Question 5 (a)
Working capital requirement on the cash cost basis
15 marks
- Time to write
- About 30 minutes
- Topic
- Working capital
Question
Question 5 (a) · 15 marksFollowing figures relate to House of Saffron Limited—
| Sales at three months' credit | ₹10,80,000 |
| Material consumed (Suppliers extend 1½ month's credit) | ₹27,00,000 |
| Wages (One month in arrear) | ₹21,60,000 |
| Manufacturing expenses outstanding at year-end (cash expenses paid one month in arrear) | ₹2,40,000 |
| Total administrative expenses for the year (cash expenses paid one month in arrear) | ₹7,20,000 |
| Sales promotion expenses (Paid quarterly in advance) | ₹14,40,000 |
The company sells its product at a gross profit of 25%, treating depreciation as a part of cost of production. It holds two months' stock of finished goods as well as one month's stock of raw material, and keeps a cash balance of ₹3,00,000. Assuming a 5% safety margin on the required (or final) working capital, work out what the working capital requirement of the House of Saffron Limited is on a cash cost basis. Ignore work-in-progress. Give working notes for calculating the cost of production and the cost of sales/total cost.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Assuming a 5% safety margin on…The paper fixes this: use it as given, and say so in your answer.
- work outFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The sales figure looks far too small for the costs given at a 25% gross profit; it is kept as printed. On the cash cost basis the question asks for, debtors are taken at the cash cost of sales, so the sales figure itself is not needed. The 5% safety margin is read as 5% of the final working capital requirement (the requirement including the margin), so the requirement is the net working capital divided by 0.95.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Working note: cash cost of production 2 marks 4 min
- 2 Working note: cash cost of sales 2 marks 4 min
- 3 Stocks of raw materials and finished goods 2 marks 3 min
- 4 Debtors at cash cost and prepaid expenses 3 marks 5 min
- 5 Current liabilities 3 marks 5 min
- 6 Net working capital, safety margin on the final figure and total 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 30 minutes for 15 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Basis. On the cash cost basis, debtors and finished goods are taken at cash cost: profit is left out, since the funds blocked in them are only their cost, and non-cash costs such as depreciation are excluded. Each element is estimated from its annual cost and its holding period. Production is taken equal to sales, and work-in-progress is ignored, as the question says.
Working note 1: cash cost of production
| Item | ₹ |
|---|---|
| Materials consumed | 27,00,000 |
| Wages | 21,60,000 |
| Manufacturing expenses (₹2,40,000 outstanding = one month, so 2,40,000 × 12) | 28,80,000 |
| Cash cost of production | 77,40,000 |
Working note 2: cash cost of sales
| Item | ₹ |
|---|---|
| Cash cost of production | 77,40,000 |
| Administrative expenses | 7,20,000 |
| Sales promotion expenses | 14,40,000 |
| Cash cost of sales | 99,00,000 |
Depreciation is part of the cost of production for the 25% gross profit, but it is a non-cash cost and is not needed on the cash cost basis. (The sales figure given cannot support these costs at a 25% gross profit, as the paper note says; debtors are therefore taken at the cash cost of sales, which does not depend on it.)
Statement of working capital requirement (cash cost basis)
| Particulars | Working | ₹ |
|---|---|---|
| A. Current assets | ||
| Stock of raw materials (1 month) | 27,00,000 × 1/12 | 2,25,000 |
| Stock of finished goods (2 months, at cash cost of production) | 77,40,000 × 2/12 | 12,90,000 |
| Debtors (3 months, at cash cost of sales) | 99,00,000 × 3/12 | 24,75,000 |
| Prepaid sales promotion (paid a quarter in advance) | 14,40,000 × 3/12 | 3,60,000 |
| Cash balance | 3,00,000 | |
| Total current assets | 46,50,000 | |
| B. Current liabilities | ||
| Creditors for materials (1½ months) | 27,00,000 × 1.5/12 | 3,37,500 |
| Wages outstanding (1 month) | 21,60,000 × 1/12 | 1,80,000 |
| Manufacturing expenses outstanding (given) | 2,40,000 | |
| Administrative expenses outstanding (1 month) | 7,20,000 × 1/12 | 60,000 |
| Total current liabilities | 8,17,500 | |
| Net working capital before the safety margin (A − B) | 38,32,500.00 | |
| Add: safety margin (5% of the final requirement: 40,34,210.53 × 5%) | 2,01,710.53 | |
| Working capital required (38,32,500 ÷ 0.95) | 40,34,210.53 |
Note on the safety margin. The question asks for a 5% safety margin on the required (final) working capital, so the margin is 5% of the final figure, as the paper note reads it: final requirement = 38,32,500 ÷ (1 − 0.05) = ₹40,34,210.53, of which ₹2,01,710.53 is the margin. (If the 5% were instead added to the net figure, the requirement would be ₹40,24,125.)
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Working note: cash cost of production | 2 |
| 2 | Working note: cash cost of sales | 2 |
| 3 | Stocks of raw materials and finished goods | 2 |
| 4 | Debtors at cash cost and prepaid expenses | 3 |
| 5 | Current liabilities | 3 |
| 6 | Net working capital, safety margin on the final figure and total | 3 |
| Total | 15 |
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