UNIT 3: MANAGEMENT OF WORKING CAPITAL

PART 2

BACHELOR OF COMMERCE IN ACCOUNTING

MANAGEMENT ACCOUNTING FOR DECISION-MAKING

(MANAGEMENT ACCOUNTING & FINANCE 3A)

23 MARCH 2024
 SCOPE OF MANAGEMENT ACCOUNTING & FINANCE 3A

The MAF3A
FURTHER ASPECTS IN BUDGETING
module comprises
THE INVESTMENT DECISION 5 learning units
MANAGEMENT OF WORKING CAPITAL
ANALYSIS & INTERPRETATION OF FINANCIAL STATEMENTS
MANAGEMENT ACCOUNTING IN THE MODERN BUSINESS ENVIRONMENT
 RECAP OF PREVIOUS PRESENTATION
 Introduction to working capital
 Working capital policies: Aggressive, Conservative, and Moderate
 Understand & implement the techniques used by firms to optimize the
management of cash and cash equivalents.
 4 motives for holding cash
 Efficient cash management strategies
 Cost of not accepting a discount
 Baumol model for cash management
 Miller-Orr Model
 Cash budgets
 Summary
 MANAGEMENT ACCOUNTING & FINANCE 3A LEVEL OUTCOMES
On successful completion of the module, you should be able to:

Outline the nature and Recognise the importance Prepare and analyse
purpose of a number of of the management of forecast statements/budgets
recent developments in working capital in a
management accounting business context
practice 2

1 3 5

Analyse financial statements Apply capital investment

and reports appraisal techniques for the
implementation of business
decisions
 UNIT 3:

MANAGEMENT OF WORKING CAPITAL:

WORKING CAPITAL FINANCING
 UNIT 3 LEVEL OUTCOMES
On successful completion of unit 3 of the module, you should be able to:

Understand Working Capital Financial Policies

Understand & implement the techniques used by firms to optimize the management of cash and
cash equivalents.
Understand and describe the advantages and disadvantages of credit sales & Implement the
techniques used to optimize debtor-management
Understand and calculate the Economic Order Quantity (EOQ), and safety inventory.

Explain the role of Just-In-Time (JIT) techniques on inventory management.

 CONTENT OF TODAY’S PRESENTATION
 Introduction to working capital: inventories, accounts receivable, cash & cash
equivalents
 A laser focus on accounts receivable
 The establishment of a credit policy & changing the credit policy
 Factoring
 A critical focus on inventory management
 Costs associated with inventory management
 EOQ
 Reorder level
 Discount quantity
 Just-in-time inventory system
 Summary
MANAGEMENT OF ACCOUNT RECIEVABLE
 INTRODUCTION TO ACCOUNTS RECEIVABLE
 With the expansion of sales, an increasing portion of investment of corporate assets is
in accounts receivable.

 Over the years, accounts receivable as a percentage of total assets have increased
relative to inventory, and this is a cause for concern for some firms in their management
of current assets.

 Thus, the management of receivable is of paramount importance.

 Two accounting ratios are used to assess the effectiveness of the management of
receivables:
 Debtors Collection Period = Average Receivables/Credit Sales x 365
 Accounts Receivable Turnover = Credit Sales / Average Receivable Balance.
 RESEARCH QUESTION: What is the optimal level of receivables as a % of current
assets?
 MANAGING ACCOUNT RECEIVABLE VIS-À-VIS INVENTORY
 The management of accounts receivable goes hand in hand with inventory
management.

 Sufficient inventory must be available to meet the increased demand for products that
comes from extending credit to customers (Marx et al., 2017:220).

 Thus, access to, and management of, inventory must PRECEDE organisation’s effort to
extend credit to customers.

 Thus, a firm’s accounts receivable policy is always managed hand-in-hand with its
inventory policy.
 CREDIT POLICY & ADMINISTRATION*
 A credit policy: the established rules and regulations that have to be followed to extend
credit to customers without exposing the organisation to unnecessary risk (Skae,
2017:347).

 When considering the extension of credit, 3 primary policy variables are considered in
conjunction with the profit objective (Block et al., 2017:205):

 Credit selection & standards: the minimum requirements for extending credit to
customers: 5C: Character; Capacity; Capital (debts & equity); Conditions(sensitivity of op income);
Collateral (assets to pledge)
 Terms of trade/Credit terms: setting credit terms involves the determination of 3 parameters: e.g.,
2/10 net 30 days
 Collection policy: the variety of procedures followed to collect accounts receivable once they
become due (Marx et al., 2017:232): Letters; Telephone calls; collection agencies, Legal actions
 DOWNSIDE OF SELLING ON CREDIT
 There are additional costs that arise from holding and managing debtors
o Increasing the volume of inventory held,
o Taking additional short-term borrowings to meet inventory requirements,
o The cost of bad debts.

GP = (S – C)n – ARC

Where:
GP = gross profit
S = selling price per unit
C = cost of goods sold per unit
n = number of units
ARC = cost of accounts receivable
 IMPACT OF CREDIT TERMS ON PROFITABILITY
 Importance of exploring the impact of credit terms on profitability (Marx et al., 2017:228).
 When a firm sells on credit, a cost is incurred that involves the value of the investment in
the sale (cost of the goods sold) during the period until the payment is received.
EXAMPLE:
AX Suppliers is considering selling a laptop to Mrs G. Smith on credit. The cost of the laptop is R6 000 and the selling price is
R10 000. A credit term of “net 60 days” has been agreed upon. AX Suppliers’ cost of capital is 10%.
Required: Determine the effect of the sale on the profit of AX Suppliers
SOLUTION

If the laptop was sold for cash, the gross profit would have been? Total cost of sale of the laptop
Cost price R6 000.00
Add: Credit cost 98.63
Total cost R6 098.63
Effect on profit
Sales R10 000.00
Less: Cost of sales (R6 098.63)
 IMPACT OF CREDIT TERMS ON PROFITABILITY
EXAMPLE 2:
AX Suppliers offers Mrs G. Smith the terms 2/30 net 60 for the sale of the laptop. The cost of the laptop is R6, 000 and the
selling price is R10 000. AX Suppliers’ cost of capital is 10%.
Required: Determine the effect of the sale on the profit of AX Suppliers
SOLUTION

Total cost of sale of the laptop

Cost price R6 000.00
Add: Credit cost 49.32
Total cost R6 049.32
Effect on profit
30-day 60-day payment
payment
Effective price (100% -2%)x R10 000 R9 800.00 R10 000.00
Less: Cost of sales (6 000) (6 000.00)
 IMPACT OF CREDIT TERMS ON PROFITABILITY
 If the customer fails to pay the amount due, the loss to the firm will be the cost price plus
the credit cost up to the point that the account is written off as a bad debt.
EXAMPLE 3:
Suppose AX Suppliers writes off all accounts after 180 days.
Required: Calculate the loss to the firm if Mrs G. Smith fails to pay her account.

SOLUTION
 CHANGING THE CREDIT POLICY
 Changes to credit policy have an impact on:
 revenue,
 those debtors whose accounts have not yet been settled,
 the amount of credit loss, and
 the cost of discounts.
 Before tightening or relaxing its credit policy, the consequences of this decision should
be analysed.
 Correia (2019:12-3) uses the following formula: ΔP = ΔG - ΔI - ΔB - ΔD
Where:
ΔP = change in net income
ΔG = change in gross profit
ΔI = change in cost of carrying receivables
ΔB = change in bad debts
ΔD = change in cost of discounts
 DEBTOR FACTORING:
 Factoring: debtor administration & collection facility that provide short-term financing
 Factor: is a firm usually a bank (or a department of the bank) that provides factoring
 Client: the firm seeking the services of a factor
 The client sells the account receivables to the factor. Factor assumes credit
administration responsibility for a fee and advances money to the client (finance charges
apply).
 Factoring can be classified as follows:
 Disclosed factoring: client’s customers are notified of the factoring arrangement
 Non-disclosed factoring: client’s customers are not notified of the arrangement; Sales
ledger administration and collection of debts remains with client.
 Recourse factoring: bad debt risk remains with client: the factor has the recourse to sell
back to the client any uncollectable debts: cheaper
 Non-recourse factoring: factor collect debts from customers: balance is paid to client:
more expensive because factor accepts risk of bad debt.
 DEBTOR FACTORING: EXAMPLE:
The management of PWD Inc. is considering factoring its accounts receivable to gain access to cash for
its daily operations. PWD’s annual credit sales amount to R52m. Currently, the average collection period
of the firm is 60 days.

A factoring company has offered the following terms in a servicing and factor-financing agreement:

 Service fees will be charged at 2% of total credit sales of SKB, and

 60% on each credit invoice will be paid immediately and interest will be charged at 2% above the
current prime rate of 9%.

Currently, some suppliers of PWD Inc. offer discounts of 5% for early settlement. The transactions for
which the discounts apply are equivalent to approximately 30% of PWD’s credit sales. If the factor
administers the accounts receivable, it is expected that there would be administration cost savings of
R250 000 per annum.

REQUIRED: Calculate the net cost of the factoring.

 DEBTOR FACTORING: EXAMPLE: SOLUTION
MANAGEMENT OF INVENTORY
 INTRODUCTION TO MANAGEMENT OF INVENTORIES
 The most expensive of the e elements of cost
 Inventory is classified into 3 categories: raw materials, work-in-progress and finished
goods (when sold constitute account receivable).
 Inventories are the least liquid of a firm’s current assets (Acid test ratio !!)
 However, they tie up a huge portion of the firm’s financial resources; thus, care should
be taken to manage the inventories properly (Marx et al., 2017:246).

 When a firm purchases inventory, provisions for ancillary expenses like insurance
coverage, storage facilities, security, spoilage and the opportunity cost of holding the
inventory are made (Marx et al., 2017:246).

 Firms have 3 motives for holding inventory: transaction, precaution and speculation
(Marimuthu, 2017:533).
 COSTS OF INVENTORY
 The costs associated with the purchase and maintenance of inventory.
 Marimuthu (2017:533-534) classifies them as follows:
o Holding/carrying costs: Costs that are incurred in the process of ensuring that there is sufficient
inventory on hand to meet demand.
 Capital invested (money spent to purchase the inventory);
 Service costs (handling, insurance);
 Storage costs (rent of warehouse, warehouse overheads, security) and
 Risks costs (possible theft, damages, obsolescence).
 Calculating holding costs: Average inventory x Cost of holding a unit inventory per year ( Marx et al.,
2017:253): (EOQ/2) x CH
o Ordering costs: expenses incurred to execute the order for inventory. They include:
 Clerical costs, transportation, inspection of the transported merchandise, and set-up costs where
applicable.
o Calculating ordering cost: Number of order per year x Cost of placing an ordering
= (D/EOQ) x CO
 COSTS OF INVENTORY
 The costs associated with the purchase and maintenance of inventory.
 Marimuthu (2017:533-534) classifies them as follows:
o Holding/carrying costs: Costs that are incurred in the process of ensuring that there is sufficient
inventory on hand to meet demand.
 Capital invested (money spent to purchase the inventory);
 Service costs (handling, insurance);
 Storage costs (rent of warehouse, warehouse overheads, security) and
 Risks costs (possible theft, damages, obsolescence).
o Calculating holding costs: Average inventory x Cost of holding a unit inventory per year ( Marx et al.,
2017:253): (EOQ/2) x CH
o Ordering costs: expenses incurred to execute the order for inventory. They include:
 Clerical costs, transportation, inspection of the transported merchandise, and set-up costs where
applicable.
o Calculating ordering cost: Number of order per year x Cost of placing an ordering
o Stock-out costs: are only crucial in cases where demand for the product is uncertain.
 DETERMINING THE ECONOMIC ORDER QUANTITY (EOQ)
 The economic order quantity (EOQ): The optimum order size is the order quantity that
will result in the total amount of the ordering and holding costs being minimized.
 ASSUMPTIONS OF THE ECONOMIC ORDER QUANTITY (EOQ)
 Ordering cost per order and carrying cost per unit per annum are known and they are
constant.

 Anticipated usage of material in units is known and is uniform during the year.

 Cost per unit of the material is constant and is known as well.

 The quantity of material ordered is received immediately i.e lead time is Zero.
 DETERMINING THE ECONOMIC ORDER QUANTITY (EOQ)
 The economic order quantity (EOQ) = ?
 ECONOMIC ORDER QUANTITY
Calculating EOQ: Based on annual demand of a particular item of inventory (D), the annual
cost of making an order () and the annual cost of holding one unit of the particular stick (),
we can calculate the EOQ as follows:

The formula can be adjusted to make provision for the effect of interest on the investment in inventory
 THE ECONOMIC ORDER QUANTITY: EXAMPLE 1
Use the information provided below to determine the number of orders that Renshaw
Wholesalers should place during 2021 at the most advantageous quantity.
INFORMATION
Renshaw Wholesalers anticipates sales of 189 000 units for 2021, a purchase price of
R640 per unit, an ordering cost of R64 per order, and a carrying cost of 5% of the unit
purchase price.

SOLUTION:
 THE ECONOMIC ORDER QUANTITY: EXAMPLE 2
Use the information provided below to answer the following questions relating to a product
sold by KWR Inc.
INFORMATION
The average weekly demand for the product is 800 units and the cost of placing an order is
R1000 and the holding cost per unit is R5.20. The cost per unit of the product is R10.
Required:
2.1. Calculate the economic order quantity.
2.2. Suppose that KWR Inc. cost of capital is 25%, calculate the economic order quantity.
SOLUTION:
 SOME METHEMATICAL CALCULATIONS
 Number of order to be placed

 Total Ordering Cost

 Total Carrying Cost

 PROBABILISTIC ESTIMATION OF OPTIMAL INVENTORY SIZE
 Sometimes the use of probability enables firms to determine the most optimal quantity to
hold.
 This requires analysts to prepare a probability analysis to determine the most cost-
benefit quantity of safety inventory that the firm should hold.

 TGH Inc. has provided the following data in terms of usage and frequency (probability):

Usage (units) 700 1 000 1 500 1 800 2 000 2200

Probability 0.1 0.2 0.3 0.25 0.1 0.05
 SOLUTION:
Usage (units) 700 1 000 1 500 1 800 2 000 2200
Probability 0.1 0.2 0.3 0.25 0.1 0.05
Probable usage 70 200 450 450 200 110
 INVENTORY QUESTION:
Centech Limited are the manufacturers of Lamps. The following are the details of their
operation during 2022:
• Average monthly market demand 2,000 lamps
• Ordering cost R200 per order
• Inventory carrying cost 20% per annum
• Cost of lamps R1000 per lamp
• Normal usage 100 lamps per week
• Minimum usage 50 lamps per week
• Maximum usage 200 lamps per week
• Lead time to supply 4 - 6 weeks
Required:
Compute from the above : (i) Economic order quantity. (ii) If the supplier is willing to supply
quarterly 1,500 units at a discount of 10%, is it worth accepting? (iii) Maximum level of
stock. (iv) Minimum level of stock. (v) Re-order level of stock.
 INVENTORY QUESTION: SOLUTION:
Centech Limited are the manufacturers of Lamps. The following are the details of their
operation during 2022:
Required:
Compute from the above :
(i) Economic order quantity.
Normal usage 100 lamps per week
Ordering cost R200 per order
Inventory carrying cost 20% per annum
Cost of lamps R1000 per lamp
 INVENTORY QUESTION: SOLUTION:
Centech Limited are the manufacturers of Lamps. The following are the details of their
operation during 2022:
Required:
Compute from the above :
(ii) If the supplier is willing to supply quarterly 1,500 units at a discount of 10%, is it worth
accepting?
Number of orders = 52 000 units/1 500 units = 3.46 or 4
Ordering cost per year @ R200 per order R800
Carrying cost of average inventory = (1500/2) x [90%xR1000 x20%] R135 000
Cost of products = (100% -10%) x R1000 x5200 R4 680 000
Total annual costs of inventory R4 815 800

If EOQ Method is used:

Number of orders = D/EOQ = 5200/102 = 51 times
Ordering cost per year @ R200 per order (51x R200) R10 200
Carrying cost of average inventory = (102/2) x [R1000 x20%] R10 200
Cost of products = (100%) x R1000 x5200 R5 200 000
Total annual costs of inventory under EOQ R5 220 400
Difference between the 2 methods: R5 220 400 – R4 815 800 R404 600
Decision: Accept the offer
 INVENTORY QUESTION: SOLUTION:
Centech Limited are the manufacturers of Lamps. The following are the details of their
operation during 2022:
Required:
Compute from the above :
(iii) Maximum level of stock. (iv) Minimum level of stock. (v) Re-order level of stock.
 JUST-IN-TIME (JIT) INVENTORY SYSTEM
 JIT systems aim to optimize inventory management and is aided by technological
advancement.

 JIT systems emerged due to the shortcomings in traditional purchasing and production
systems that used to manufacture units in huge batches that tended to result in
unnecessarily high set-up and production costs (Skae 2017:358).

 No firm wants to have inventory sitting around longer than it is supposed to, since
inventory-holding is not a value-adding activity, and so the costs thereof do not benefit
the organisation (Marimuthu, 2017:551).

 JIT aims to eliminate all the inefficiencies in the traditional systems by a flexible and on-
the-moment response to customer demand
 FACTORS THAT SUPPORT JIT INVENTORY SYSTEM
 The elimination of all non-value adding activities (Value Chain Analysis).
o Zero inventory: JIT advocates for lengthy contracts with suitably located suppliers who can meet the
demands of the organisation on short notice.
o
o Zero defect: defects not only disrupt the production process but also leads to wastage. The organisation
will have to engage in preventive maintenance and training, as well as implement a pull-through system
in order to achieve the goal of zero defects (TQM).

o Producing batches of one: JIT advocates for the implementation of a production layout that will
substantially reduce or completely eliminate the set-up costs that may arise from producing in smaller
batches, which is more reasonable that producing in large batches with the associated storage costs.

o Customer delivery service: whereas traditional systems advocated for large inventory holding to cater to
customer demands and to make provision for possible breakdowns, JIT advocates for flexible set-ups
that will minimize lead times and improve the quality of the product.
 BENEFITS OF JIT INVENTORY SYSTEM
 Benefits from the successful implementation of JIT (Marimuthu, 2017:552). :
o lower investment in inventory,
o reduction in carrying costs,
o lower investment in storage facilities,
o reduction in set-up and overall production costs,
o increased revenue because of a shorter turnaround time with regards to customer
needs,
o decreases in breakdowns and wastages.