Accounting and Finance for Managers

LESSON

23
WORKING 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
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Contd...

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

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 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.

23.2 OBJECTIVES OF THE WORKING CAPITAL MANAGEMENT

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 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.

23.3 APPROACHES OF THE WORKING CAPITAL

The approaches of the working capital are classified into two categories viz the hedging approach and conservative approach: The hedging approach: Under this approach, the maturity of the financial resources are matched with the nature of assets to be financed.
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Permanent working capital are financed by the long-term financial resources and the seasonal working capital requirements are met out through short term financial resources. The conservative approach: 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.

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 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.

Production cycle: 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. Business cycle: 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. Production policy: 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:
(i) The firm produces the goods then and there to the tune of immediate needs of the market. 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.

(ii) 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.

Credit policy: 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
(i)

Liberal credit policy: The liberal credit policy may lead to have greater volume of book debts, greater credit period, huge amount required for the built of stock; require the firm to have greater amount of working capital

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

Growth and Expansion: 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. 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 of production 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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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.

Working Capital Management

N e t p ro fit: is one of the major sources of working capital and practically speaking it is It one of the sources of cash from operations. To maintain the liquidity, the net profit earning capacity should be maintained forever. D iv id e n d po lic yThe 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. D e p re ciatio n po lic y : depreciation policy of the firm not only facilitates to bring The down the taxable liability but also brings down the profit which enhances the liquidity of the firm on the other side. P rice le v e l ch an ge s: price level changes require the firm to keep more amount of The working capital to go hand in hand with the price changes which normally affect the firm's liquidity position. During the periods of inflation, the firm is required to anticipate the 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 less than its requirement to meet out the needs. If the working capital is more than the requirement means that the firm is expected to unnecessarily keep short-term assets idle in state and vice versa. The maintaining of the working capital management is mainly depending 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 current assets are inadequate to meet the short term obligations of the firm on time, which may lead 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 short term 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 excessive volume of current assets drastically affects the profitability of the firm due to excess liquidity 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 volume of fixed assets. i) The working capital management policies are studied in the following context viz ii) iii) 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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Aggressive 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.

23.6 ESTIMATION OF WORKING CAPITAL REQUIREMENT

The following is the proforma of the working capital requirement Statement of working capital required Current Assets: i) ii) Cash Debtors XXXX XXXX XXXX XXXX XXXX

iii) Stocks iv) Advanced payments v) Less: Current liabilities Creditors Others

XXXX

ii)

Lag in payment of expenses

XXXX XXXX

iii) Outstanding expenses if any

Working capital (Current assets-Current liabilities)

XXXX

Add: Provision for contingencies Net working capital required

XXXX 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

Statement of working capital requirements Current Assets

Debtors (8 weeks)Rs.15,00,000 8/52(At cost)

S c ( w

eks) Rs.15,00,000 12/52 Less Current liabilities Creditors (4 weeks) Rs15,00,000 4/52 Net working capital Add: 10% contingencies

Rs

2,30,769.23 3,46,153.38 1,15,384.61 4,61,538.0 46,153.8 5,07,691.8

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Working capital required

i)

a) b)

d) e) f) g)

Check Your Progress

Working Capital Management

1. 2.

The recent release of the finance minister during the budget session on the special excise duty on the cement industry. How the construction industry is affected ? In what way? Which factor of influence affects the firm?

23.7 CASH MANAGEMENT

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.

23.7.1 Motives of holding cash

T ra n s ac tion M otiv e : the cash outflows are more than that of the cash inflows, the If firms are expected to maintain the cash resources. P re ca u tio n ary M o tiv e : 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. S pe cu lativ e M o tive : is a motive holding the cash resources by the firm to exploit the It 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. C om pe n s atio n m otiv Banks provide certain services to the firms only on the basis of e: the certain amount of balances in the accounts. That is the motive holding cash resources to avail services from the banker viz compensation motive.

23.7.2 Objectives of Cash Management

(i)

M e e tin g th e ca sh re q u ire m e Mt: n eeting of cash requirem ents 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.
M in im is in g th e fu n d s lo c k e d u p in th e c a s h b a la n ce s : locked up in the The funds form of cash resources should be more, but it should only to the tune of the requirement.

(ii)

23.7.3 Basic Problems of Cash Management

(i) Controlling level of cash (a)

Preparing the cash budget: 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.
P rov id in g roo m fo r u n p re d icta b le discre p a nThes: cie separate amount should be maintained for the purpose to meet out the discrepancies which are not easily foreseen. C o n ce n tra tion b a n k in The amount of collection from the local branches g: are normally deposited in a particular account of the firm, as soon as the
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(b)

(ii) Controlling of inflows of cash (a)

Accounting and Finance for Managers

deposit 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.

Lock box system: 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 . This system 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) Controlling of cash outflows

Centralizing of disbursing the payments: 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. Stretching payment schedule: 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) Investing the excessive cash surplus Determine the need of the surplus cash: Identify the excessive cash resources which are kept simply idle more than the requirement. Determination of the various avenues of investment: 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.
Check Your Progress

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) cash i.e marketable securities

None of the above

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

Transaction motive Compensating motive Speculative motive Precautionary motive

Stretching cash payment is Controlling the cash inflow c) a) & b) d) Controlling cash outflows None of the above

23.8 MANAGEMENT OF INVENTORIES

23.8.1 Meaning of Inventory
The inventory includes the following :

Stock of raw materials: 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

(b)

(a)

(b)

(a) (b)

1.

c)

2.
a) c) b) d)

3. a) b)

l
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classified normally into two categories viz opening stock and closing stock of raw materials.
l

Working Capital Management

S to ck of w o rk in p ro g re s s : 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 stock and 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. S to ck of fin is h e d g o o dThis is the stage at which the goods are readily available s: 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.

Inventory

Raw materials

Work in progress

Finished goods

23.8.2 Why inventory is to be controlled ?

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.

On/of the Production department: 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.
Less the stock of raw materials and accessories - Risk of Lock out due to insufficient 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 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 to loose the benefits out of the bulk procurement. Not advisable for the materials which are in scarcity. Lesser the quantum of purchase - Greater will be cost of procurement and lesser will the economic benefits and vice versa
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On/of the Sales department: Due 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.
More the stock of the finished goods - Better the position for the firm to meet the needs of the biz environment and more the cost of storage and investment on 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 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. 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 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:
Purchase Department

Finance Department Production Department Sales Department

Inventory control: Inventory control means that maintenance of desired level of inventory by 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.

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

23.8.3 Major Benefits of Inventory Control

l

Working Capital Management

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.

l l

l l

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) b) c) Centralised stores Decentralised stores Central and Sub stores

23.8.4 Centralised Stores

Under this type, the materials are received by and issued at one central place by the department 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
l The major advantages are following: l l

It requires less space It facilitates to minimize the stock investment The centralization leads to lower administrative and maintenance cost of stores
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In addition to the advantages, the present organization suffers with its own limitation while in applications; which are following:
l l l l

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

23.8.5 Decentralised Stores

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.

23.8.6 Central stores and Sub 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.

S u b S to re W e ld in g D ep t

S u b S to re P la n n in g D e p t

P ro d u ctio n D e p t

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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.

First we will discuss, the various methods of requisitioning of materials.

Working Capital Management

23.8.7 Reordering Level

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 of purchase 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 reorder 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.

23.8.8 Minimum Level/Safety level

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:
l

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 Reorder period) 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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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 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 ?
l l l

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)

23.8.10 Danger level

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

23.8.11 Average Stock Level

Average stock level =Minimum stock level + of the reorder quantity

23.8.12 Economic Ordering Quantity

The ordering of materials usually tagged with three different component of costs viz:
l l l

Acquisition cost of materials Ordering cost of materials Carrying cost of materials

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The ordering quantity of materials may be either larger or meager in volume, which carries its own advantages and disadvantages. If the quantity ordered is larger in volume, the following are some of the important advantages: The bulk purchase order reduces the ordering cost of the materials. The greater l the size of the order which leads to reduce the number of the orders in procuring the materials. Quantity discounts: The discount can be classified into two categories viz Trade l discount and Cash discount . What is trade discount ? l

Trade discount is the discount granted by the supplier to the buyer of materials at the moment of bulk purchase. This % of discount is greatly possible only during the periods of 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 l l l

Working Capital Management

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 2AO 1

Economic Ordering Quantity =

A = Annual requirement in units O = Ordering cost I = Cost of storing per year or cost of carrying the inventory
Graph of EOQ:

Total cost Rupees

Cost of carrying Ordering cost

Units per order Insert the picture anpve

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 Econom ic Ordering Quantity (EOQ) = = 2 20,000 Rs.100 0.16% on Rs.4 = 2,500 units 2AQ I

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Accounting and Finance for Managers

The 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 = Total Annual Need Size of the order Average stock = Size of the order 2 Average stock value =Average stock cost per unit Rs Carrying cost = 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 6,400 3,200 1,600 800 160 40,000 20,000 10,000 5,000 1,000 10,000 5,000 2,500 1,250 250 1 20,000 1 2 10,000 2 3 5000 4 4 2,500 8 5 500 40

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 Economic Ordering Quantity (EOQ)= 2 1600 = 200 units Rs.50 10% on Rs.40 2AO 1

EO Q =

Illustration 3
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

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%

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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 2AO 1

Working Capital Management

Economic Order Quantity (EOQ) = =

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 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 1,800 Rs.2 25% on 32 paise = 300 units 2 AO 1

Illustration 6 a) 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

Illustration 7 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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Normal 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 Lead time) 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 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

Illustration 8 Two components A and B are used as follows

Normal usage Minimum usage Maximum usage Re order quantity 50 units per week each 25 units per week each 75 units per week each 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 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) (4 + 6)) 2

Working Capital Management

= 450 unit (50 unit

= 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

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 - (Minimum consumption 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 issuing and receiving the materials. It is maintained by the store keeper for physical verification

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

(A)

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immediately 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:

Two Bin card system: 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.
Bin card for Mini and Reorder level Bin card for Maximum Level Maximum Level

Maximum Level

Reorder Level

Three Bin Card system: 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.
Reorder level

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Minimum stock level

Lead time stock level

Maximum stock level

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

Working Capital Management

23.8.13 ABC analysis

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

Based on the basis the materials are classified into three categories: Lesser percentage in volume and Greater percentage in Value- Category A Greater percentage in volume and Lesser percentage in Value - Category B and 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. 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.
Table of Items and value
Group A B No. of Items 320 1000 % of Items 8% 25% Value Rs 15,00,000 4,00,000 % of Value 75% 20%

The importance of 2,680analysis 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:
Group N o . o f Item s Level of Control % of Items 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% Value Rs % of Value

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

theC

67%

on

5%

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The Unique features of the ABC analysis:

Nature Level of Control Order frequency A Group of Items Rigid control Frequent orderingweeks, Fortnights 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 valueleast volume safety stock to be maintained System of Purchase Higher value demands centralized system of procurement Moderate value requires centralized and decentralized system of purchase Supervision By Senior officers By Middle level managers By clerical staff Lower value needs decentralized system of purchase Due to moderate value-lesser safety stock is required Due to lower valueHigh safety stock is required B Group of Items Moderate control Once in 2 months C Group of Items Very little control Once in 6 months

Advantages
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 controlled which finally led to lesser investments. 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 the production. 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.
Check Your Progress

1)

Inventory means
a) Stock of Cash b) Stock of Raw materials, work in progress and Finished goods
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Stock of spares

d)

Both b) & c) only

Contd...

(1) (2)

(3)

c)

2)

Inventory control is for the maintenance of

a) c) High level of inventory Low level of inventory b) d) Optimum level of inventory Average level of inventory

Working Capital Management

3)

Excessive inventory holding is a) c) Better for the firm Neither better nor worse for the firm the firm To minimize the excessive stock b) consumer To maintain liquidity d) b) Worse for the firm d) Either better or worse for

4)

The purpose of inventory control is a) To meet the needs of the

c) 5)

a),b) & c)

Inventory control is in relevance with a) c) Storage cost Ordering cost b) d) Carrying cost (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 and conditions of repayment on an agreed time period.

Meaning of the receivables management: 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. i)

23.9.2 Objectives of Accounts Receivables

iii) Achieving the growth in the volume of sales Increasing the volume of profits Meeting the acute competition

ii)

23.9.3 Cost of Maintaining the Accounts Receivables

Capital cost: 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. Administrative cost: Cost of maintaining the receivables. Collection cost: Whatever the cost incurred for the collection of the receivables are known as collection cost. Defaulting cost: This may arise due to defaulters and the cost is in other words as cost of bad debts and so on.

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23.9.4 Factors Affecting the Accounts Receivables

i) ii)

Level of sales: The volume of sales is the best indicator of accounts receivables. It differs from one firm to another. Credit policies: The credit policies are another major force of determinant in deciding the size of the accounts receivable. There are two types of credit policies viz lenient and stringent credit policies. Lenient credit policy: Enhances the volume of the accounts receivable due to liberal terms of the trade which normally encourage the buyers to buy more and more. Stringent credit policy: It curtails the motive buying the goods on credit due stiff terms of the trade put forth by the supplier unlike the earlier.

Terms of trade: The terms of the trade are normally bifurcated into two categories viz credit period and cash discount Credit period: Higher the credit period will lead to more volume of receivables, on the other 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 sales on the other hand that will affect the income of the enterprise.

iii)

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 short term resources for the smooth conduct of the firm.

23.10 VARIOUS COMMITTEE REPORTS ON WORKING CAPITAL

The following committees were especially appointed for the purpose to administer the working capital i) Dheja Committee Report 1969 ii) iii) iv) Tandon Committee Report 1975 Chore Committee Report 1980 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 needs inflated and such trends were checked" by the under the chairmanship of Dheja Committee.

Findings
i) ii) iii)
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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 to assess the financial position of the firm

Recommendations
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 the bankers to lend the corporate borrowers

Working Capital Management

23.10.2 Tandon Committee

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.

Findings of the Committee

i) 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 to the tune of firm's requirement It should be treated as supplementary source of finance but not as major source of finance Loans were lent only in accordance on the basis of the securities produced by the borrower but not on basis of level of operations Security compliance wont provide any safety to the banks but the periodical follow up only should facilitate the banker to get back the amount of loans and advances lent

ii) iii) iv)

Recommendations: It reached the land mark in studying the need of the industries towards the requirements of the working capital. The committee has subm itted its report on 9th Aug , 1975 by studying the lending policies. Necessary information about the future operations are to be supplied i)
ii) iii) 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.

23.10.3 Chore Committee Report 1979

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. The another 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. i) ii) iii) 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
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iv) No frequent sanction of ad hoc limits of borrowing from the banker

Accounting and Finance for Managers

v)

The overdependence on the bank credit should be lessened among the practices of the 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 bank of India and it submitted the report on 1983. The recommendations were implemented by the Government of India from April 1,1984.

Recommendations
i) ii) 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

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

The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenue through 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 include the short term loans". The working capital requirements are normally estimated to the tune of production policies, nature of the business, length of manufacturing process, credit policy and so on. The need of the working capital is determined on the basis of duration of the production cycle. The time duration taken by the manufacturing process should be considered from the stage of raw materials to the stage of finished goods. The cycle of the business should be relatively considered for the need of working capital. The credit policy of the firm is another determinant for the determination of the working capital. There are two different credit policies viz liberal and stringent credit policies. The management of cash resources should be not only in a position to afford liquidity but also it should not require the firm to keep the cash resources simply idle; which should be invested in the marketable securities to earn some rate of return whenever the firm feel excessive holding of cash resources. Banks provide certain services to the firms only on the basis of the certain amount of balances in the accounts. That is the motive holding cash resources to avail services from the banker viz compensation motive. Timely supply

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of the goods to the requirements, facilitates the firm to earn greater volume of earning. Reordering Level is the level at which the firm should go for fresh purchase requisition of material through the store keeper to meet the requirements. There are few models exercise the inventory control, which facilitates the firm to avoid either under or over stocking
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Working Capital Management

ABC Analysis 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 financial commitments

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 resources should be invested in the marketable securities
In ve n to ry : Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods and Stock of Spares but not Stock of Loose tools.

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

C arry in g co s t: Cost is incurred for carrying the materials from the place of purchase to place of production centre/profit centre O rd e rin g C os t: Cost incurred at the moment of placing the order of goods or materials e.g. Administration costs, cost of communication and so on.

Maximum level:The stock level of the firm should not be more than the determined level Minimum level:The further issues should not be done below the level of the stock of the firms

Reorder level: At this level, the firm should place an order for the materials to the requirement
L e a d tim e s to ck le v eThis is level required by all the firm s to maintain the stock till the l: next delivery from the supplier A B C A n aly s is: 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

VED Analysis: Vital, Essential and Desirable Analysis Designed for Spares and accessories
Bin card: Card or Tag used to illustrate the level of the stock position of the certain materials at the stores
Stores ledger: 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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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. 2. 3. 4. 5. 6. 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.

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 McGraw Hill, 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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