Estimation of working capital:Estimation process: A firm must estimate in advance as to how much net working capital will

required for the smooth operations of the business. Working capital can be divided into partsi. ii. Permanent working capital Temporary working capital

Approaches for the estimation for working capital:i. Working capital as a percentage of Net Sales:-

This approach is based on the fact that working capital is directly related to the sales volume thus W.C. estimate is solely dependent on the sales forecast. This approach assumes that higher the sales level the greater would be the need of W.C. ii. Working capital as a percentage of Total Asset or Fixed Asset:-

This approach of estimation of W.C. is based of the fact that the total asset of the firm are consisting of fi!ed assets and current assets W.C. may also be determined as a " of fi!ed assets. To plan about the future level of fi!ed assets comes under the capital budgeting decision but in order to maintain the efficiency of fi!ed asset sufficient W.C. is required. #o the W.C. requirement is depend upon the planned level of fi!ed asset. iii. Working capital based on perating !"cle:

$perating cycle may be defined as the time duration starting fro the procurement of goods or raw-material and ending with the sales reali%ation. &n this approach working capital estimates depends upon the operating cycle of the firm. 'ifferent components of current assets and current liabilities require funds depending upon the respective operating cycle and the cost involved.

1

Work sheet for the estimation of working capital re#$irement:(&) Current Assets*+inimum Cash ,alance &nventories* -aw +aterial Work in Progress .inished /oods -eceivables* 'ebtors ,ills /ross Working Capital

(&&)

Current 0iabilities*Creditors for Purchase Creditors for Wages Creditors for overhead Total Current 0iabilities 1!cess of C. A. over C. 0. (2) #afety +argin 3et Working Capital

%mportant &oints:-

2

'anagement of cash and marketable sec$rities Cash management refers to management of cash balance and the bank balance including short term deposits. ii.To meet out the day to day transaction of the business firm keeps the cash. !ompensation 'oti(e:-+inimum cash balance kept in bank4s current account to make the account operative.Cash may be held for speculative purpose in order to take advantage of potential profit making situation. i(. Spec$lati(e 'oti(e: .or cash management the term cash is used in broader sense it covers* i. Transaction moti(e: . b*ecti(e of !ash 'anagement • • To ensure availability of cash as per payment schedule. iii.The necessity of keeping cash balance to meet any emergency situation or unpredictable obligation is known as precautionary motive. &reca$tionar" 'oti(e: . #econd in broader sense it also includes near cash assets such as marketable securities and short term deposits with bank . The term cash may be used in two different ways* $ne it may include currency cheques demand drafts demand deposits held by a firm. 'oti(es for )olding !ash:i. Cash Cash equivalent Assets which can be immediately converted into cash. iii. ii. To minimi%e the amount of idle cash. 3 .

The timings of cash inflow and outflow may not always matched therefore cash balance is required to fill this gap.Timing of cash inflows and outflows 6.-Total Assets. &ro-forma .Factors Effecting the !ash Needs: !ash !"cle: Cash cycle refers to the time gap between the payment for purchase of raw material and receipt of sales revenue.Cash is pro8ected for each period and the cash balance is find out as per Accounting equation. 'ifferent pattern of cash cycle and cash flows depending upon the nature of business. !ash 'anagement: Planning Aspect for the purpose of cash management the firm should prepare cash budget.alance: Another factor to be considered while determining the minimum cash balance is the cost of maintaining e!cess cash or meeting shortage of cash.'esired cash position 'ethods of &reparing !ash .$dget:Ad*$sted Net %ncome 'ethod: &n this method &ncome #tatement is prepared. !ash %nflow + !ash $tflows: 1very firm has to maintain cash balance because its e!pected inflows and outflows are not always synchroni%ed.There is always opportunity cost of holding cash.Then net income figure for each period are then ad8usted to a cash basis by deleting the transaction that are affecting the income statement but not the cash balance. To prepare a cash budget the following components should be known* 5.Total 4 .alance Sheet method: &n this method each item of balance sheet is taken e!cept cash.This ad8usted figure is taken as cash profit9loss during that period.+agnitude of receipts and payments (e!pected sales and e!penses) 7. !ost of !ash .This can be taken as net increase9decrease in cash balance during the year.

alancing figure of proforma balance sheet is taken as the cash balance. To deal with this problem following are the two models* . The most popular method of preparing cash budget is by the -eceipts : Payments method.A3' /4S ' 5E/ -%n(entor" 'odel1 5 . ptim$m cash . 2eceipt + &a"ment 'ethod: A cash budget is a summary of movement of cash during particular period. The most common -eceipts : Payments are* 2eceipts: • • • Cash sales Collection from credit sale customers Any disposal value of fi!ed assets a &a"ments: • • • • • • • • • Payments to creditors or suppliers -aw materials payments Payment of wages and salaries $verhead e!penses #elling general and administrative e!penses +aintenance and miscellaneous e!penses Ta! payments Purchase of fi!ed assets -etirement of 0ong-term debts etc./iabilities0 !apital..alance :A few 'odels The problem of determining optimum cash balance for a firm implies a trade-off between risk and return of maintaining cash balance.1.

?Total Cash required during the year T?Cost of each transaction r? rate of interest on marketable securities 6 . Transaction cost is known : remain stable.aumol (5.. The firm known its cash requirements with certainty The cash payments of firm occurs uniformly over a period of time and is known with certainty $pportunity cost of holding cash is known : remains stable over time. Ass$mptions: %. !alc$lation of cash balance The optimum cash balance is obtained when the total cost is minimum. %%%. &t considers optimum cash balance similar to the economic order =uantity since it is based on 1$= concept and also in both the cases there is trade off between cost of borrowing (sales of security cost) or conversion cost and opportunity cost.ut in case of deficit firm can acquire the cash by selling marketable securities which also carry transaction cost. %6. The formula for the optimum cash balance is as follows: C= >6.&.This model was suggested by W. Thus optimum cash balance can be achieved by controlling these two cost. %%.<6) this model is suitable only when the cash flows are predictable (under certainty). .alance .T9r C?Cash . This model is based on the proposition that in order to reduce the holding cost a firm should keep minimum cash balance. Thus firm has to deal with the holding cost and transaction cost.

+iller : $rr model overcomes the limitations of .'%//E2 + 22 ' 5E/ The miller and $rr model is an attempt to make . .aumol4s model is based on that assumption that firm should keep uniform : certain level of cash balances.aumol +odel. This model provides two control limit along with a return point.armol model more elastic with regards to the pattern of periodic changes in cash balances.ut in practice firm do not keep a uniform cash balance nor daily cash outflows : inflows can be predicted. . 7 .

@pper Control 0imit (@C0) C a s h (-eturn Point (-P) 0ower Control 0imit (0C0) Time According to this model cash balance fluctuates between 0C0 : @C0. The cash balance at 0C0 is set by the firm as per requirement of maintaining minimum cash balance. Whenever cash balances touches @C0 then the firm purchase sufficient marketable securities. 8 .

After knowing the cash position the management should work out the basic strategies to be employed to manage its cash. This model uses one year planning hori%on with twelve monthly periods because of its simplicity. The strategies of cash management are essentially related to the cash turnover process that is the cash cycle together with the cash turnover. &t is a model that provides for integration of cash management with production and other aspects of the firm. The construction of this model comprises three sections namely* • • • #election of the appropriate planning hori%on #election of the appropriate decision variables and . &t has four basic sets of decision variables which influence cash management of a firm and which must be incorporated into the linear programming model of the firm. Efficient !ash 'anagement @pon preparation of cash budgets after forecasting the receipts and payments the management will have knowledge about the cash position of the firm.rgler7s 'odel According to this model the optimal cash management strategy can be determined through the use of a multiple linear programming model.ormulation of the cash management strategy. These are * • • • • Payment schedule #hort-term financing and Purchase and sale of marketable securities and Cash balance. 9 . The cash cycle is the amount of time cash is tied up between payment for production inputs and receipt of payment from the sale of the resulting finished product.

.Efficient %n(entor"-&rod$ction 'anagement and Another strategy is to increase the inventory turnover avoiding stock-outs or shortage of stocks by the following ways* 10 .y effective collection efforts and by speeding up the collection of accounts receivables the cash cycle would come down thereby resulting in saving a cost to the firm. Cash discounts should be given for immediate payments or payments within 5B days of invoice to encourage customers to speed up the payments.Cash cycle ? Average age of &nventory 2 Average collection period .ut the speeding up of accounts receivables should be done very carefully so that the customers are not lost. 8. 9. This is one of the main strategies of efficient cash management. :. .Average Accounts Payable period Cash turnover ? 3umber of times cash is used during the year ? 3umber of days in a year9Cash cycle +inimum operating cash A &t is the level of opening cash balance at which a firm would meet all obligations and is computed by dividing total annual outlays by the cash turnover. The basic strategies that can be employed to effectively manage cash are* • • • • 'elaying and stretching Accounts Payables #peeding up collection of Accounts -eceivables 1fficient &nventory-Production +anagement and Combined cash management strategies. The reason is that the cost of not taking a discount will work out more than the cost of delaying payment.5ela"ing and stretching Acco$nts &a"ables The firm should pay its accounts payable as late as possible without damaging its credit standing. Efficient !ash 'anagement Strategies: Cash management strategies are intended to minimi%e the operating cash balance requirement.ut the firm should take advantage of cash discount if any offered by suppliers for prompt payment.Speeding $p collection of Acco$nts 2ecei(ables . The average collection period of receivables can be reduced by changes in credit terms credit standards and collection policies.

&ncreasing the raw materials turnover by using more efficient inventory control techniques. &ncreasing the finished goods turnover through better forecasting of demand and a better . 'ecreasing the production cycle through better production planning scheduling and control techniques which will lead to an increase in the work-in-progress inventory turnover.loat 'anagement 11 . 7.5. 6.

'isbursement float ? CompanyEs available bank balance A CompanyEs ledger balance ?F -s. #imilarly when the company has deposited many cheques that are yet to be collected by the bank the available balance will be smaller. The bank however will not debit C 0td. $n 6nd +arch it receives a cheque for -s. This will increase the ledger balance by -s. 1!ample* 0et us assume that C 0td.5isb$rsement float .5BB BBB as on 5st +arch.7B BBB.6B BBB. 1!ample* 0et us assume that C 0td. 6. . This is called as playing the float. The cash balance as per the compan"4s records ma" not alwa"s be the same as the bank balance a(ailable.6B BBB from one of its accounts receivables.The amount of cheque deposited in the bank but not yet collected is called as the collection float. $n 6nd +arch it issues a cheque for -s.!ollection Float . The company can take advantage of the smaller cash balance available if it e!pects a little longer time for its issued cheques to get cleared.5BB BBB as on 5st +arch. has a ledger balance and bank available balance of -s. When the company has issued many cheques that are awaiting clearance the available balance will be larger than the ledger balance.irms can manage the float by speeding up collections and slowing down payments. #o till this happens the available balance is greater than the book balance by -s. . The difference between both the balances is called as the Net float. This consequently reduces the ledger balance to -s. till the cheque is presented for payment. T"pes of Float: 5.7B BBB.The amount of cheque issued but not presented for payment is known as disbursement float.5BB BBB A -s. has a ledger balance and bank available balance of -s. #ay the suppliers present the cheque on Dth +arch only.DB BBB.7B BBB to one of its suppliers..ut this amount will not be 12 .DB BBB ?F -s.loat plays an important role in cash management.

#ay the cheque is collected on Dth +arch. %f 5isb$rsement float = !ollection float< then Net float is negati(e.5B BBB. %f 5isb$rsement float .7B BBB is more than collection float of -s.6B BBB ?F -s.available to the company till its bank presents the cheque for collection. Speeding $p of collections: The financial or the collection manager has to send timely invoices and outstanding statements so that there is no delay in payments. 1!ample* &n the above two cases C 0td. To manage the float effectively collections have to be speeded up and disbursements should be delayed.56B BBB ?F(6B BBB) Net Float The o(erall difference between the a(ailable balance in bank acco$nt and the compan"4s book balance is called as the net float. Also discounts should be given and early payment should 13 . This net float is positive because the disbursement float of -s. #o a company that has a positive net float at a point of time can effectively use and manage the float in such a way that it can maintain a smaller cash balance. Thus by properly managing the float the finance manager can avoid stagnant money that will be otherwise tied up.7B BBB A -s.6B BBB. The available bank balance will be lower than the book balance. The available bank balance e!ceeds the book balance. 3et flows would be* 3et float ? -s.6B BBB. %f the compan" has a positi(e net float< it ma" iss$e more che#$e amo$nts< e(en tho$gh the balance as per its book is lower. Collection float ? Company4s available bank balance A Company4s ledger balance ?F 5BB BBB . !ollection float< then Net float is positi(e. #o between those periods the available balance will be lower than the book balance by -s.

anking: &t is a collection procedure in which payments are made to regionally dispersed collection centres and then deposited in local banks for quick clearing. &t reduces the float by shortening the lethargy as well as postal and bank floats. 9.!entrali>ed disb$rsements A All payments can be made by the head office from a centrali%ed disbursement account which would enable the firm to delay payments and conserve cash. &t represents a source of funds requiring no interest payments.Float . After the receipt of the cheque steps should be immediately taken to deposit it in the bank without any unnecessary delay..A(oidance of earl" pa"ments A the firm can decide the make the payment on the last date of credit period in the absence of any trade discounts. -81/ock-box s"stem: @nder this system firms hire a post office lock-bo! at important collection centres. The techniques to delay the payments of accounts payable are* 8. &f cash discounts e!ist for earlier payments it can take advantage of them because the cost of not taking discounts may work out more than benefit of delaying payments. -91!oncentration . Postal float is the delay between the time when payer mails a payment and the time when the payee receives it.be encouraged. :. &t reduces float by shortening the postal and bank float. To speed $p collections< companies ma" $se /ock-box s"stem or concentration banking. Slowing disb$rsements: The operating cash requirement can be reduced by slow disbursements of accounts payable.loat used in this conte!t is called as cheque kiting which is a method of consciously anticipating the resulting float or delay associated with the payment process using it to keep 14 . The benefits of this method include increase in transit time which delays payments and a smaller minimum cash balance requirement which is sufficient to be maintained in the centrali%ed bank account as otherwise each branch making payments needs to maintain separate minimum cash balance in their respective branch bank accounts. 0ethargy9processing float is the delay between the receipt of a cheque by the payee and its deposit in the account. 0ockbo! system is a collection procedure in which payers send their payments9cheques to a nearby post bo! that is emptied by the firm4s bank several times and the bank deposits the cheque in the firm4s account.

They are* a. #o different investment options with varying maturities should be considered. %n(estment in 'arketable Sec$rities !hoosing the channels of %n(estment After estimating the surplus cash available the ne!t step is to invest the surplus cash in profitable investments. c.2et$rn: The investment is being made to earn a return out of it. ?.funds in an interest-earning form for as long as possible. There are various factors to be considered before choosing an investment channel. d. They are the outcome of rapid growth of credit sales given by the firm to their customers./i#$idit" of in(estment: Cash being a current asset is highly required for maintaining liquidity.Safet" and Sec$rit": Any investment mode chosen must be safe and secure enough to recover the minimum principal invested. #o various investments should be considered in a portfolio after comparing the return each one yields. The ways of doing it are a) paying from a distant bank b) scientifically cheque-cashing analysis. Choosing an investment that has a maturity date equal to a definite cash obligation in future could also be considered. 2E!E%6A.'at$rit" period: Cash being a current asset does not remain surplus for a long period of time.Accr$als A Another important tool for delaying the accounts payable is accruals which are defined as current liabilities that represent a service or goods received by a firm but not yet paid for. Credit 15 . #o highly risky securities should be avoided to ensure security. This is because cash needs to be withdrawn to meet any unforeseen contingencies and emergencies./E 'ANA@E'ENT:Accounts -eceivable occupy an important position in the structure of current assets of a firm. #o any investment of liquid current asset should be in investments that are liquid. 1!ample* +arketable securities and short-term investments. The investment must be chosen based on optimal risk and return. Any return is associated with a level of risk. b.

ills -eceivable on the asset side of . 'egree of credit sales to be made. $ptimum &nvestment in #undry 'ebtor* When the credit sales e!pand but it also involve blockage of fund that have an opportunity cost which can be reduced by optimum investment in receivable. +a!imi%ing the value of the firm* . -isk involvement .sales are reflected in the value of sundry debtors. 'ebtors collection. +eaning of Accounts -eceivable* The term receivable is defined as Gdebt owed to the firm by customers arising from sale of goods or services in the ordinary course of businessH. When the firm sells its products : services on credit and it does not receive cash for it immediately but would be collected in near future.alance sheet.asic ob8ective of 'ebtors management is to ma!imi%e the value of the firm by achieving a trade off between liquidity (risk) and return. b*ecti(es of Acco$nts 2ecei(able 'anagement:. Till collection they form as current asset. %%%. %%.uturity 'eaning of Acco$nts 2ecei(able 'anagement:Acco$nts recei(able management in(ol(es:%. %%. %%%. %%.ollowing are the main ob8ectives of accounts receivable management*%. +aintain the optimum level of receivable.ased on 1conomic Ialue &mplies . Thus Accounts receivable ? #undry 'ebtors 2 . &t is also known as Trade 'ebtors Accounts -eceivable . Control the cost of Trade Credit* !ost in(ol(ed in Acco$nts 2ecei(able 'anagement:16 .ills -eceivable !haracteristics of 2ecei(able: %. %%%.

ill discounting and 1ndorsement !redit &olic": Credit Policy of the firm may be lenient or stringent (tight). 6. &&. • • • &. %6. and for making payments to employees and supplier firm need to arrange funds which also carries e!plicit or implicit cost. %%%. -%1 Ad(antages of liberal credit &olic":a1 &ncrease in sales volume b1 Jigher profit 5isad(antages of /enient !redit &olic":a1 Chances of . Administrative cost 'elinquency cost Cost of 'efault by customer .• Cost of financing-conversion of receivables into cash takes time and this result into blockage of funds. /enient !redit &olic":&t is the policy where the seller sells goods on very liberal credit terms and standard.enefits of Acco$nts 2ecei(able:&ncreased #ales &ncreased in Profits &ncrease in profits Factors infl$encing the si>e of %n(estment in 2ecei(ables:0evel of investment in receivables is affected by the following factors*%. 6%. &&&.ad 'ebt b1 0iquidity problem -%%1 17 #tringent Credit Policy*- . %%. Iolume of Credit #ales Credit policy of the firm Credit terms #easonality of business Collection policy .

'ebtors -eceivable 7K< %%.or e!ample a company or a firm selling dairy products fruits and vegetables will have a less investment in inventory 18 . Ad(antages:%. %. This level varies among industries and among companies in a given industry. 0ess Chances of . %%. 2ecei(able T$rno(er Credit #ales -eceivable Turnover ? ----------------------------------Av. %%. .@nder this policy seller sells the goods on credit on a highly selective basis. Average Collection Period? ------------------------------------'ebtors Turnover %n(entor" 'anagement The purpose of inventory management is to develop policies that will achieve an optimal inventory investment. 'onitoring of Acco$nts 2ecei(able:Traditional techniques of monitoring of accounts receivables are*%.ad debt #ound 0iquidity position 5isad(antages:0ess #ales 0ess Profits Thus the firm should follow $ptimum Credit Policy.

L. 0ead time in an acquisition refers to the time taken to receive the merchandise from the suppliers after an order is placed. K. 7. 1!amples of such inventories are technological fashionable flammable goods etc.&nventory levels are also affected by short-term interest rates. <. This depends upon many factors like sales liquidity available inventory financing production supplier reliability delay in receiving new orders and seasonality. &f the company finds that some of their products are slow-moving it may consider clearing them off selling at discounted prices.0ead time should be minimi%ed in a companyEs acquisition manufacturing and distributing functions. #uccessful inventory management minimi%es inventory lowers cost and improves the profitability. 19 . 1!ample* 0et us assume that a productEs selling price is ML BBB if is sold in the current stage of inventory.When computing desired inventory levels obsolescence and spoilage risks of inventories must be considered. When short-term interest rates increase the optimum level of holding inventory is reduced. $n the contrary a company manufacturing and selling cars will have a huge investment in inventory and their inventory passes through various stages of raw materials stage work-in-progress stage and finally finished goods stage.and their inventory will also get converted into cash very faster. Factors to be considered in %n(entor" 'anagement 5. 6.Adequacy of inventory levels should be appraised. &t will take quite a longer time comparatively for their inventory to get converted into cash.&nventory management also involves the decision of selling a product at the current stage or to sell it after further processing.The benefits of getting discounts on bulk orders must be considered while purchasing. . &f the further processed product has no demand or very less demand there is no question of further processing. &f it is processed further the selling price becomes MD BBB. D. The cost of further processing is M5 BBB. #o the decision should be to further process it as the benefit gained out of processing are more than the costs of it.ut an important factor to be considered in this regard is the demand for the product at both the stages. &f the costs of holding the inventory works out lower than the discount benefit discount should be availed.&nventory management involves a trade-off between the costs of keeping inventory and the benefits of holding it.

#tore and #pares 2ole of %n(entor" in Working !apital &nventory The term inventory refers to the stockpile of the products a firm is offering for sale and the components that make up the product.inished goods inventory will be then distributed to wholesalers distributors or retailers as the case may be. 6. &nventory A Current asset in working capital 20 .inished goods inventory is the final stage of inventory. They are partly processed materials and as such direct material labor and overheads would have been incurred to bring the raw materials into the work-in-progress state. They contain the material or the parts required for production. All the processes are over and the product fully manufactured and ready for sale. .Types of &nventory &n a typical manufacturing company inventory will be in the following forms* 5. 7.inished goods &nventory .. They can also be e!tracted materials if not purchased from the supplier. #ometimes companies also procure short-term finance pledging the finished goods inventory as security.Work-in-Progress &nventory Work-in-Progress inventory is in a stage between the raw materials stage and the finished goods stage. They cannot be called finished goods until they are fully processed or produced. L. They are in the stage as such purchased from the supplier.-aw +aterials &nventory -aw materials as the name implies are in the raw stage without any processing.

Accounts receivables converted into cash iv.-aw materials converted into work-in-progress iii. &n fact they are not quick assets and hence not included as cash equivalent in calculating quick ratio or acid-test ratio.Cash converted into -aw materials ii. The time depends upon the nature of the product demand for the product price and market conditions.&nventory converted into accounts receivables iii. ii. &t is assumed that inventory can also be sold and converted into cash within a yearEs time and hence categori%ed as current assets. &nventory and $perating cycle $perating cycle has the following events* i.Work-in-progress converted into finished goods inventory iv.Although inventory can be sold and converted into cash or accounts receivables it is a blocked up fund till the accounts receivables are collected.&t is a part of current asset in working capital calculations. %n(entor" and working capital &nventory is treated as a current asset for working capital purposes also.The time it takes for the inventory to convert into sales may be longer sometimes even more than a year. &n case of manufacturing businesses the inventory passes through three stages and operating cycle will be as given below* i. &t is assumed that inventory can be converted into sales and then to cash9accounts receivables to meet the current liabilities or obligations.Cash converted into inventory ii. Working capital is the net of current assets and current liabilities.. 0iquidity of &nventory Though it is categori%ed as a current asset practically they cannot be equivalent to cash and cash equivalents. The reasons are* i. Current assets are those assets which can be converted into cash easily within a period of one year.inished goods inventory converted into accounts receivables 21 .Cash again re-converted into inventory The above is the case of a normal wholesale or retail business.

Cost of preparation of purchase order b. To minimi%e the ordering costs a firm should place minimum number of orders possible. -eceiving inspecting and recording the goods received to check the quantity and quality c. Apart from placing orders the other costs related to ordering also form part of ordering costs. #uch other costs are* a. $rdering costs and 6.Cash re-converted into raw materials. &n case of cash sales inventory will be straight-away reconverted into cash. Carrying costs can be further sub-divided into* a.ut a large order may decrease ordering costs while increasing carrying costs. &n case of produced items ordering cost also includes scheduling cost $rdering cost ? #9= ! P Where* # ? Total @sage = ? =uantity Per $rder P ? Cost of Placing an $rder The acquisition costs are inversely related to the si%e of inventoryN they decline with the level of inventory. . Costs associated with storing of &nventory This type of costs consists of 22 . 91 !arr"ing cost The costs involved in stocking the inventory like maintenance ad holding inventory come under carrying costs. %n(entor" !osts The costs associated with holding inventories fall into two basic categories* 5.v. Carrying costs 7. Clerical costs and costs of stationery(set up cost) The set up costs are generally fi!ed per order placed irrespective of the amount of order. &n all the above cases accounts receivables come into picture in case of credit sales.Accounts receivables converted into cash and vi. #tock $ut 81 rdering costs $rdering cost is the cost associated with placing an order to the supplier.

$pportunity cost of funds $pportunity costs refer to the interest lost which otherwise could have been earned if funds blocked in inventory are invested in interest-bearing securities. Total cost ? $rdering costs 2 Carrying costs Total inventory cost ? #P9= 2 =C96 Economic rder A$antit" -E A1 1conomic $rder =uantity model is the inventory management technique for determining the optimum order quantity which is the one that minimi%es the total of its ordering and carrying costs. Carrying cost ? =96 ! C Where* =9 ? Average quantity 6 C ? Carrying cost per unit ordering cost increases with a decrease in order si%e and carrying cost increases with an increase in order si%e. Thus the 1$= analysis provides answers to the following order quantity problems* 5.i. &nsurance of inventory against fire and theft. #torage cost like ta! depreciation and insurance maintenance of the building utilities and 8anitorial services. 'eterioration in inventory because of pilferage fire or technical fashion obsolescence and price decline. The carrying cost and the inventory si%e are positively related and move in the same direction. b. &t also balances the fi!ed ordering costs against variable ordering costs. The 1$= is the optimum amount of goods to order each time to minimi%e total inventory costs. &f the level of inventory decreases the carrying costs will also decrease and vice versa. Jow much of inventory should be bought in an order on each replenishmentO 6. iv. #erving costs like labor for handling inventory accounting and clerical costs. iii. #hould the quantity be purchased be large or smallO 7. ii. 1$= analysis should be applied to every product that represents a significant proportion of sales. #hould the requirement of materials during a given period of time be purchased in one lot or should it be purchased in instalmentsO 23 . Total cost is the sum of ordering and carrying costs.

The orders placed to replenish inventory stocks are received at e!actly that point in time when inventories reach %ero. 1$= . #afety stock is always required because deliveries from suppliers may be delayed for reasons beyond control. 'epletion of stock is linear and constant. Computational problems may arise and hence the number of orders to be placed may not be always 5BB" accurate if fractions or decimals are involved. &nflation affects 1$= in two possible ways* 24 . L. 6.ormula* 1$= ? >6#P 9 C Where*# ? Annual usage in units P ? $rdering cost per order C ? Carrying cost per unit 3umber of orders to be placed in a period ? # 9 1$= Figure showing EOQ Point: 0imitations of 1$= +odel* 5.Assumptions of 1$= model* 5. L. 'emand is known with certainty and is constant during the period. Also because there may be an une!pected demand for stocks. %nflation and Economic rder A$antit" -E A1 There is always an effect of inflation on economic order quantity. 6. The time interval between placing an order and receiving delivery (lead time) is constant. 1$= assumes that the demand is constant and known with certainty which always is not the case. 'emand may rise and fall depending upon various factors leaving a certain degree of uncertainty behind it. 7. 7. The assumption of constant usage and the instantaneous or immediate replenishment of inventories are not always practical.

Change in the total annual purchase and 6. Also if carrying costs go up the economic order quantity decreases according to the 1$= model which increases the total ordering costs 2eorder &oint S"stem -eorder point may be defined as the level of inventory when fresh order should be placed with the suppliers for procuring additional inventory equal to the economic order quantity. -eorder point ? 5B BBB units ! 6B days ?F 6BB BBB units. The number of days required to receive the delivery of inventory after placing an order is 6B days. 6. &ncrease in carrying costs 5. &t can be defined as the minimum additional inventory to serve as a safety margin or buffer to meet an unanticipated increase in usage resulting from an unusually high demand and or uncontrollable late receipt of incoming inventory. Change in the total annual purchase and 1$= model assumes that the annual demand is constant and is known with certainty. &nflation may change the quantity of units purchased or consumed. -e-order Point ? 0ead time in days ! average daily usage of inventory 0ead time is time normally taken in receiving delivery after placing orders with suppliers Example: Average daily consumption for a firm is 5B BBB units. &t may be influenced by the months of supply or total dollar ceilings of the inventory to be ordered or held. $f course the benefit is the procurement of inventory at the prevailing lower prices.5. This means that the firm should place the order for replenishing the stock of inventory as soon as the level reaches 6BB BBB units #afety #tock #afety stock implies e!tra inventories that can be drawn down when actual lead time and9or usage rates are greater than e!pected. At times the manufacturers may anticipate a rise in price of inventory in future and hence may wish to order in bulk and store it to avoid paying high price in future. Calculating the reorder point requires knowledge of the lead time between order and receipt of merchandise. The reorder point is a signal that informs when to place an order. 'etermination of #afety #tock 25 . &ncrease in carrying costs The cost of carrying inventory goes up as a result of increase in the interest rates due to inflation. @ltimately the quantity purchased increases in such situations due to inflation.

26 . 6. The larger the safety stock the smaller would be the stock-out costs. #o based on the stock-out costs and carrying costs safety stock will be determined attaining a trade-off between the two. Carrying costs Carrying costs are the costs associated with the maintenance of inventory.The financial manager should determine the appropriate level of safety stock on the basis of a trade-off between the following two costs associated with it* 5. &t is an opportunity cost of losing the benefits that would have been gained if stocks were there. The larger the safety stock the larger would be the carrying costs and vice versa. #tock-out costs #tock-out costs refer to the cost associated with the shortage of inventory.