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working capital mgmt

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Dr Ajay Kumar
Dr Ajay Kumar

- Working capital refers to the capital required to finance short-term operating expenses like inventory, receivables, and payables. It allows a company to operate on a day-to-day basis. - There are two concepts of working capital - the balance sheet concept and operating cycle concept. The balance sheet concept defines it as current assets minus current liabilities, while the operating cycle concept considers the cash conversion cycle. - The operating cycle includes the inventory conversion period, receivables conversion period, and payables deferral period and indicates the time between cash expenditure and cash recovery. Managing working capital effectively is important for business operations and liquidity.

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Working Capital
Working capital typically means the firms holding of current or short-term assets such as cash, receivables, inventory and marketable securities. Working Capital refers to that part of the firms capital, which is required for financing short-term or current assets. These items are also referred to as circulating capital. Working capital: Concept
There are two possible interpretations of working capital concept: 1. Balance sheet concept 2. Operating cycle concept Balance sheet concept: There are two interpretations of working capital under the balance sheet concept. a. Excess of current assets over current liabilities b. Gross or total current assets. Excess of current assets over current liabilities are called the net working capital or net current assets. Concept of working capital
Operating cycle concept A companys operating cycle typically consists of three primary activities: Purchasing resources, Producing the product and Distributing (selling) the product. These activities create funds flows that are both unsynchronized and uncertain. Unsynchronized because cash disbursements usually take place before cash receipts. Uncertain because future sales and costs cannot be forecasted with complete accuracy.
The firm has to maintain cash balance to pay the bills as they come due. In addition, the company must invest in inventories to fill customer orders promptly. And finally, the company invests in accounts receivable to extend credit to customers. Operating cycle is equal to the length of inventory and receivable conversion periods. Operating cycle concept
Operating cycle of a typical company Payable Deferral period Inventory conversion period Cash conversion cycle Operating cycle Pay for Resources purchases Receive CashPurchase resources Sell Product On credit Receivable Conversion period
THE WORKING CAPITAL CYCLE (OPERATING CYCLE) Accounts Payable Cash Raw Materials W I P Finished Goods Value Addition Accounts Receivable SALES
If you Then ...... Collect receivables (debtors) faster You release cash from the cycle Collect receivables (debtors) slower Your receivables soak up cash Get better credit (in terms of duration or amount) from suppliers You increase your cash resources Shift inventory (stocks) faster You free up cash Move inventory (stocks) slower You consume more cash
Raw material storage peiod: = Average stock of raw material Cost of raw material consumed/365 WIP holding period: Average WIP inventory/ Cost of production/365 Finished goods storage period: Average stock of finished goods/Cost of goods sold/365 Inventory conversion period: Avg. inventory/ Cost of sales/365 Receivable conversion period:Accounts receivable/Annual credit sales/365 Payables deferral period: Accounts payable/(Credit purchases)/365 Operating cycle: Inventory conversion period + receivable conversion period. Cash conversion cycle = operating cycle payables deferral period.
TYPES OF WORKING CAPITAL WORKING CAPITAL BASIS OF CONCEPT BASIS OF TIME Gross Working Capital Net Working Capital Permanent / Fixed WC Temporary / Variable WC Regular WC Reserve WC Special WC Seasonal WC
The size and nature of investment in current assets is a function of different factors such as Type of products manufactured, Length of operating cycle, Sales level, Inventory policies, Unexpected demand and Unanticipated delays in obtaining new inventories, Credit policies and Current assets. Working capital investment
Difference between permanent & temporary working capital Amount Variable Working Capital of Working Capital Permanent Working Capital Time
Variable Working Capital Amount of Working Capital Permanent Working Capital Time
Matching approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Rs Short-term Debt Long-term Debt + Equity Capital
Conservative approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Rs Short-term Debt Long-term Debt + Equity capital
Aggressive approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time RS Short-term Debt Long-term Debt + Equity capital
FACTORS DETERMINING WORKING CAPITAL 1. Nature of the Industry 2. Demand of Industry 3. Cash requirements 4. Nature of the Business 5. Manufacturing time 6. Volume of Sales 7. Terms of Purchase and Sales 8. Inventory Turnover 9. Business Turnover 10. Business Cycle 11. Current Assets requirements 12. Production Cycle
Working capital estimation
Satyam Ltd profit and loss A/c and balance sheet for the year ended 31.12.15 are given below. You required to calculate the working capital requirement under operating cycle method: Opening stock Raw material 10,000 WIP 30,000 Finished goods 5,000 Credit purchase 35,000 Manufacturing expn 15,000 Gross profit 55,000 150,000 Administration expn 15,000 Selling &distrbtn expn 10,000 Net profit 30,000 55,000 Credit sales 1,00,000 Closing stock Raw material 11,000 WIP 30,500 Finished goods 8,500 150,000 Gross profit 55,000 . 55,000
Liabilities Equities (16,000@Rs.10) 160,000 Net Profit 30,000 Creditors 10,000 2,00,000 Assets Fixed Assets 1,00,000 Debtors 30,500 Cash and Bank 19,500 Closing stock Raw material 11,000 WIP 30,500 Finished goods 8,500 2,00,000 Opening debtors (excluding profit) and opening creditor were Rs.6,500 and Rs.5,000 respectively
Calculation of operating cycle Raw material Average raw material /Raw material consumed per day =10,500/34,000/365 = Work in progress Average WIP /Total cost of production per day =30,250/48500/365 =
Calculation of operating cycle Finished goods Average stock/ Total cost of goods sold per day =6750/45,000/365 = Debtors Average Debtors/ credit sales per day =18,500/ 100,000/365 =
Calculation of operating cycle Creditor Average creditor/credit purchases per day =7500/35,000/365 Net Operating Cycle is Total days Credit allowed by creditors =
Estimation of Net Working capital requirement for Exl Ltd from the data given below Cost of production (per unit) Amount(per unit ) Raw materials 100 Direct labour 40 Overheads 80 220 The following are the additional information: Selling price per unit Rs.240 Level of activity 1,04,000 units p.a Raw material in stock Average 4 weeks Work In Progress (Assume 100% stage of completion of materials and 50 percent for labor and overheads) Average 2 weeks Finished goods in stock Average 4 weeks Credit allowed by supplier Average 4 weeks Credit allowed by debtors Average 8 weeks Lag in payment of wages Average 1.50 weeks Cash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year
Statement of Working Capital Requirement Particulars Amount Raw materials 2,000 x 4 x 100 8,00,000 WIP Raw materials 2,000 x 2 x 100 4,00,000 Wages (2,000 x 2 x 40)50% 80,000 Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000 Finished stock 2,000 x 4 x 220 17,60,000 Debtors 2,000 x 8 x 220 35,20,000 Cash 25,000 Total Current Assets 67,45,000 Creditors 2,000 x 4 x 100 8,00,000 Outstanding wages 2,000 x 4 x 1.5 1,20,000 Total current liabilities 9,20,000 Net working capital (TCA - TCL) 58,25,000
INVENTORY MEANING Held for SALE Consumed in the PRODUCTION of goods and services Forms of Inventory for Manufacturing firm. Raw materials, Work in process, Finished goods and stores & spares.
Inventory Management- objectives Minimize investments in inventory Meet the demand for products by efficiently organizing the production & sales operations.
RISK OF HOLDING INVENTORY Price decline Product Deterioration Product Obsolescence
COSTS OF HOLDING INVENTORIES Ordering costs Inventory Carrying/storage costs Opportunity costs of funds blocked Shortage
TOOLS & TECHNIQUES OF INVENTORY MANAGEMENT/ CONTROL ABC Analysis Economic Ordering Quantity (EOQ) Order Point Problem
ABC analysis ABC analysis is an inventory categorization method which consists in dividing items into three categories, A, B and C: A being the most valuable items, C being the least valuable ones. This method aims to draw managers attention on the critical few (A-items) and not on the minor many (C-items).
ABC Analysis CATEGORY NO. OF ITEMS(%) ITEM VALUE(%) MANAGEMENT CONTROL A 15 70 (HIGHEST) MAXIMUM B 30 20(MODERATE) MODERATE C 55 10(LEAST) MINIMUM TOTAL 100 100
Example ABC Analysis Stock Number Annual Volume Percent of Annual Volume J24 12,500 46.2 R26 9,000 33.3 L02 3,200 11.8 M12 1,550 5.8 P33 620 2.3 T72 65 0.2 S67 53 0.2 Q47 32 0.1 V20 30 0.1 Total = 100.0
Solution ABC Groups Class Items Annual Volume Percent of Volume A J24, R26 21,500 79.5 B L02, M12 4,750 17.6 C P33, T72, S67, Q47, V20 800 2.9 S = 100.0
Economic Ordering Quantity (EOQ) Level of Inventory at which Total Cost* of Inventory is MINIMUM *(Ordering and Carrying Cost)
EOQ MODEL 2AO Q = S Q = Economic Order Quantity A = Annual usage/demand O= Cost of Placing an order S = Storage cost per unit per order * Where Storage cost is given in % , it is always calculated by multiplying the % with the purchase price of raw material per unit, i.e Storage cost = % X Purchase price of raw material
BEHAVIOR OF INVENTORY RELATED COSTS Costs Total costs Carrying costs Ordering costs Quantity ordered
BEHAVIOUR OF INVENTORY RELATED COSTS Total cost of Inventory = Ordering cost + Holding cost Ordering cost = Annual Demand*Ordering cost/Q Holding cost = Q*Holding cost /2
EOQ- Example A firms annual inventory is 1,600 units. The cost of placing an order is Rs 50, purchase price of raw material/unit is Rs.10 and the carrying costs is expected to be 10% per unit p.a. Calculate EOQ? A=1600, O= Rs. 50, S= .10 x Rs.10=Rs.1 EOQ = 2 x 1600 x 50 1 = 400 units
Order Point Problem The re-order point is that level of inventory when a fresh order should be placed with suppliers. It is that inventory level which is equal to the consumption during the lead time or procurement time. Re-order level = (Daily usage Lead time) + Safety stock. Safety stock is minimum level of inventory that a firm keeps in hand. The firm reorders more inventory if the current inventory falls to safety level. Safety Stock = (Maximum Daily Usage Average Daily Usage) Lead Time
Example ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL Ltd. takes 10 days in manufacturing and delivering an order. ABC's requires 10,000 units of rims per year. Its ordering cost is Rs.1,000 per order and its carrying costs are Rs.3 per unit per year. The maximum usage per day could be 50 per day. Calculate economic order quantity, total cost of inventory, reorder level and safety stock.
Solution EOQ, (Q) = (2*Annual Demand*Ordering Cost Per Unit / Carrying Cost Per Unit)^1/2 Q = (2*10,000*1,000/3)^1/2 = 2582 Total cost of Inventory = Ordering cost + Holding cost Ordering cost = Annual Demand*Ordering cost/Q = 10,000*1,000/2582 Holding cost = Q*Holding cost /2 =
Reorder point Safety Stock = (Maximum Daily Usage Average Daily Usage) Lead Time Reorder Level = Safety Stock + Average Daily Usage Lead Time
Example Assume you have a product with the following parameters: Annual Demand: 360; Holding cost per unit: Rs.1; Cost per order: Rs.100 The maximum daily demand is 3 units per day 1. What is the EOQ? 2. Given the data, and assuming a 300-day work year; how many orders should be processed per year? What is the expected time between orders? 3. What is the total cost for the inventory policy used ? 4. Assume that the demand was actually higher than estimated (i.e., 500 units instead of 360 units). What will be the actual annual total cost?
Solution EOQ Demand Order cost Holding cost items 2 2 360 100 1 72000 268 * * * * N Demand Q orders per year 360 268 134. T Working days Expected number of orders days between orders 300 134 224/ .
Total cost of Inventory = Ordering cost + Holding cost Ordering cost = Annual Demand *Ordering cost/Q = 360* 100/268 = 134 Holding cost = Q*Holding cost /2 = 268*1/2 = Total Cost of inventory =
JUST-IN-TIME (JIT) INVENTORY CONTROL The JIT control system implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components just-in-time to meet its assembly requirements. JIT also known as Zero Inventory Production Systems(ZIPS), Zero Inventories(ZIN), Materials as Needed(MAN), or Neck of Time(N0T)
Cash Management
Definition Cash Management refers to management of cash & bank balance and also includes the management of short term deposits.
Motives of cash management Transaction motive: Business firm keep cash to meet their demand for cash arising from day to day transactions. Precautionary motive: Maintenance of cash balance to act as buffer against unexpected events. Speculative motive: Cash balance to take advantage of potential profit making situations that may occur in future.
Optimum Cash Balance Baumols model Miller-orr model
Baumols model Suggested by William J. Baumol (1952) The model attempts to balance the income foregone on cash held by the firm against the transaction cost of converting cash into marketable securities or vice versa. This model can be presented on assumption as follows: Fixed Cash flow : The Baumols model assumes that the firm uses cash at an already known rate per period and that this rate of use is constant. Holding cost: The holding cost is the opportunity cost in terms of interest foregone on investment in cash. Transaction cost: whenever cash is invested in marketable securities, there is cost involved like brokerage or commission.
working capital mgmt
Illustration The annual cash requirement of A Ltd. is Rs 10 lakhs. The company has marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000. Cost of conversion of marketable securities per lot is Rs.1,000. The company can earn 5% annual yield on its securities. You are required to prepare a table indicating which lot size will have to be sold by the company. Also estimate the economic lot size can be obtained by the Baumol Model.
Baumol model C= 2A*F/O Where A= Annual requirement = 10 lakh F = Fixed conversion charges = 1000 O = opportunity 5% C = 2*10,00,000*1000/0.05 = 2,00,000
Table indicating lot size S. No Particulars Situation 1 Situtation2 Situation 3 A Annual cash requirement (Given) 10,00,000 10,00,000 10,00,000 B Lot size of securities (Given) 50,000 1, 00,000 2,00,000 C No. of lot sizes (A/B) 20 10 5 D Average holding OF CASH (B/2) 25,000 50,000 1,00,000 E Opportunity cost of holding cash (D x 0.05) 1250 2500 5000 F Fixed conversion cost (given) 1000 1000 1000 G Total conversion cost (C x F) 20,000 10,000 5,000 H Total cost (E+G) 21,250 12,500 10,000 The above illustration shown that the minimum cost is Rs.10,000 when the lot size is 2,00,000
Miller and Orr model Baumols model is based on the basic assumption that the size and timing of cash flows are known with certainty. Whereas, in real situation, the cash flows of a firm are neither uniform nor certain. M.H. Miller and Daniel Orr (A Model of the Demand for Money) expanded on the Baumol model and developed Stochastic Model for firms with uncertain cash inflows and cash outflows.
The Miller and Orr (MO) model provides two control limits-the upper control limit and the lower control limit along-with a return point as shown in the figure below:
Miller and Orr model If the cash balance touches the upper control limit (H), marketable securities are purchased to the extent of (H-Z) to return back to the normal cash balance of Z. If the cash balance touches lower control limit (O), the firm will sell the marketable securities to the extent of O-Z to again return to the normal cash balance. The spread between the upper and lower cash balance limits (called Z) can be computed using Miller-Orr model as below:
Receivables Management Accounts receivables for the selling firm is same as an account payable for the purchaser. The purpose of credit analysis is to assess the credit worthiness of potential customers and the corresponding risk of late payments or default.
Receivables Management Credit analysis consists of: 1. Gathering information about the potential customer 2. Analyzing the information to derive a credit decision about the payment terms and amount of trade credit granted Credit agencies provide credit ratings and reports on companies.
STEPS IN CREDIT ANALYSIS The 5 Cs of Credit Analysis Character - Reputation, Track Record Capacity - Ability to repay. Capital - Financial Position of the co. Collateral - The type and kind of assets pledged Conditions - Economic conditions & competitive factors that may affect the profitability of the customer.
Credit planning Aspects of credit planning Credit policy Credit standards Credit terms
Credit policy A company's policy related to trading off the profit on additional sales that arises due to credit sales and the cost of carrying those debtors and probable bad debts.
Credit standards The guidelines issued by a company that are used to determine if a potential borrower is creditworthy. Credit standards are often created after careful analysis of past borrowers and market conditions, and are designed to limit the risk of a borrower not making credit payments or defaulting on loaned money.
Credit terms The terms which indicate when payment is due for sales made on account (or credit). Credit period Discount period Discount rate The general credit terms are expressed as 2/10, net 30. This means the amount is due in 30 days; however, if the amount is paid in 10 days a discount of 2% will be permitted.
Calculation of annualized return If credit term is expressed as a/b,net c then; Annualized return = a/(1-a) * 360/(c-b) Which of the below terms have lower cost to company? 1. 2/10, net 30 2. 5/10, net 60

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working capital mgmt

  • 2. Working capital typically means the firms holding of current or short-term assets such as cash, receivables, inventory and marketable securities. Working Capital refers to that part of the firms capital, which is required for financing short-term or current assets. These items are also referred to as circulating capital. Working capital: Concept
  • 3. There are two possible interpretations of working capital concept: 1. Balance sheet concept 2. Operating cycle concept Balance sheet concept: There are two interpretations of working capital under the balance sheet concept. a. Excess of current assets over current liabilities b. Gross or total current assets. Excess of current assets over current liabilities are called the net working capital or net current assets. Concept of working capital
  • 4. Operating cycle concept A companys operating cycle typically consists of three primary activities: Purchasing resources, Producing the product and Distributing (selling) the product. These activities create funds flows that are both unsynchronized and uncertain. Unsynchronized because cash disbursements usually take place before cash receipts. Uncertain because future sales and costs cannot be forecasted with complete accuracy.
  • 5. The firm has to maintain cash balance to pay the bills as they come due. In addition, the company must invest in inventories to fill customer orders promptly. And finally, the company invests in accounts receivable to extend credit to customers. Operating cycle is equal to the length of inventory and receivable conversion periods. Operating cycle concept
  • 6. Operating cycle of a typical company Payable Deferral period Inventory conversion period Cash conversion cycle Operating cycle Pay for Resources purchases Receive CashPurchase resources Sell Product On credit Receivable Conversion period
  • 7. THE WORKING CAPITAL CYCLE (OPERATING CYCLE) Accounts Payable Cash Raw Materials W I P Finished Goods Value Addition Accounts Receivable SALES
  • 8. If you Then ...... Collect receivables (debtors) faster You release cash from the cycle Collect receivables (debtors) slower Your receivables soak up cash Get better credit (in terms of duration or amount) from suppliers You increase your cash resources Shift inventory (stocks) faster You free up cash Move inventory (stocks) slower You consume more cash
  • 9. Raw material storage peiod: = Average stock of raw material Cost of raw material consumed/365 WIP holding period: Average WIP inventory/ Cost of production/365 Finished goods storage period: Average stock of finished goods/Cost of goods sold/365 Inventory conversion period: Avg. inventory/ Cost of sales/365 Receivable conversion period:Accounts receivable/Annual credit sales/365 Payables deferral period: Accounts payable/(Credit purchases)/365 Operating cycle: Inventory conversion period + receivable conversion period. Cash conversion cycle = operating cycle payables deferral period.
  • 10. TYPES OF WORKING CAPITAL WORKING CAPITAL BASIS OF CONCEPT BASIS OF TIME Gross Working Capital Net Working Capital Permanent / Fixed WC Temporary / Variable WC Regular WC Reserve WC Special WC Seasonal WC
  • 11. The size and nature of investment in current assets is a function of different factors such as Type of products manufactured, Length of operating cycle, Sales level, Inventory policies, Unexpected demand and Unanticipated delays in obtaining new inventories, Credit policies and Current assets. Working capital investment
  • 12. Difference between permanent & temporary working capital Amount Variable Working Capital of Working Capital Permanent Working Capital Time
  • 14. Matching approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Rs Short-term Debt Long-term Debt + Equity Capital
  • 15. Conservative approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Rs Short-term Debt Long-term Debt + Equity capital
  • 16. Aggressive approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time RS Short-term Debt Long-term Debt + Equity capital
  • 17. FACTORS DETERMINING WORKING CAPITAL 1. Nature of the Industry 2. Demand of Industry 3. Cash requirements 4. Nature of the Business 5. Manufacturing time 6. Volume of Sales 7. Terms of Purchase and Sales 8. Inventory Turnover 9. Business Turnover 10. Business Cycle 11. Current Assets requirements 12. Production Cycle
  • 19. Satyam Ltd profit and loss A/c and balance sheet for the year ended 31.12.15 are given below. You required to calculate the working capital requirement under operating cycle method: Opening stock Raw material 10,000 WIP 30,000 Finished goods 5,000 Credit purchase 35,000 Manufacturing expn 15,000 Gross profit 55,000 150,000 Administration expn 15,000 Selling &distrbtn expn 10,000 Net profit 30,000 55,000 Credit sales 1,00,000 Closing stock Raw material 11,000 WIP 30,500 Finished goods 8,500 150,000 Gross profit 55,000 . 55,000
  • 20. Liabilities Equities (16,000@Rs.10) 160,000 Net Profit 30,000 Creditors 10,000 2,00,000 Assets Fixed Assets 1,00,000 Debtors 30,500 Cash and Bank 19,500 Closing stock Raw material 11,000 WIP 30,500 Finished goods 8,500 2,00,000 Opening debtors (excluding profit) and opening creditor were Rs.6,500 and Rs.5,000 respectively
  • 21. Calculation of operating cycle Raw material Average raw material /Raw material consumed per day =10,500/34,000/365 = Work in progress Average WIP /Total cost of production per day =30,250/48500/365 =
  • 22. Calculation of operating cycle Finished goods Average stock/ Total cost of goods sold per day =6750/45,000/365 = Debtors Average Debtors/ credit sales per day =18,500/ 100,000/365 =
  • 23. Calculation of operating cycle Creditor Average creditor/credit purchases per day =7500/35,000/365 Net Operating Cycle is Total days Credit allowed by creditors =
  • 24. Estimation of Net Working capital requirement for Exl Ltd from the data given below Cost of production (per unit) Amount(per unit ) Raw materials 100 Direct labour 40 Overheads 80 220 The following are the additional information: Selling price per unit Rs.240 Level of activity 1,04,000 units p.a Raw material in stock Average 4 weeks Work In Progress (Assume 100% stage of completion of materials and 50 percent for labor and overheads) Average 2 weeks Finished goods in stock Average 4 weeks Credit allowed by supplier Average 4 weeks Credit allowed by debtors Average 8 weeks Lag in payment of wages Average 1.50 weeks Cash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year
  • 25. Statement of Working Capital Requirement Particulars Amount Raw materials 2,000 x 4 x 100 8,00,000 WIP Raw materials 2,000 x 2 x 100 4,00,000 Wages (2,000 x 2 x 40)50% 80,000 Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000 Finished stock 2,000 x 4 x 220 17,60,000 Debtors 2,000 x 8 x 220 35,20,000 Cash 25,000 Total Current Assets 67,45,000 Creditors 2,000 x 4 x 100 8,00,000 Outstanding wages 2,000 x 4 x 1.5 1,20,000 Total current liabilities 9,20,000 Net working capital (TCA - TCL) 58,25,000
  • 26. INVENTORY MEANING Held for SALE Consumed in the PRODUCTION of goods and services Forms of Inventory for Manufacturing firm. Raw materials, Work in process, Finished goods and stores & spares.
  • 27. Inventory Management- objectives Minimize investments in inventory Meet the demand for products by efficiently organizing the production & sales operations.
  • 28. RISK OF HOLDING INVENTORY Price decline Product Deterioration Product Obsolescence
  • 29. COSTS OF HOLDING INVENTORIES Ordering costs Inventory Carrying/storage costs Opportunity costs of funds blocked Shortage
  • 30. TOOLS & TECHNIQUES OF INVENTORY MANAGEMENT/ CONTROL ABC Analysis Economic Ordering Quantity (EOQ) Order Point Problem
  • 31. ABC analysis ABC analysis is an inventory categorization method which consists in dividing items into three categories, A, B and C: A being the most valuable items, C being the least valuable ones. This method aims to draw managers attention on the critical few (A-items) and not on the minor many (C-items).
  • 32. ABC Analysis CATEGORY NO. OF ITEMS(%) ITEM VALUE(%) MANAGEMENT CONTROL A 15 70 (HIGHEST) MAXIMUM B 30 20(MODERATE) MODERATE C 55 10(LEAST) MINIMUM TOTAL 100 100
  • 33. Example ABC Analysis Stock Number Annual Volume Percent of Annual Volume J24 12,500 46.2 R26 9,000 33.3 L02 3,200 11.8 M12 1,550 5.8 P33 620 2.3 T72 65 0.2 S67 53 0.2 Q47 32 0.1 V20 30 0.1 Total = 100.0
  • 34. Solution ABC Groups Class Items Annual Volume Percent of Volume A J24, R26 21,500 79.5 B L02, M12 4,750 17.6 C P33, T72, S67, Q47, V20 800 2.9 S = 100.0
  • 35. Economic Ordering Quantity (EOQ) Level of Inventory at which Total Cost* of Inventory is MINIMUM *(Ordering and Carrying Cost)
  • 36. EOQ MODEL 2AO Q = S Q = Economic Order Quantity A = Annual usage/demand O= Cost of Placing an order S = Storage cost per unit per order * Where Storage cost is given in % , it is always calculated by multiplying the % with the purchase price of raw material per unit, i.e Storage cost = % X Purchase price of raw material
  • 37. BEHAVIOR OF INVENTORY RELATED COSTS Costs Total costs Carrying costs Ordering costs Quantity ordered
  • 38. BEHAVIOUR OF INVENTORY RELATED COSTS Total cost of Inventory = Ordering cost + Holding cost Ordering cost = Annual Demand*Ordering cost/Q Holding cost = Q*Holding cost /2
  • 39. EOQ- Example A firms annual inventory is 1,600 units. The cost of placing an order is Rs 50, purchase price of raw material/unit is Rs.10 and the carrying costs is expected to be 10% per unit p.a. Calculate EOQ? A=1600, O= Rs. 50, S= .10 x Rs.10=Rs.1 EOQ = 2 x 1600 x 50 1 = 400 units
  • 40. Order Point Problem The re-order point is that level of inventory when a fresh order should be placed with suppliers. It is that inventory level which is equal to the consumption during the lead time or procurement time. Re-order level = (Daily usage Lead time) + Safety stock. Safety stock is minimum level of inventory that a firm keeps in hand. The firm reorders more inventory if the current inventory falls to safety level. Safety Stock = (Maximum Daily Usage Average Daily Usage) Lead Time
  • 41. Example ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL Ltd. takes 10 days in manufacturing and delivering an order. ABC's requires 10,000 units of rims per year. Its ordering cost is Rs.1,000 per order and its carrying costs are Rs.3 per unit per year. The maximum usage per day could be 50 per day. Calculate economic order quantity, total cost of inventory, reorder level and safety stock.
  • 42. Solution EOQ, (Q) = (2*Annual Demand*Ordering Cost Per Unit / Carrying Cost Per Unit)^1/2 Q = (2*10,000*1,000/3)^1/2 = 2582 Total cost of Inventory = Ordering cost + Holding cost Ordering cost = Annual Demand*Ordering cost/Q = 10,000*1,000/2582 Holding cost = Q*Holding cost /2 =
  • 43. Reorder point Safety Stock = (Maximum Daily Usage Average Daily Usage) Lead Time Reorder Level = Safety Stock + Average Daily Usage Lead Time
  • 44. Example Assume you have a product with the following parameters: Annual Demand: 360; Holding cost per unit: Rs.1; Cost per order: Rs.100 The maximum daily demand is 3 units per day 1. What is the EOQ? 2. Given the data, and assuming a 300-day work year; how many orders should be processed per year? What is the expected time between orders? 3. What is the total cost for the inventory policy used ? 4. Assume that the demand was actually higher than estimated (i.e., 500 units instead of 360 units). What will be the actual annual total cost?
  • 45. Solution EOQ Demand Order cost Holding cost items 2 2 360 100 1 72000 268 * * * * N Demand Q orders per year 360 268 134. T Working days Expected number of orders days between orders 300 134 224/ .
  • 46. Total cost of Inventory = Ordering cost + Holding cost Ordering cost = Annual Demand *Ordering cost/Q = 360* 100/268 = 134 Holding cost = Q*Holding cost /2 = 268*1/2 = Total Cost of inventory =
  • 47. JUST-IN-TIME (JIT) INVENTORY CONTROL The JIT control system implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components just-in-time to meet its assembly requirements. JIT also known as Zero Inventory Production Systems(ZIPS), Zero Inventories(ZIN), Materials as Needed(MAN), or Neck of Time(N0T)
  • 49. Definition Cash Management refers to management of cash & bank balance and also includes the management of short term deposits.
  • 50. Motives of cash management Transaction motive: Business firm keep cash to meet their demand for cash arising from day to day transactions. Precautionary motive: Maintenance of cash balance to act as buffer against unexpected events. Speculative motive: Cash balance to take advantage of potential profit making situations that may occur in future.
  • 51. Optimum Cash Balance Baumols model Miller-orr model
  • 52. Baumols model Suggested by William J. Baumol (1952) The model attempts to balance the income foregone on cash held by the firm against the transaction cost of converting cash into marketable securities or vice versa. This model can be presented on assumption as follows: Fixed Cash flow : The Baumols model assumes that the firm uses cash at an already known rate per period and that this rate of use is constant. Holding cost: The holding cost is the opportunity cost in terms of interest foregone on investment in cash. Transaction cost: whenever cash is invested in marketable securities, there is cost involved like brokerage or commission.
  • 54. Illustration The annual cash requirement of A Ltd. is Rs 10 lakhs. The company has marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000. Cost of conversion of marketable securities per lot is Rs.1,000. The company can earn 5% annual yield on its securities. You are required to prepare a table indicating which lot size will have to be sold by the company. Also estimate the economic lot size can be obtained by the Baumol Model.
  • 55. Baumol model C= 2A*F/O Where A= Annual requirement = 10 lakh F = Fixed conversion charges = 1000 O = opportunity 5% C = 2*10,00,000*1000/0.05 = 2,00,000
  • 56. Table indicating lot size S. No Particulars Situation 1 Situtation2 Situation 3 A Annual cash requirement (Given) 10,00,000 10,00,000 10,00,000 B Lot size of securities (Given) 50,000 1, 00,000 2,00,000 C No. of lot sizes (A/B) 20 10 5 D Average holding OF CASH (B/2) 25,000 50,000 1,00,000 E Opportunity cost of holding cash (D x 0.05) 1250 2500 5000 F Fixed conversion cost (given) 1000 1000 1000 G Total conversion cost (C x F) 20,000 10,000 5,000 H Total cost (E+G) 21,250 12,500 10,000 The above illustration shown that the minimum cost is Rs.10,000 when the lot size is 2,00,000
  • 57. Miller and Orr model Baumols model is based on the basic assumption that the size and timing of cash flows are known with certainty. Whereas, in real situation, the cash flows of a firm are neither uniform nor certain. M.H. Miller and Daniel Orr (A Model of the Demand for Money) expanded on the Baumol model and developed Stochastic Model for firms with uncertain cash inflows and cash outflows.
  • 58. The Miller and Orr (MO) model provides two control limits-the upper control limit and the lower control limit along-with a return point as shown in the figure below:
  • 59. Miller and Orr model If the cash balance touches the upper control limit (H), marketable securities are purchased to the extent of (H-Z) to return back to the normal cash balance of Z. If the cash balance touches lower control limit (O), the firm will sell the marketable securities to the extent of O-Z to again return to the normal cash balance. The spread between the upper and lower cash balance limits (called Z) can be computed using Miller-Orr model as below:
  • 60. Receivables Management Accounts receivables for the selling firm is same as an account payable for the purchaser. The purpose of credit analysis is to assess the credit worthiness of potential customers and the corresponding risk of late payments or default.
  • 61. Receivables Management Credit analysis consists of: 1. Gathering information about the potential customer 2. Analyzing the information to derive a credit decision about the payment terms and amount of trade credit granted Credit agencies provide credit ratings and reports on companies.
  • 62. STEPS IN CREDIT ANALYSIS The 5 Cs of Credit Analysis Character - Reputation, Track Record Capacity - Ability to repay. Capital - Financial Position of the co. Collateral - The type and kind of assets pledged Conditions - Economic conditions & competitive factors that may affect the profitability of the customer.
  • 63. Credit planning Aspects of credit planning Credit policy Credit standards Credit terms
  • 64. Credit policy A company's policy related to trading off the profit on additional sales that arises due to credit sales and the cost of carrying those debtors and probable bad debts.
  • 65. Credit standards The guidelines issued by a company that are used to determine if a potential borrower is creditworthy. Credit standards are often created after careful analysis of past borrowers and market conditions, and are designed to limit the risk of a borrower not making credit payments or defaulting on loaned money.
  • 66. Credit terms The terms which indicate when payment is due for sales made on account (or credit). Credit period Discount period Discount rate The general credit terms are expressed as 2/10, net 30. This means the amount is due in 30 days; however, if the amount is paid in 10 days a discount of 2% will be permitted.
  • 67. Calculation of annualized return If credit term is expressed as a/b,net c then; Annualized return = a/(1-a) * 360/(c-b) Which of the below terms have lower cost to company? 1. 2/10, net 30 2. 5/10, net 60

Editor's Notes

  • #22: Total cost of production: = Opn WIP + Raw material consumed + Manufacturing expn Cls. WIP 30,000 + (10,000 +35000- 11,000)+ 15,000 30,500 = 48,500
  • #23: Cost of goods sold = Opn Finished Goods + Cost of production Cls Finished Goods= 5,000 + 48,500 8,500 = 45,000 Average Debtors: (6500 + 30,500)/2 = 18,500
  • #24: Average creditor = (5,000 + 10,000)/2 = 7,500
  • #26: 1,04,000/52 = 2,000