CAIIB-FM-Module D topics

1
CAIIB-FM-Module D topics

• Marginal Costing
• Capital Budgeting
• Cash Budget
• Working Capital

2
COSTING

• Cost accounting system provides information about
  cost
• Aim best use of resources and maximization of
  returns
• cost amount of expenditure incurred( actual
  notional)
• Purposes profit from each job/product, division,
  segmentpricingdecisioncontrolprofit planning
  inter firm comparison

3
Marginal costing

• Marginal costing distinguishes between fixed cost
  and variable cost
• Marginal cost is nothing but variable cost of
  additional unit
• Marginal cost variable cost
• MC Direct Material Direct Labour Direct
  expenses

4
Marginal costing problems

• Sales (-) variable cost () contribution
• Contribution(/ divided by) sales
• () C.S. Ratio
• ContributionFixed cost ()Break even point
• Fixed Cost (/ divided by) contribution per unit
  break even units

5
Basic formulaSales price (-) variable cost
contribution
SP less VC Contribution
10 6 4
9 6 3
8 6 2
7 6 1
6 6 0
5 6 (1)
4 6 (2)
6
Marginal costing problems

• SP Rs.10, VC Rs.6 Fixed Cost Rs.60000
• Find
• Break even point (in Rs. in units)
• C/S ratio
• Sales to get profit of Rs.20000

7
Marginal costing problems

• Sales Rs.100000
• Fixed Cost Rs.20000
• B.E.Point Rs.80000
• What is the profit ?

8
Management decisions- assessing profitability
CONTRIBUTION/SALESC.S.RATIO
Product sp vc Contribtion c/s Ratio ranking
A 20 10 10 10/20 50 1
B 30 20 10 10/30 33 2
C 40 30 10 10/40 25 3
9
DECISION when limiting factors
SP Rs.14 Rs.11
VC 8 7
Contribution Per unit 6 4
Labour hr. pu 2 1
Contri.per hr 3 4
10
DECISIONS

• Make or buy decisions
• Close department
• Accept or reject order
• Conversion cost pricing

11
Marginal costing

• cost-volume-profit analysis is reliant upon a
  classification of costs in which fixed and
  variable costs are separated from one another.
  Fixed costs are those which are generally time
  related and are not influenced by the level of
  activity.
• Variable cost on the other hand are directly
  related to the level of activity if activity
  increases, variable costs will increase and
  vice-versa if activity decreases.

12
Marginal costing

• USES OF COST-VOLUME-PROFIT ANALYSIS
• The ability to analyse and use cost-volume-profit
  relationship is an important management tool. The
  knowledge of patterns of cost behaviour offers
  insights valuable in planning and controlling
  short and long-run operations. The example of
  increasing capacity is a good illustrations of
  the power of the technique in planning.
• The implications of changes in the level of
  activity can be measured by flexing a budget
  using knowledge of cost behaviour, thereby
  permitting comparison to be made of actual and
  budgeted performance for any level of activity.

13
Marginal costing

• LIMITATIONS OF COST-VOLUME-PROFIT ANALYSIS
• A major limitation of conventional CVP analysis
  that we have already identified is the assumption
  and use of linear relationships. Yet another
  limitation relates to the difficulty of dividing
  fixed costs among many products and/or services.
  Whilst variable costs can usually be identified
  with production services, most fixed cost
  usually can only be divided by allocation and
  apportionment methods reliant upon a good deal of
  judgement. However, perhaps the major limitation
  of the technique relates to the initial
  separation of fixed and variable costs.

14
Marginal costing

• ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING
• ADVANTAGES
• 1. More efficient pricing decisions can be made,
  since their impact on the contribution margin can
  be measured.
• 2. Marginal costing can be adapted to all costing
  system.
• 3. Profit varies in accordance with sales, and is
  not distorted by changes in stock level.
• 4. It eliminates the confusion and
  misunderstanding that may occur by the presence
  of over-or-under-absorbed overhead costs in the
  profit and loss account.

15
Marginal costing

• 5. The reports based on direct costing are far
  more effective for management control than those
  based on absorption costing. First of all, the
  reports are more directly related to the profit
  objective or budget for the period. Deviations
  from standards are more readily apparent and can
  be corrected more quickly. The variable cost of
  sales changes in direct proportion with volume.
  The distorting effect of production on profit is
  avoided, especially in month following high
  production when substantial amount of fixed costs
  are carried in inventory over to next month. A
  substantial increase in sales in the month after
  high production under absorption costing will
  have a significant negative impact on the net
  operating profit as inventories are liquidated.

16
Marginal costing

• 6. Marginal costing can help to pinpoint
  responsibility according to organisational lines
  individual performance can be evaluated on
  reliable and appropriate data based on current
  period activity. Operating reports can be
  prepared for all segments of the company, with
  costs separated into fixed and variable and the
  nature of any variance clearly shown. The
  responsibility for costs and variances can then
  be more readily attributed to specific
  individuals and functions, from top management to
  down management

17
Marginal costing

• DISADVANTAGES OF MARGINAL COSTING
• 1. Difficulty may be experienced in trying to
  segregate the fixed and variable elements of
  overhead costs for the purpose of marginal
  costing.
• 2. The misuse of marginal costing approaches to
  pricing decisions may result in setting selling
  prices that do not allow the full recovery of
  overhead costs.
• 3. Since production cannot be achieved without
  incurring fixed costs, such costs are related to
  production, and total absorprtion costing
  attempts to make an allowance for this
  relationship. This avoids the danger inherent in
  marginal costing of creating the illusion that
  fixed costs have nothing to do with production.

18
CAPITAL BUDGETING

• It involves current outlay of funds in the
  expectation of a stream of benefits extending far
  into the future

Year Cash flow
0 (100000)
1 30000
2 40000
3 50000
4 50000
19
CAPITAL BUDGETING

• A capital budgeting decision is one that involves
  the allocation of funds to projects that will
  have a life of atleast one year and usually much
  longer.
• Examples would include the development of a major
  new product, a plant site location, or an
  equipment replacement decision.
• Capital budgeting decision must be approached
  with great care because of the following reasons
• Long time period consequences of capital
  expenditure extends into the future and will have
  to be endured for a longer period whether the
  decision is good or bad.

20
CAPITAL BUDGETING

• . Substantial expenditure it involves large sums
  of money and necessitates a careful planning and
  evaluation.
• Irreversibility the decisions are quite often
  irreversible, because there is little or no
  second hand market for may types of capital
  goods.
• Over and under capacity an erroneous forecast of
  asset requirements can result in serious
  consequences. First the equipment must be modern
  and secondly it has to be of adequate capacity

21
CAPITAL BUDGETING

• Difficulties
• There are three basic reasons why capital
  expenditure decisions pose difficulties for the
  decision maker. These are
• Uncertainty the future business success is
  todays investment decision. The future in the
  real world is never known with certainty.
• Difficult to measure in quantitative terms Even
  if benefits are certain, some might be difficult
  to measure in quantitative terms.
• Time Element the problem of phasing properly the
  availability of capital assets in order to have
  them come on stream at the correct time.

22
CAPITAL BUDGETING

• Methods of classifying investments
• Independent
• Dependent
• Mutually exclusive
• Economically independent and statistically
  dependent
• Investment may fall into two basic categories,
  profit-maintaining and profit-adding when viewed
  from the perspective of a business, or service
  maintaining and service-adding when viewed from
  the perspective of a government or agency.

23
CAPITAL BUDGETING

• Expansion and new product investment
• Expansion of current production to meet increased
  demand
• Expansion of production into fields closely
  related to current operation horizontal
  integration and vertical integration.
• Expansion of production into new fields not
  associated with the current operations.
• Research and development of new products.

24
CAPITAL BUDGETING

• Reasons for using cash flows
• Economic value of a proposed investment can be
  ascertained by use of cash flows.
• Use of cash flows avoids accounting ambiguities
• Cash flows approach takes into account the time
  value of money
• For any investment project generating either
  expanded revenues or cost savings for the firm,
  the appropriate cash flows used in evaluating the
  project must be incremental cash flow.
• The computation of incremental cash flow should
  follow the with and without principle rather
  than the before and after principle

25
Types of capital investments

• New unit
• Expansion
• Diversification
• Replacement
• Research Development

26
Significance of capital budgeting

• Huge outlay
• Long term effects
• Irreversibility
• Problems in measuring future cash flows

27
Facets of project analysis

• Market analysis
• Technical analysis
• Financial analysis
• Economic analysis
• Managerial analysis
• Ecological analysis

28
Financial analysis

• Cost of project
• Means of finance
• Cost of capital
• Projected profitability
• Cash flows of the projects
• Project appraisal

29
Decision process
INVESTMENT OPPORTUNITIES
PROPOSALS
PLANNING PHASE
REJECTED OPPORTUNITIES
Improvement in planning Evaluation procedure
Improvement in planning Evaluation procedure
PROPOSALS
NEW INVESTMENT OPPORTUNITIES
EVALUATION PHASE
Rejected Proposals
PROJECTS
SELECTION PHASE
Rejected projects
ACCEPTED PROJECTS
IMPLEMENTATION PHASE
ONLINE PROJECTS
CONTROL PHASE
PROJECT TERMINATION
AUDITING PHASE
30
Methods of capital investment appraisal
DISCOUNTING NON-DISCOUNTING
Net present value (NPV) Pay back period
Internal rate of return (IRR) Accounting rate of return
Profitability Index or Benefit cost ratio
31
Present value of cash flow stream- (cash outlay
Rs.15000)_at_ 12
Year Cash flow PV factor _at_12 PV
1 1000 0.893 893
2 2000 0.799 1594
3 2000 0.712 1424
4 3000 0.636 1908
5 3000 0.567 1701
6 4000 0.507 2028
7 4000 0.452 1808
8 5000 0.404 2020 13376
32
Present value of cash flow stream- (cash outlay
Rs.15000 )_at_10
Year Cash flow PV factor _at_10 PV
1 2000 0.909 1818
2 2000 0.826 1652
3 2000 0.751 1502
4 3000 0.683 2049
5 3000 0.621 1863
6 4000 0.564 2256
7 4000 0.513 2052
8 5000 0.466 2330 15522
33
Methods of capital investment appraisal

• Solution IRR NAV
• Project A 20 309
• Project B 15 1441
• These project are mutually exclusive
• The IRR ranks project A higher, whereas the NPV
  ranks project B first.
• The conflict arises because B is ten times the
  size of A. This gives a higher NPV but in
  relative terms it is less profitable with a lower
  percentage return. Naturally, B is preferable
  because it gives the greatest increase in
  shareholders wealth.

34
Methods of capital investment appraisal

• The advantages of IRR over NPV are
• 1. It gives a percentage return which is easy to
  understanding at all levels of management.
• 2. The discount rate/required rate of return does
  not have to be known to calculate IRR. It does
  have to be decided upon at sometime because IRR
  must be compared with something. The discussion
  as to what is an acceptable rate of return can
  however be left until much later stage. In a NPV
  calculation the discount rate must be specified
  prior to any calculation being performed.

35
Methods of capital investment appraisal

• The advantages of NPV over IRR are
• 1. NPV gives an absolute measure of profitability
  and hence immediately shows the increase in
  shareholders wealth due to an investment
  decision.
• 2. NPV gives a clear answer in an accept/reject
  decision. IRR gives multiple answers.
• 3. NPV always gives the correct ranking for
  mutually exclusive project while IRR may not.
• 4. NPVs of projects are additive while IRRs are
  not.
• 5. Any changes in discount rates over the life of
  a project can more easily be incorporated into
  the NPV calculation.
• The NPV approach provides as absolute measure
  that fully represents in value of the company if
  a particular project is undertaken. The IRR by
  contrast, provides a percentage figure from which
  the size of the benefits in terms of wealth
  creation cannot always be grasped.

36
(No Transcript)
37
(No Transcript)
38
(No Transcript)
39
(No Transcript)
40
(No Transcript)
41
Future value

• Assume that an investor has 1000 and wishes to
  know its worth after four years if it grows at 10
  percent per year. At the end of the first year,
  he will have 1000 X 1.10 or 1,100. By the end
  of the year two, the 1,100 will have grown to
  1,210 (1,100 X 1.10). The four-year pattern is
  indicated below.

42
BUDGET

• Quantitative expression of management objective
• Budgets and standards
• Budgetary control
• Cash budget

43
PROFIT PLANNING

• Budget budgetary control
• Marginal costing
• CVP and break even point
• Comparative cost analysis
• ROCE

44
PRICING DECISIONS

• Full cost pricing
• Conversion cost pricing
• Marginal cost pricing
• Market based pricing

45
PRICING DECISIONS

• PRICING AND ITS OBJECTIVES
• The objective of pricing in practice will
  probably be one of the following
• (a) To skim the market (in the case of new
  products) by the use of high prices
• (b) To penetrate deeply into the market (again
  with new products) at an early stage, before
  competition produces similar goods
• (c) To earn a particular rate of return on the
  funds invested via the generating of revenue and
• (d) To make a profit on the product range as a
  whole, which may involve using certain items in
  the range as loss leaders, and so forth.

46
PRICING DECISIONS

• Full cost pricing
• The object is to recover all costs incurred plus
  a percentage of profit. It is a method best used
  where the product is clearly differentiated and
  not in immediate, direct competition. It would
  not lend itself to situation where price tended
  to be determined by the market,

47
PRICING DECISIONS

• Conversion cost pricing
• Conversion cost consists of direct labour cost
  and factory overhead, ignoring the cost of the
  raw material on the grounds that profit should be
  made within the factory and not upon materials
  bought from suppliers.

48
PRICING DECISIONS

• Marginal cost pricing
• Briefly it is that cost which would not be
  incurred if the production of the product were
  discontinued. An important advantage of
  differential cost of pricing is the flexibility
  it gives to meet special short-term
  circumstances, while accepting that full costs
  must be recovered in the long term. This is by no
  means always desirable in the short term. For
  example, there may be surplus productive capacity
  in a factory, in which case any opportunity to
  accept an order which covers differential cost
  and makes a contribution to fixed cost and profit
  should be accepted. Any contribution is better
  than none.

49
PRICING DECISIONS

• Market based pricing
• This can be based on the value to a customer of
  goods or services and involves variable pricing.
  It also takes account of the price he is able and
  willing to pay for the goods or services.
  Businesses using this approach develop special
  products or services which command premium
  prices.
• The other market-based approach is to price on
  the basis of what competitors are charging.

50
Operating leverageFinancial leverage

• OL amount of fixed cost in a cost structure.
  Relationship between sales and op. profit
• FL effect of financing decisions on return to
  owners. Relationship between operating profit and
  earning available to equity holders (owners)

51
Working capital

• Current assets less current liabilities net
  working capital or net current assets
• Permanent working capital vs. variable working
  capital

52
Working capital cycle

• cashgt Raw material gt Work in progress gt finished
  goods gt Sales gt Debtors gt Cashgt
• Operating cycle it is a length of time between
  outlay on RM /wages /others AND inflow of cash
  from the sale of the goods

53
Matching approach to asset financing

Total Assets
Short-term Debt

Fluctuating Current Assets
Long-term Debt Equity Capital
Permanent Current Assets
Fixed Assets
Time
54
Accounts Payable
Value Addition
Raw Materials
W I P
THE WORKING CAPITAL CYCLE(OPERATING CYCLE)
Finished Goods
Cash
Accounts Receivable
SALES
55

• 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 (for
  example, payments for resource purchases) usually
  take place before cash receipts (for example
  collection of receivables).
• They are uncertain because future sales and
  costs, which generate the respective receipts and
  disbursements, cannot be forecasted with complete
  accuracy.

Working capital cycle
Working capital cycle
56
Working capital

• FACTORS DETERMINING WORKING CAPITAL 1.    
  Nature of the Industry2.     Demand of
  Industry3.     Cash requirements4.     Nature
  of the Business5.     Manufacturing time6.    
  Volume of Sales7.     Terms of Purchase and
  Sales8.     Inventory Turnover9.     Business
  Turnover10. Business Cycle11. Current
  Assets requirements12. Production Cycle

57
Working capital

• Working Capital Determinants (Contd)13.    
  Credit control14.     Inflation or Price level
  changes15.     Profit planning and
  control16.     Repayment ability17.     Cash
  reserves18.     Operation efficiency19.    
  Change in Technology20.     Firms finance and
  dividend policy 21.     Attitude towards Risk

58
TYPES OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF CONCEPT
BASIS OF TIME
Permanent / Fixed WC
Temporary / Variable WC
Gross Working Capital
Net Working Capital
Special WC
Seasonal WC
Regular WC
Reserve WC
59
Working capital

• Working Capital Levels in Different Industries
• A retailing company usually has high levels of
  finished goods stock and very low levels of
  debtors. Most of the retailers sales will be for
  cash, and an independent credit card company or a
  financial subsidiary of the retail business
  (which on occasions is not consolidated in the
  group accounts). The retailing company, however,
  usually has high levels of creditors. It pays its
  suppliers after an agreed period of credit. The
  levels of working capital required are therefore
  low

60
Working capital

• Excess of current assets over current liabilities
  are called the net working capital or net current
  assets.
• Working capital is really what a part of long
  term finance is locked in and used for supporting
  current activities.
• The balance sheet definition of working capital
  is meaningful only as an indication of the firms
  current solvency in repaying its creditors.
• When firms speak of shortage of working capital
  they in fact possibly imply scarcity of cash
  resources.
• In fund flow analysis an increase in working
  capital, as conventionally defined, represents
  employment or application of funds.

61
Working capital

• In contrast, a manufacturing company will require
  relatively high levels of working capital with
  investments in raw materials, work-in-progress
  and finished goods stocks, and with high levels
  of debtors. The credit terms offered on sales and
  taken on purchases will be influenced by the
  normal contractual arrangements in the industry.

62
Working capital

• Debtors Volume of credit sales
• Length of credit given
• Effective credit control and cash
  collection
• Stocks Lead time safety level
• Variability of demand
• Production cycle
• No. of product lines
• Volume of
•    planned output
•     actual output
•    sales
• Payables Volume of purchases
• Length of credit allowed
• Length of credit taken Discounts
• Short-term finance All the above
• Other
  payments/receipts
• Availability of
  credit Interest rates

63
Working capital

• Cash Levels
• it is necessary to prepare a cash budget where
  the minimum balances needed from month to month
  will be defined.
• business is seasonal, cash shortages may arise in
  certain periods. Generally it is thought better
  to keep only sufficient cash to satisfy
  short-term needs, and to borrow if longer-term
  requirements occur
• The problem, of course, is to balance the cost of
  this borrowing against any income that might be
  obtained from investing the cash balances.
• The size of the cash balance that a company might
  need depends on the availability of other sources
  of funds at short notice, the credit standing of
  the company and the control of debtors and
  creditors

64
Working capital

• Debtors
• The debtors problem again revolves around the
  choice between profitability and liquidity. It
  might, for instance, be possible to increase
  sales by allowing customers more time to pay, but
  since this policy would reduce the companys
  liquid resources it would not necessarily result
  in higher Profits.
• historical analysis or the use of established
  credit ratings to classify groups of customers in
  terms of credit risk

65
Working capital

• Establish clear credit practices as a matter of
  company policy.
• Make sure that these practices are clearly
  understood by staff, suppliers and customers.
• Be professional when accepting new accounts, and
  especially larger ones.
• Check out each customer thoroughly before you
  offer credit. Use credit agencies, bank
  references, industry sources etc.
• Establish credit limits for each customer... and
  stick to them.
• Have the right mental attitude to the control of
  credit and make sure that it gets the priority it
  deserves.

66
Working capital

• 7. Continuously review these limits when you
  suspect tough times are coming or if
  operating in a volatile sector. 8. Keep
  very close to your larger customers. 9.
  Invoice promptly and clearly. 10. Consider
  charging penalties on overdue accounts. 11.
  Consider accepting credit /debit cards as a
  payment option. 12. Monitor your debtor
  balances and ageing schedules, and don't
  let any debts get too large or too old.

67
DIMENSIONS OF RECEIVABLES MANAGEMENT
OPTIMUM LEVEL OF INVESTMENT IN TRADE
RECEIVABLES Profitability Costs
Profitability
Optimum Level
Liquidity
Stringent Liberal
68
Working capital-FACTORING

• Factoring
• Definition
• Factoring is defined as a continuing legal
  relationship between a financial institution (the
  factor) and a business concern (the client),
  selling goods or providing services to trade
  customers (the customers) on open account basis
  whereby the Factor purchases the clients book
  debts (accounts receivables) either with or
  without recourse to the client and in relation
  thereto controls the credit extended to customers
  and administers the sales ledgers.

69
Working capital-FACTORING

• It is the outright purchase of credit approved
  accounts receivables with the factor assuming bad
  debt losses.
• Factoring provides sales accounting service, use
  of finance and protection against bad debts.
• Factoring is a process of invoice discounting by
  which a capital market agency purchases all trade
  debts and offers resources against them.

70
Working capital-FACTORING

• Debt administration
• The factor manages the sales ledger of the client
  company. The client will be saved of the
  administrative cost of book keeping, invoicing,
  credit control and debt collection. The factor
  uses his computer system to render the sales
  ledger administration services.

71
Working capital-FACTORING

• Different kinds of factoring services
• Credit Information Factors provide credit
  intelligence to their client and supply periodic
  information with various customer-wise analysis.
• Credit Protection Some factors also insure
  against bad debts and provide without recourse
  financing.
• Invoice Discounting or Financing Factors
  advance 75 to 80 against the invoice of their
  clients. The clients mark a copy of the invoice
  to the factors as and when they raise the invoice
  on their customers.

72
Working capital-FACTORING

• Services rendered by factor
• Factor evaluated creditworthiness of the customer
  (buyer of goods)
• Factor fixes limits for the client (seller)
  which is an aggregation of the limits fixed for
  each of the customer (buyer).
• Client sells goods/services.
• Client assigns the debt in favour of the factor
• Client notifies on the invoice a direction to the
  customer to pay the invoice value of the factor.

73
Working capital-FACTORING

• Client forwards invoice/copy to factor along with
  receipted delivery challans.
• Factor provides credit to client to the extent of
  80 of the invoice value and also notifies to the
  customer
• Factor periodically follows with the customer
• When the customer pays the amount of the invoice
  the balance of 20 of the invoice value is passed
  to the client recovering necessary interest and
  other charges.
• If the customer does not pay, the factor takes
  recourse to the client.

74
Working capital-FACTORING

• Benefits of factoring
• The client will be relieved of the work relating
  to sales ledger administration and debt
  collection
• The client can therefore concentrate more on
  planning production and sales.
• The charges paid to a factor which will be
  marginally high at 1 to 1.5 than the bank
  charges will be more than compensated by
  reductions in administrative expenditure.
• This will also improve the current ratio of the
  client and consequently his credit rating.
• The subsidiaries of the various banks have been
  rendering the factoring services.
• The factoring service is more comprehensive in
  nature than the book debt or receivable financing
  by the bankers.

75
Working capital- INVENTORY MANAGEMENT

• Managing inventory is a juggling act.
• Excessive stocks can place a heavy burden on the
  cash resources of a business.
• Insufficient stocks can result in lost sales,
  delays for customers etc.
• INVENTORIES INCLUDE
• RAW MATERIALS, WIP FINISHED GOODS

76
FACTORS INFLUENCING INVENTORY MANAGEMENT

• Lead Time
• Cost of Holding Inventory
• Material Costs
• Ordering Costs
• Carrying Costs
• Cost of tying-up of Funds
• Cost of Under stocking
• Cost of Overstocking

77
Working capital

• Cost of Working capital
• The other aspect of the working capital problem
  concerns obtaining short-term funds. Every source
  of finance, including taking credit from
  suppliers, has a cost the point is to keep this
  cost to the minimum. The cost involved in using
  trade credit might include forfeiting the
  discount normally given for prompt payment, or
  loss of goodwill through relying on this strategy
  to the point of abuse. Some other sources of
  short-term funds are bank credit, overdrafts and
  loans from other institutions. These can be
  unsecured or secured, with charges made against
  inventories, specific assets or general assets.

78
Working capital

• Disadvantages of Redundant or Excess Working
  Capitalõ Idle funds, non-profitable for
  business, poor ROIõ Unnecessary purchasing
  accumulation of inventories over required level
  õ  Excessive debtors and defective credit
  policy, higher incidence of B/D.õ Overall
  inefficiency in the organization.õ When there is
  excessive working capital, Credit worthiness
  suffers õ  Due to low rate of return on
  investments, the market value of shares may fall

79
Working capital

• Disadvantages or Dangers of Inadequate or Short
  Working Capital õ Cant pay off its short-term
  liabilities in time. õ  Economies of scale are
  not possible.õ  Difficult for the firm to
  exploit favourable market situations
  õ  Day-to-day liquidity worsensõ  Improper
  utilization the fixed assets and ROA/ROI falls
  sharply

80
Working capital cycle

• Example X Company plans to attain a sales of Rs
  5 crores. It has the following information for
  production and selling activity. It is assumed
  that the activities are evenly spread through out
  the year.
• (a) Average time raw materials are kept in
  store prior to issue for production.2months
• (b) Production cycle time or work-in-progress
  cycle time. 2months
• (c) Average time finished stocks are kept in
  sale in unsold condition 1/2 months
• (d) Average credit available from suppliers
  1 1/2 months
• (e) Average credit allowed to customer
  1 1/2 months
• (f) Analysis of cost plus profit for above sales
• Rs. In Crores
• Raw Materials 50 2.50
• Direct Labour 20 1.00
• Overheads 10 0.50
• Profit 20 1.00
• Total 100 5.00
• -----------

81
Working capital cycle

• Calculation of Wokring Capital Requirement
• 1. Total months to be financed to Raw Material
  Months
• Time in raw material store 2
• Working progress cycle 2
• Finished goods store 1/2
• Credit given to customer 1 1/2
• 
  
  6
• Less Credit available from suppliers 1 ½
• ----------------
• Total months to be financed to Raw Materials
  4 ½
• ----------------
• 2. Total months to be financed to Labour
• Production cycle 2
• In Finished stock store ½
• Credit to customer 1
  ½
• Total Months to be financed 4

82
Working capital cycle

• 3. Total months to be finacned to overhead
• Production cycle 2
• In finished goods stores ½
• Credit to customer 1 ½
• -------------
• 4
• Less Credit from suppliers
  1 ½
• -------------
• Total months to be financed 2 ½
• 4. Maximum working capital required Rs in
  crores
• Raw Materials 4 ½ / 12 2.50 0.94
• Direct Labour  4 / 12     1.00
  
  
  
  0.33
• Overheads 2 ½ 0.50 0.10
• -------
• Maximum Working Capital
  1.37
• -------

83
E N D

• THANK YOU VERY MUCH FOR YOUR
• PATIENCE I TRUST IT WAS USEFUL.
• ANY QUERIES MAY BE ADDRESSED TO
• techengine_at_rediffmail.com
• Ullal.ravishankar_at_gmail.com