MANAGEMENT ACCOUNTING & CONTROL

WORKING CAPITAL MANAGEMENT

LEARNING ACTIVITY 3

Answer the following short problems:

1. Ogayon, Inc. has determined the following for a given year:

Economic order quantity 5,000 units

Total cost to place purchase orders for the year P 10,000
Cost to place one purchase order P 50
Cost to carry one unit for 1 year P4

What is Ogayon’s estimated annual usage in units?

Annual usage units = 10,000/50

= 200 x 5,000
Annual usage units = 1,000,000

2. Lota Company is planning to build a new plant in Batangas City. The plant is expected to
provide additional sales as follows:

First Year P 2.0 million

Second Year P 2.5 million
Third Year P 3.0 million (maximum capacity)

The financial manager of Lota estimates that for every peso of sales, P0.25 must be
invested in current assets. If all discounts are taken and bills are paid on time, accounts
payable average P 0.04 per peso of sales. Other current liabilities, such as wages payable,
typically average P0.05 per peso of sales.

Required:
a. Estimate the working capital investments required for the new plant in the 1st,
2nd & 3rd year of operations.

Year 1 Year 2 Year 3

Sales 2,000,000 2,500,000 3,000,000
Current Asset 500,000 625,000 750,000
Current Liabilities (80,000) (100,000) (120,000)
Other current (100,000) (125,000) (150,000)
Liabilities
Working Capital 320,000 400,000 480,000
 b. How do these requirements affect the associated cash flows and the viability
of the project?
Working capital is an important part of a cash flow analysis. It is defined as
the amount of money needed to facilitate business operations and transactions
and is calculated as current assets (cash or near cash assets) less current
liabilities (liabilities due during the upcoming accounting period). Computing
the amount of working capital gives you a quick analysis of the liquidity of
the business over the future accounting period. If working capital appears to
be sufficient, developing a cash flow budget may not be critical. But if
working capital appears to be insufficient, a cash flow budget may highlight
liquidity problems that may occur during the coming year.

3. Marques Corporation spends Php 220,000 per annum on its collection department. The
company has Php 12M in credit sales. Its average collection period is 2.5 months, and the
percentage of bad debts loss is 4%. The company believes that if it were to double its
collection personnel, it could bring down the average collection period to 2 months and
bad debt losses to 3%. The added cost is Php 180,000, bringing total expenditures to Php
400,000 annually.

Is the increased effort worthwhile if the opportunity cost of funds is 20%? If it is 10%?

If the before-tax opportunity cost of funds is 20%:

Particulars Current Level Proposed Level

Sales 12,000,000 12,000,000
Costs:
Carrying Cost of 500,000 400,000
receivables
Bad debts (Sales*Bad 480,000 360,00
Debt %)
Department expenses 220,000 400,00
Pre-tax profits 10,800,000 10,840,000
Incremental profit ₱ 40,000

Note for Current level Cost:

Carrying Cost of Receivables = (Sales x Average collection period)
(360 x Opportunity Cost)
= 12,000,000 x 75
360 x 0.20
Carrying Cost of Receivables = 500,000

Note for Proposed level Cost:

Carrying Cost of Receivables = (Sales x Average collection period)
(360 x Opportunity Cost)
= 12,000,000 x 60
 360 x 0.20
Carrying Cost of Receivables = 400,000

If the before-tax opportunity cost of funds is 10%:

Particulars Current Level Proposed Level

Sales 12,000,000 12,000,000
Costs:
Carrying Cost of 250,000 200,000
receivables
Bad debts (Sales*Bad 480,000 360,00
Debt %)
Department expenses 220,000 400,00
Pre-tax profits 11,050,000 11,040,000
Incremental profit (₱ 10,000)
(Loss)

Note for Current level Cost:

Carrying Cost of Receivables = (Sales x Average collection period)
(360 x Opportunity Cost)
= 12,000,000 x 75
360 x 0.10
Carrying Cost of Receivables = 250,000

Note for Proposed level Cost:

Carrying Cost of Receivables = (Sales x Average collection period)
(360 x Opportunity Cost)
= 12,000,000 x 60
360 x 0.10
Carrying Cost of Receivables = 200,000