Working Capital Management

By : Kavita Vijay
 Introduction
• Working capital management is a significant in
Financial Management due to the fact that it
plays a pivotal role in keeping the wheels of a
enterprise running
• Working capital management is concerned
with short term financial decisions.
• Working capital management if carried out
effectively , efficiently and consistently will
ensure the health of an organization.
 Meaning
• A company invests its funds for long term
purposes and for short term purposes.

• The portion of a company’s capital, invested in

short term or current assets to carry on its day
to day operations smoothly is called working
capital.
Objectives of Working capital Management

• To improve the return on capital employed

• To meet current Obligation
• Marginal return on investment should not be
less than the cost of capital employed
• Maintain proper balance between current
assets and current liabilities to meet its day to
day obligations
 Components of working capital
Current Assets:
• Cash and bank balances
• Short term advances
• Prepaid expenses
• Receivables
• stock

Current Liability:
• Creditors
• Outstanding expenses
• Taxes and dividends payable
• Bank overdraft
Classification of Working Capital
 On the Basis Of Concept

1) Gross WC
 The gross working capital refers to investment in all the
current assets. It is also known as Gross current assets. The
sum of all of a company's current assets (assets that are
convertible to cash within a year or less).

2) NET WC
 It is a difference between current assets and current liabilities.
It is the amount invested by the promoters on the current
assets of the organization.
 ON THE BASIS OF TIME

1) Permanent working capital

 Minimum amount of investment in current assets required at all point
of time.
 Remains in the business in one form or another.
 Grows with the size of the business.
 Financed by long term funds.

2) Temporary working capital

 Variable working capital, required by business over and above
permanent working capital.
 Additional current assets required at different point of time.
E.g. Extra inventory should be maintained during peak sales period
like festivals, seasons, etc.
 Will decrease in depression periods or off seasons.
 Financed from short term loans.
 Factors Determining Working capital
Requirements
• Basic nature of business
• Business Cycle Fluctuations
• Seasonal Operations
• Market Competitiveness
• Credit Policy
• Supply Conditions
 Disadvantages of Excess Working Capital

• Opportunity Cost
• Low Efficiency
• Reduced Profitability
• Limited Return on Assets
 Disadvantages of Inadequate Working
Capital
• Financial Distress
• Limited Growth
• Reduced Supplier Relations
• High Borrowing Cost
• Loss Of Discount
• Creditworthiness Concern
 Operating cycle and Working capital
• The operating cycle may be defined as the time duration starting
from the procurement of goods or raw materials and ending with
the sales realization.

• The length and nature of the operating cycle may differ from one
firm to another depending upon the size and nature of the firm.

• The longer the operating cycle, the larger the working capital
requirements.

• Based on the length of operating cycle the working capital finance

is done by the commercial banks
 Operating cycle Period
• The length or time duration of the operating cycle of
any firm can be defined as the sum of inventory
conversion period and the receivable conversion
period.
• Inventory Conversion Period (ICP): It is the time
required for the conversion of raw materials into
finished goods sales.
• ICP = RMCP+WPCP+FGCP
• Receivables conversion Period : It is the time required
to convert the credit sales into cash realization.
Cont…
• The total of ICP and RCP is also known as total
operating Cycle period.
• The firm may getting some credit facilities from
the supplier of raw materials, wage earners etc.
• This period for which the payments to these
parties are deferred or delayed known as
Deferral period.
• The net operating cycle of the firm is arrived by
deducting the DP from the TOCP
• RMCP= Average Raw material stock * 365
Total Raw Material Consumed

• WPCP= Average Work in progress* 365

Total Cost of production

• FGCP= Average Finished goods * 365

Total Cost of goods sold

• RCP= Average REceivable* 365

Total Credit sales

• DP= Average Creditors* 365

Total Credit Purchase
 Calculate the operating cycle of a company with
following details
• Ram material Consumption per annum 8,42,000
• Annual cost of production 14,25,000
• Annual Cost of sales 15,30,000
• Annual Sales 19,50,000
• Average Value of current assets held :
• Raw Materials 1,24,000
• Work in progress 72,000
• Finished goods 1,22,000
• Debtors 2,60,000
The company gets 30 days credit from its suppliers. All sales made by the firm are on
credit only. Take one year as 365 days.
 How to reduce operating Cycle
• Purchase Management
• Production Management
• Marketing Management
• Credit Collection Policies
• External Environment
• Personnel Management
Illustration 1
Illustration 2
Risk and Return
 Risk
• Risk is associated with the possibility of not
realizing return or realizing less return than
expected. .
• Risk and return are two sides of the
investment coin.
• Risk refers to a situation where the decision
maker knows the possible consequences of a
decision and their related likelihoods.
 Causes of risk
• Wrong method of investment
• Wrong timing of investment
• Nature of investment instruments
• Natural calamities
• National and international factors etc.
 Types of Risk
Systematic risk Unsystematic risk
• Market risk • Business risk
• Interest rate risk • Financial risk
• Purchasing power risk • Credit or default risk
Liquidity versus Profitability- A Risk-
Return Trade-off
An important aspect of a working capital policy is to
maintain and provide sufficient liquidity to the firm.
The decision on how much working capital be
maintained involves a trade-off i.e., having a large net
working capital may reduce the liquidity-risk faced by
the firm, but it can have a negative effect on the cash
flows. Therefore, the net effect on the value of the
firm should be used to determine the optimal amount
of working capital.
 Determining Financing-
mix
There are two sources from which funds can be
raised for current assets financing-
o Short term sources, like bank credit, commercial
paper etc.
o long term sources, such as share capital, long
term borrowings, internally generated resources
like retained earnings, etc.
 Approaches to determine an
appropriate Financing-mix
There are three basic approaches to determine
an appropriate financing mix:

• Hedging approach, also called the matching

approach,
• Conservative approach,
• Aggressive approach.
 Hedging Approach/ Matching
•
Approach
The Hedging approach suggests that long term funds should
be used to finance the fixed portion of current assets
requirements in a manner similar to the financing of fixed
assets.

• The purely temporary requirements, that is, the seasonal

variations over and above the permanent financing needs
should be appropriately financed with short term funds.

• This approach, therefore, divides the requirements of total funds

into permanent and seasonal components, each being financed
by a different source.
Matching approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
 Conservative
Approach
This approach suggests that the estimated
requirement of total funds should be met from long
term sources; the use of short term funds should be
restricted to only emergency situations or when
there is an unexpected outflow of funds.
 Aggressive
approach
A working capital policy is called an aggressive policy if the
firm decides to finance a part of the permanent working
capital by short term sources. The aggressive policy seeks
to minimize excess liquidity while meeting the short term
requirements. The firm may accept even greater risk of
insolvency in order to save cost of long term financing and
thus in order to earn greater return.
The trade-off between risk and profitability depends
largely on the financial manager’s attitude towards risk, yet
while doing so he must take care of the following factors-
o Flexibility of the mix
o Cost of financing
o Risk attached with financing mix
Aggressive approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Forecasting / Estimation of Working
Capital Requirements

Factors to be considered
 Total costs incurred on materials, wages and overheads
 The length of time for which raw materials remain in stores before they
are issued to production.
 The length of the production cycle or WIP, i.e., the time taken
for conversion of RM into FG.
 The length of the Sales Cycle during which FG are to be kept waiting for
sales.
 The average period of credit allowed to customers.
Cont…

The amount of cash required to pay day-to-day expenses of

the business.
The amount of cash required for advance payments if any.
The average period of credit to be allowed by suppliers.
Time – lag in the payment of wages and other overheads.
 Methods of Estimating Working Capital Requirement

• The following are the top five methods for

estimating working capital requirements.
• Percentage of Sales Method
• Regression Analysis Method
• Cash Forecasting Method
• Operating Cycle Method
• Projected Balance Sheet Method
 Percentage of sales method
• This method of estimating working capital
requirements is based on the assumption that
the level of working capital for any firm is directly
related to its sales value.
• If past experience indicates a stable relationship
between the amount of sales and working capital
• This basis may be used to determine the
requirements of working capital for future period.
Illustration
 Regression analysis
• This method of forecasting working capital
requirements is based upon the statistical
technique of estimating or predicting the
unknown value of a dependent variable from
the known value of an independent variable.
• It is the measure of the average relationship
between two or more variables, i.e.; sales and
working capital, in terms of the original units
of the data.
The relationships between sales and working capital
are represented by the equation:
The sales and working capital figures of Suvidha Ltd. for a period of 5 years are given as follows:
 Cash Forecasting method
• This method of estimating working capital requirements involves
forecasting of cash receipts and disbursements during a future
period of time.

• Cash forecast will include all possible sources from which cash
will be received and the channels in which payments are to be
made so that a consolidated cash position is determined.

• This method is similar to the preparation of a cash budget.

• The excess of receipts over payments represents surplus of cash
and the excess of payments over receipts causes deficit of cash or
the amount of working capital required.
Illustration:
• Texas Manufacturing Company Ltd. is to start production on 1st January, 2009. The prime
cost of a unit is expected to be Rs 40 out of which Rs 16 is for materials and Rs 24 for
labour. In addition, variable expenses per unit are expected to be Rs 8 and fixed expenses
per month Rs 30,000. Payment for materials is to be made in the month following the
purchases. One-third of sales will be for cash and the rest on credit for settlement in the
following month. Expenses are payable in the month in which they are incurred. The
selling price is fixed at Rs 80 per unit.

• The numbers of units manufactured and sold are expected to be as under:

• January 900
• February 1200
• March 1800
• April 2100
• May 2100
• June 2400
• Draw up a statement showing requirments of working capital from month to month.
 Operating cycle method
• This method of estimating working capital requirements is based upon the
operating cycle concept of working capital.

• The cycle starts with the purchase of raw material and other resources and
ends with the realization of cash from the sale of finished goods.

• It involves purchase of raw materials and stores, its conversion into stock of
finished goods through work-in-process with progressive increment of labour
and service costs, conversion of finished stock into sales, debtors and
receivables, realization of cash and this cycle continues again from cash to
purchase of raw material and so on.

• The speed/time duration required to complete one cycle determines the

requirement of working capital – longer the period of cycle, larger is the
requirement of working capital and vice-versa.
Cont…
Estimation of Amount of Different Components of Current Assets and Current Liabilities

• The various constituents of current assets and current

liabilities have a direct bearing on the computation of working
capital and the operating cycle. The holding period of various
constituents of Current Assets and Current Liabilities cycle
may either contract or expand the net operating cycle period.
Shorter the operating cycle period, lower will be the
requirement of working capital and vice-versa.
Problem
• Prepare an estimate of working capital requirement from
the following information of a trading concern.
• Projected annual sales 10,000 units
• Selling price Rs. 10 per unit
• Percentage of net profit on sales 20%
• Average credit period allowed to customers 8 Weeks
• Average credit period allowed by suppliers 4 Weeks
• Average stock holding in terms of sales requirements 12
Weeks
• Allow 10% for contingencies
Problem 2
Problem 3
Problem
 Projected Balance sheet
• Under this method, projected balance sheet
for future date is prepared by forecasting of
assets and liabilities by following any of the
methods stated above.
• The excess of estimated total current assets
over estimated current liabilities, as shown in
the projected balance sheet, is computed to
indicate the estimated amount of working
capital required.
Prepare an estimate of working capital requirement
from the following information of a trading concern:
 Unit 2
Cash Management
 Introduction
• Cash is one of the current asset of a business
• A business concern should always keep sufficient
cash for meetings its obligation
• Cash itself does not produce any goods and
services.
• Any shortage of cash will hamper the operations of
a concern and any excess of it will be unproductive
• So, cash management has assumed much
importance.
 Motives for holding cash
• Transaction Motive
• Precautionary Motive
• Speculative Motive
 Cash Management
• Cash management needs strategies to deal
with various facets of cash. Following are
some of its facets:
a) Cash planning: cash planning is a technique
to plan and control the use of cash
b) Cash forecasts and Budgeting : A cash budget
is a an estimate of cash receipts and
disbursements during a future period of time
 Objectives of cash management
• To provide cash needed to meet the
obligations,
• To minimize the idle cash held by the firm
 Factors affecting the cash Needs
• Cash cycle
• Cash inflows and outflows
• Cost of Cash Balance
• Other Consideration
 Managing cash flow
• Cash management will be successful only if cash collections are accelerated and cash
disbursement , as far as , are delayed.

• The following methods will help in accelerating cash inflow:

1. Prompt payment by Customers

2. Quick conversion of payment into cash
3. Decentralized collection
4. Lock box system

• Methods of slowing cash outflow

1. Paying on last date

2. Payment through drafts
3. Adjusting payroll funds
4. Centralization of payments
5. Making use of float
Cash Budget
 William J. Baumol’s model
• William J. Baumol developed a model (The Transactions Demand for
Cash: An Inventory Theoretic Approach) which is usually used in
inventory management but has its application in determining the
optimal cash balance also.
• Baumol found similarities between inventory management and cash
management.
• As Economic Order Quantity (EOQ) in inventory management involves
tradeoff between carrying costs and ordering cost
• The optimal cash balance is the tradeoff between opportunity cost or
cost of borrowing or holding cash and the transaction cost (i.e. the
cost of converting marketable securities into cash etc.)
• The optimal cash balance is reached at a point where the total cost is
the minimum.
The figure below shows the optimum cash
balance
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 show that the economic lot size can
be obtained by the Baumol Model.
 Miller and Orr Model
• Baumol’s model is based on the basic assumption that the size
and timing of cash flows are known with certainty.
• This usually does not happen in practice. The cash flows of a firm
are neither uniform nor certain.
• The Miller and Orr model overcomes the shortcomings of
Baumol model.
• 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 .
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:
Cont…
• When the cash balance touches the upper
control limit (h), marketable securities are
purchased to the extent of hz to return back
to the normal cash balance of z.
• In the same manner when the cash balance
touches lower control limit (o), the firm will
sell the marketable securities to the extent of
oz 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:

Variance of Cash Flows = (Standard deviation)2 or (s)2:

Illustration :
• A company has a policy of maintaining a
minimum cash balance of Rs 1, 00,000. The
standard deviation in daily cash balances is Rs
10,000. The interest rate on a daily basis is
0.01%. The transaction cost for each sale or
purchase of securities is Rs 50. Compute the
upper control limit and the return point as per
the Miller-Orr model.
 Marketable securities
• Marketable securities are financial
instruments that can be sold or converted into
cash (at reasonable value) within one year.
• They are highly liquid investments that are
generally issued by businesses to raise funds
for operating expenses or expansion.
• When a business invests in marketable
securities, it is usually to generate short-term
earnings from excess cash.
Characteristics of Marketable Securities

Marketable securities have the following characteristics:

• Be available for purchase and sale on public exchanges
• Be expected to be converted into cash within one year
• Have a maturity date of one year or less
• Have a strong secondary market that allows for timely
transactions at fair market price
 Important Point to be considered while
choosing Securities
• Safety
• Maturity
• Liquidity and marketability
• Return or yield
Unit 3
 Receivables Management
• Credit sales are common practice in businesses. It is widely believed throughout the
country that offering credit is important for nurturing business relationships and
developing new ones.
• However ,late payment and payment default situations happen with alarming frequency
– it’s critical to the financial health of the company to minimize them.
• Credit management seeks to mitigate risk while helping to make a business as attractive
as possible to potential customers.
• Credit management is the process of granting credit, setting the terms it's granted on,
recovering this credit when it's due, and ensuring compliance with company credit
policy, among other credit related functions.
• Higher credit sales at more liberal terms will no doubt increase the profit of the firm, but
simultaneously also increase the risk of bad debts as well as result in more and more
funds blocking in the receivables.
• So , a careful analysis of various aspects of the credit policy required. This is known as
receivables management
• By employing effective credit management procedures, you can help your business bring
in the revenue it’s entitled to and ensure long-term business continuity.
 Costs of Receivables
• Cost of financing
• Cost of Collection
• Bad debts
 Benefits of Receivables
• Increase in sales
• Increase in profits
• Extra Profits
 Factor influencing the size of receivables

• Size of credit sales

• Credit policies
• Expansion plans
• Relation with profits
• Credit collection efforts
• Habits of customer
Trade off between Receivables
 Dimensions of Receivables management
• Forming of credit policy
a) Quality of trade accounts or credit standards
b) Length of credit period
c) Cash discount
d) Discount period
• Executing Credit Policy
a) Collecting credit information
b) Credit analysis
c) Credit decision
d) Financing Investments in Receivables and factoring
• Formulating and executing collection policy
Illustration
 Illustration
• A firm sells 40,000 units of its product per annum @ Rs 35 per
unit. The average cost per unit is Rs 31 and the variable cost
per unit is Rs 28. The average collection period is 60 days. Bad
debt losses are 3% of sales and the collection charges amount
to Rs 15000. The firm is considering to proposal to follow a
stricter collection policy which would reduce bad debt losses
to 1% of sales and the average collection period to 45 days. It
would however, reduce sales volumes by 1000 units and
increase the collection expenses to Rs 25000.
• The firm’s required rate of return is 20%. Would you
recommend the adoption of the new collection policy ?
Assume 360 days in a year for the purpose of your calculation
Illustration:
 Introduction
• Inventories occupy the most strategic position in
the structure of working capital of most business
enterprises.
• It constitutes the largest component of current
asset in most business enterprises
• The turnover of working capital is largely governed
by the turnover of inventory.
• It is therefore quite natural that inventory which
helps in maximize profit occupies the most
significant place among current assets.
 Meaning
• The word inventory is understood differently by various authors. In
accounting language it may mean stock of finished goods only. In
manufacturing concern it may include raw materials work in
process and stores etc.
• The term ‘inventory’ refers to the stockpile of production a firm is
offering for sale and the components that make up the production.
• Inventory includes following things
1. Raw material
2. Work in progress
3. Consumables
4. Finished goods
5. spares
 Benefit of holding inventories
• The transaction motive
• The precautionary Motive
• The speculative motive
Risk and cost of holding Inventories
• Capital Cost
• Storage and handling cost
• Risk of price decline
• Risk of obsolescence
• Risk Deterioration in quality
 Inventory management
• Inventories consist of raw materials, stores, spares, packing materials, coal,
petroleum products, works-in-progress and finished products in stock either at
the factory or deposits.
• The maintenance of inventory means blocking of funds and so it involves the
interest and opportunity cost to the firm.
• Efforts are made to minimize the stock of inputs and outputs by proper planning
and forecasting of demand of various inputs and producing only that much
quantity which can be sold in the market.
• A proper planning of purchasing handling, storing, and accounting should form a
part of Inventory Management
• An efficient system of Inventory management will determine
1. what to purchase
2. How much to purchase
3. From where to purchase
4. Where to store
 Cont…
• The purpose of inventory management is to
keep the stocks in such a way that neither
there is a over stocking nor under stocking .
• The over stocking will mean a reduction of
liquidity and starving of other production
processes; Under stocking on the other hand
will result in stoppage of work .
• The investment in inventory should be kept in
reasonable limits
 Objectives of Inventory Management
• To maintain sufficient stock of raw material in the period of short supply and
anticipate price changes.
• To ensure a continuous supply of material to production department facilitating
uninterrupted production.
• To minimize the carrying cost and time.
• To maintain sufficient stock of finished goods for smooth sales operations.
• To ensure that materials are available for use in production and production services
as and when required.
• To ensure that finished goods are available for delivery to customers to fulfil orders,
smooth sales operation and efficient customer service.
• To minimize investment in inventories and minimize the carrying cost and time.
• To protect the inventory against deterioration, obsolescence and unauthorized use.
• To maintain sufficient stock of raw material in period of short supply and anticipate
price changes.
• To control investment in inventories and keep it at an optimum level.
 Tools and Techniques of Inventory
Management
• Determination of stock levels
• Determination of Safety Stocks
• Selecting a proper system of ordering for Inventory
• Economic order quantity. ...
• ABC analysis. ...
• VED Analysis
• Inventory Turnover Ratio
• Aging Schedule of Inventories
• Classification and codification of Inventories
• Preparation of Inventory Reports
• Lead Time
• Perpetual Inventory System
• Just-in-time inventory management. ...
 Determination of stock level
• Carrying of too much and too little of inventories is
detrimental to the firm.
• If the inventory level is too little, the firm will face frequent
stock-outs involving heavy ordering cost and if the inventory
level is too high it will be unnecessary tie-up of capital.
• Therefore, an efficient inventory management requires that
a firm should maintain an optimum level of inventory where
inventory costs are the minimum and at the same time
there is not stock-out which may result in loss of sale or
stoppage of production. Various stock levels are discussed
as follows
 Cont…
• Minimum Level:
• This represents the quantity which must be maintained in hand at all times. If stocks
are less than the minimum level then the work will stop due to shortage of
materials. Following factors are taken into account while fixing minimum stock level:
• Lead Time: A purchasing firm requires some time to process the order and time is
also required by supplying firm to execute the order. The time taken in processing
the order and then executing it is known as lead time.
• Rate of Consumption: It is the average consumption of materials in the factory. The
rate of consumption will be decided on the basis pas experiences and production
plans.
• Nature of Material: The nature of material also affects the minimum level. If
material is required only against special orders of customer then minimum stock will
not be required for such materials.
• Minimum stock level = Re-ordering level − (Normal consumption × Normal Reorder
period)
 Cont…
• Re-ordering Level:
• When the quantity of materials reaches at a certain
figure then fresh order is sent to get materials again. The
order is sent before the materials reach minimum stock
level. Reordering level is fixed between minimum and
maximum level. The rate of consumption, number of
days required to replenish the stock and maximum
quantity of material required on any day are taken into
account while fixing reordering level.
• Re-ordering Level = Maximum
Consumption × Maximum Re-order period
 Cont…
• Maximum Level:
• It is the quantity of materials beyond which a firm should not exceed its stocks. If the
quantity exceeds maximum level limit then it will be overstocking. A firm should avoid
overstocking because it will result in high material costs.
• Maximum Stock Level = Re-ordering Level + Re-ordering Quantity
− (Minimum Consumption × Minimum Re-ordering period)
• (d) Danger Level:
• It is the level beyond which materials should not fall in any case. If danger level arises
then immediate steps should be taken to replenish the stock even if more cost is
incurred in arranging the materials. If materials are not arranged immediately there is
possibility of stoppage of work.
• Danger Level = Average Consumption × Maximum reorder period for
emergency purchases
• Average Stock Level:
• The average stock level is calculated as such:
• Average Stock level = Minimum Stock Level + ½ of Re-order quantity
 Determination of safety stocks
• Safety stock is an inventory formula retailers use to determine the
emergency stock – the extra stock of products they need to have in case of
unforeseen circumstances that can put them on the verge of selling out.
• The demand for materials may fluctuate and delivery of inventory may also
be delayed and in such a situation the firm can face a problem of stock out .
• In order to protect against the stock out , firms usually maintain some
margin of safety.
• The basic problem is to determine the level of quantity of safety stocks.
• Two costs are involved in the determination of this stock i.e. opportunity
cost of stock outs and the carrying costs.
• If a firm maintain low level of safety frequent stock outs will occur resulting
into larger opportunity costs.
• On the other hand , the larger quantity of safety stocks involve higher
carrying costs.
 Economic order quantity
• A decision about how much to order has great
significance.
• The quantity to be purchased should neither be small
nor big because cost of buying and carrying is too high
• Economic order quantity is the size of the lot to be
purchased which is economically viable. This is the
quantity of materials which can be purchased at
minimum costs
• Generally economic order quantity is the point at
which inventory carrying costs are equal to order costs.
Cont…
• Ordering Costs: These are the cost which are associated
with the purchasing or ordering of materials
• Carrying costs: These are the costs for holding the
inventories. These costs will not be incurred if
inventories are not carried.
• The ordering and carrying costs have a reverse
relationship .
• The ordering cost goes up with the increase in number
of orders placed. On the other hand , carrying costs go
down per unit with the increase in number of units
purchased and stored
 Cont…
• The ordering and carrying costs of material
being high , an effort should be made to
minimise these costs.
• The quantity to be ordered should be large so
that economy may be made in transport costs
and discounts may also be earned.
• On the other hand storing facilities , capital to
be locked up , insurance costs should also be
taken into accounts
illustration
 Illustration
• The annual demand for a product is 6400units.
The unit cost is Rs 6 and inventory carrying
cost per unit per annum is 25% of the average
inventory cost. If the cost of procurement is Rs
75. Determine :
• Economic order quantity
• Number of orders per annum
• Time between two consecutives orders
 Illustration
• Vision Tubes Ltd. are the manufacturers of picture tubes for T.V.
The following are the details of their operations during 2007-2008
•Ordering cost RS 100 per order
•Inventory carrying cost 20% p. a.
•Cost of tubes Rs 500 per tube
•Normal usage 100 tubes per week
•Minimum Usage 50 Tubes
•Maximum Usage 200 tubes per week
•Lead Time to Supply 6-8 weeks
Required
1. EOQ. If the supplier is willing to supply 1500 units at a discount of 5% is it worth
accepting
2. Re order level
3. Maximum level of stock
4. Minimum level of stock
 Illustration
• A manufacturing company purchases 24000 pieces of a
component from a subcontractor at Rs 500 per piece and uses
them in its assembly department at a steady rate. The cost of
placing an order and following it up is Rs 2500. The Estimated
stock holding cost is approximately 1% of the value of average
stock held. The company is at present placing orders which at
present vary between an order placed every two months(i.e.
six orders p.a.) to one order per annum. Which policy would
you recommend.
Illustration
 Cont…
Assumptions of EOQ: while calculating EOQ the following assumption are made:
1. The supply of goods is satisfactory . The goods can be purchased whenever
these are needed
2. The quantity to be purchased by the concern is certain.
3. The Prices of goods are stable . It results to stablise carrying costs
 ABC analysis
• The ABC analysis classifies various inventory items into
three sets or groups of priority and allocates
managerial efforts in proportion of the priority .
• The most important items are classified as class A ,
those of intermediate importance are classified as
class B and the remaining items are classified as class C
• The financial manager should monitor different items
belonging to different groups in that order of priority .
• Utmost attention is required for class A item , followed
by items in class B and then items in class C
Cont…
 VED analysis
• The VED analysis is used generally for spare parts.
• The requirements and urgency of spare parts is different from that
of materials .
• The demand for spares depends upon the performance of the
plant and machinery .
• Spare parts are classified as vital essential, and desirable.
• The vital spares are must for running the concern smoothly and
these must be stored adequately.
• The E type of spares are also necessary but their stocks may be
kept at low figures.
• The D types of spares may be avoided at times . If lead time of
these spares is less, then stocking of these spares can be avoided
 Inventory Turnover Ratio
• Inventory turnover ratio are calculated to indicate whether inventories
have been used efficiently or not.
• The purpose is to ensure the blocking of only required minimum funds in
inventory
• Inventory conversion period may also be calculated to find the average
time taken for clearing the stocks