Question 5 (b)
The operating cycle method of estimating working capital
6 marks
- Time to write
- About 12 minutes
- Topic
- Working capital
Question
Question 5 (b) · 6 marksExplain the Operating Cycle Method of working capital estimation.
Reworded from the university paper; 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
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of the operating cycle 1 mark 1 min
- 2 Length of the cycle: stages and formula, with example 2 marks 4 min
- 3 Estimation of each component from cost and holding period 2 marks 3 min
- 4 Merits 1 mark 2 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning of the operating cycle (step 1, 1 mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.
Short on time? Keep step 1 short. Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks. End with step 4 in a line or two.
Try it first. About 12 minutes for 6 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.
Operating cycle. The operating cycle is the time money takes to go round the business, and the net operating (working capital) cycle is the time between paying for raw materials and receiving cash from the sale of the finished goods made from them. Cash is turned into raw materials, raw materials into work-in-progress, work-in-progress into finished goods, finished goods into debtors and debtors back into cash.
1The carpenter's cash becomes a cartload of timber.
Raw material storage periodCash is turned into raw materials.
2Saw and hammer turn the timber into half-made chairs.
Conversion (work-in-progress) periodRaw materials into work-in-progress.
3The finished chairs line the store room, ready.
Finished goods storage periodWork-in-progress into finished goods.
4The chairs go out on credit, and Lakshmi's notebook follows the money home.
Debtors' collection periodFinished goods into debtors and debtors back into cash.
Length of the cycle. The gross operating cycle is the sum of the stages; the net cycle deducts the credit received from suppliers:
Gross operating cycle = raw material storage period + conversion (work-in-progress) period + finished goods storage period + debtors' collection period.
Net operating (working capital) cycle = gross operating cycle − creditors' payment period.
For example, raw materials held 60 days, supplier credit 15 days, production 15 days, finished goods 30 days and debtors 30 days give a gross cycle of 135 days and a working capital cycle of 60 − 15 + 15 + 30 + 30 = 120 days.
Estimating working capital by this method. Each component of working capital is estimated separately from the cost tied up in it and the time it is held:
Each annual figure is converted to the period it is held: × months ÷ 12, or × days ÷ 360 (or 365).
- Raw materials: annual material cost × storage period.
- Work-in-progress: annual cost of materials, wages and overheads × production period (with the degree of completion).
- Finished goods: annual cost of production × storage period.
- Debtors: annual cost of sales × average credit period allowed to customers.
- Cash: the amount needed for day-to-day expenses.
- Less current liabilities: annual credit purchases of materials × credit period received from suppliers, and the annual wages and overheads × the lag in paying them.
The difference, with a margin for contingencies, is the net working capital required.
Merits. The method links working capital to the firm's actual production and credit periods, so it shows which stage ties up funds; shortening any stage (for example, collecting debtors faster) releases cash and reduces the working capital needed.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of the operating cycle | 1 |
| 2 | Length of the cycle: stages and formula, with example | 2 |
| 3 | Estimation of each component from cost and holding period | 2 |
| 4 | Merits | 1 |
| Total | 6 |
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