterest on the borrowings . The interest which is paid by the firm due to the borrowingsin order to meet the shortage of working capital is known as capital cost of receivables.

Administrative cost: Cost of maintaining the receivables.

Collection cost: Whatever the cost incurred for the collection of the receivables areknown as collection cost.

Defaulting cost: This may arise due to defaulters and the cost is in other words as costof bad debts and so on.

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23.9.4 Factors Affecting the Accounts Receivables

i) Level of sales:The volume of sales is the best indicator of accounts receivables.It differs from one firm to another.

ii) Credit policies: The credit policies are another major force of determinant indeciding the size of the accounts receivable. There are two types of credit policiesviz lenient and stringent credit policies.

Lenient credit policy: Enhances the volume of the accounts receivable due toliberal terms of the trade which normally encourage the buyers to buy more andmore.

Stringent credit policy: It curtails the motive buying the goods on credit due stiffterms of the trade put forth by the supplier unlike the earlier.

iii) Terms of trade: The terms of the trade are normally bifurcated into two categoriesviz credit period and cash discount

Credit period: 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.

Cash discount: If the discount on sales is more , that will enhance the volume of saleson the other hand that will affect the income of the enterprise.

23.9.5 Management of Accounts Payable/Financing the Resources

It is more important at par with the management of receivable, in order to avail the shortterm resources for the smooth conduct of the firm.

23.10 VARIOUS COMMITTEE REPORTS ON WORKINGCAPITAL

The following committees were especially appointed for the purpose to administer theworking capital

i) Dheja Committee Report 1969

ii) Tandon Committee Report 1975

iii) Chore Committee Report 1980

iv) Marathe Committee Report 1984

The various committee report implications are the following:

23.10.1 Dheja Committee Report 1969

"The study carried out on the credit need of the industry and trade and how that needsinflated and such trends were checked" by the under the chairmanship of DhejaCommittee.

Findings

i) General tendency was found among the firms to avail the bank credit more thantheir requirements

ii) Another tendency was among them that the short term credit was generally madeuse of by thee for the acquisition of the long term assets

iii) 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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Working Capital ManagementRecommendations

i) Appraisal should be done by the bankers on the present and future performance ofthe firms

ii) The total dealings are segmented into two categories viz core and short-term needs

iii) The committee suggested the firms to maintain only one account with the onebanker For huge amount of borrowing, consortium was suggested among thebankers to lend the corporate borrowers

23.10.2 Tandon Committee

The next committee was appointed Tandon Committee 1975, in an intention of grantingloans and advances to the industry on the need basis through the study of the developmentproceeds only in order to improve the weaker section of the people.

Findings of the Committee

i) The bank should not reveal this much only to lent to the requirements of the firm inaccordance with lending policy, in spite of that the banks were expected to lend tothe tune of firm's requirement

ii) It should be treated as supplementary source of finance but not as major source offinance

iii) Loans were lent only in accordance on the basis of the securities produced by theborrower but not on basis of level of operations

iv) 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

Recommendations: It reached the land mark in studying the need of the industriestowards the requirements of the working capital. The committee has submitted its reporton 9th Aug , 1975 by studying the lending policies.

i) Necessary information about the future operations are to be supplied

ii) The supporting current assets should be shown to the banker at the moment ofborrowing

iii) The bank should understand that the bank credit is only for the purposes to meetout the needs of the borrower but not for any other.

23.10.3 Chore Committee Report 1979

This committee especially constituted only for the purpose to study the sanctionablelimits 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 andmeans to afford credit facility to the industries to enhance the productive activities in thecountry.

i) Continuance of the existing three system of credits by the banker viz cash credit,loans and bills

ii) No need to bifurcate the cash credit accounts of the borrower for the implementationof the differential rate of interest

iii) According to the specifications of the borrower, the banker should come to oneconclusion which in normal peak level and non peak level of operations only to thetune of operations

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

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v) The overdependence on the bank credit should be lessened among the practices ofthe industrialists through emphasizing the need of term finance.

23.10.4 Marathe Committee Report 1984

The fourth committee is Marathe committee which was instituted by the Reserve bankof India and it submitted the report on 1983. The recommendations were implementedby the Government of India from April 1,1984.

Recommendations

i) Reasonability of the projection statements are to be studied by the banks morecarefully

ii) Current assets and liabilities are to be classified in accordance with the normsissued by the Reserve bank of India

iii) Maintenance of the current assets ratio 1.33:1

iv) Timely supply the information stipulated by the bankers

v) Apt supply of annual accounting information

Illustration

ABC Ltd. decides to liberalise credit to increase its sales . The liberalized credit policywill bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales andthere will be 10% risk for non-payment and 5% collection cost .Will the company benefitfrom the new 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.

23.11 LET US SUM UP

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 includethe short term loans". The working capital requirements are normally estimated to thetune 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 ofduration of the production cycle. The time duration taken by the manufacturing processshould be considered from the stage of raw materials to the stage of finished goods. Thecycle 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 workingcapital. 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 butalso it should not require the firm to keep the cash resources simply idle; which should beinvested in the marketable securities to earn some rate of return whenever the firm feelexcessive holding of cash resources. Banks provide certain services to the firms only onthe basis of the certain amount of balances in the accounts. That is the motive holdingcash resources to avail services from the banker viz compensation motive. Timely supply

Particulars Rs Additional sales volume 3,00,000 (-) Variable cost 1,80,000 Additional revenue 1,20,000 (-)Non payment risk 10% on additional sales volume 30,000 (-) 5% on collection 15,000 Additional revenue from increased sales due to liberal credit policy 75,000

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Working Capital Managementof 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 requisitionof material through the store keeper to meet the requirements. There are few modelsexercise the inventory control, which facilitates the firm to avoid either under or overstocking

l ABC Analysis

l VED Analysis

23.12 LESSON-END ACTIVITY

Discuss inventory management as applicable in an industry of your choice.

23.13 KEYWORDS

Working capital: The short term asset meant for day today or immediate financialcommitments

Net working capital: Current assets - current liabilities

Temporary working capital: Which are of immediate importance

Permanent working capital: Which are regular in feature

Cash: coins, notes, currencies and near cash i.e., marketable securities

Cash management: maintain the adequate cash resource and excessive resourcesshould be invested in the marketable securities

Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goodsand Stock of Spares but not Stock of Loose tools.

EOQ: Economic Order Quantity of materials to be ordered/procured

Carrying cost: Cost is incurred for carrying the materials from the place of purchase toplace of production centre/profit centre

Ordering Cost: Cost incurred at the moment of placing the order of goods or materialse.g. Administration costs, cost of communication and so on.

Maximum level: The stock level of the firm should not be more than the determinedlevel

Minimum level: The further issues should not be done below the level of the stock ofthe firms

Reorder level: At this level, the firm should place an order for the materials to therequirement

Lead time stock level: This is level required by all the firms to maintain the stock till thenext delivery from the supplier

ABC Analysis: 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-Moderatecontrol for lesser value goods and C- Little control on the least value goods

VED Analysis: Vital, Essential and Desirable Analysis – Designed for Spares andaccessories

Bin card: Card or Tag used to illustrate the level of the stock position of the certainmaterials at the stores

Stores ledger: It is a official record of receipt and issuance of materials or goods interms of quantities with value of them

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Receivables: It is an asset arises at the moment of credit sales, owed to the firm

Collection cost: Cost of collection incurred by the firm due to collection of receivables

Agency charges, brokerage charges for collection

Default cost: Cost due to bad debts

23.14 QUESTIONS FOR DISCUSSION

1. Define the working capital management.

2. Explain the objectives of working capital management.

3. Explain the various components of working capital management.

4. Write detailed note on cash management.

5. Elucidate the various practices of Inventory management.

6. Highlight the importance of the receivable management through various strategies.

23.15 SUGGESTED READINGS

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 McGrawHill, New Delhi (1994).

I.M. Pandey, “Financial Management”, Vikas Publishing, New Delhi.

Nitin Balwani, “Accounting & Finance for Managers”, Excel Books, New Delhi.

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