Question 6
Excess and shortage of inventory; gross working capital
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 6 · 18.75 marksExplain: "For a business firm, excess as well as shortage of inventory is not desirable".
Estimate the gross working capital requirements of MNO Ltd., taking 3,600 units as its monthly sales level. A cash balance equal to 5% of the requirement of gross working capital is desired; work-in-progress is 25% complete in respect of manufacturing expenses. The goods' expected cost is as below:
| Rs. (per unit) | |
|---|---|
| Raw material | 120 |
| Manufacturing expenses (depreciation Rs.5 per unit included) | 35 |
| Expenses: selling, administration and financial | 15 |
| Selling price | 220 |
The expected duration of the various stages of the operating cycle is:
| Stage: raw material | 2 months |
| Stage: work-in-progress | 1 month |
| Stage: finished goods | 1/2 month |
| Stage: debtors | 1 month |
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
- ExplainTie the answer to the quoted statement: say what it means first, and come back to it at the end.
- EstimateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The cash balance is 5% of gross working capital including cash, so the other items are grossed up by dividing by 0.95. Costs exclude depreciation (cash cost); debtors are valued at cost including selling, administration and financial expenses. No mark is printed for the question; the paper asks for any four of six, equal marks.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Excess and shortage of inventory 6 marks 11 min
- 2 Basis: cash cost and work in progress 3 marks 5 min
- 3 Raw material, finished goods and debtors 6 marks 11 min
- 4 Cash and gross working capital 3.8 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 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.
"Excess as well as shortage of inventory is not desirable"
Inventory management aims to keep stocks so that there is neither over-stocking nor under-stocking: over-stocking reduces liquidity and starves other parts of the business of funds, while under-stocking interrupts production.
- Funds are blocked, with an opportunity cost (interest) and lower liquidity.
- Carrying costs rise: storage, handling, insurance and record-keeping.
- Losses from deterioration, obsolescence, pilferage and wastage increase.
- Profitability falls because idle funds earn nothing.
Costs of shortage of inventory
- Stock-out costs: when an item is not in store but is demanded by customers or production, the firm loses sales and goodwill.
- Production stops, labour and machines lie idle, and urgent purchases cost more.
- Frequent small orders raise ordering costs.
The optimum. The firm should hold the level of inventory at which the total of carrying and ordering costs is the lowest without risking stock-outs; tools such as EOQ, stock levels and ABC analysis serve this aim.
Gross working capital of MNO Ltd.
Basis (paper note). Monthly sales 3,600 units. Costs are taken at cash cost: manufacturing expenses exclude the ₹5 depreciation, so they are ₹30 a unit. Cost of production = raw material 120 + manufacturing 30 = ₹150; total cash cost including selling, administration and financial expenses = ₹165. Work in progress carries raw material in full and manufacturing expenses at 25%. Cash is 5% of gross working capital including cash, so the other items are 95% of the total.
| Element | Working | ₹ |
|---|---|---|
| Raw material (full) | 3,600 × 120 | 4,32,000 |
| Manufacturing expenses (25%) | 3,600 × 30 × 25% | 27,000 |
| Total | 4,59,000 |
Statement of gross working capital
| Particulars | Working | ₹ |
|---|---|---|
| Raw material (2 months) | 3,600 × 2 × 120 | 8,64,000 |
| Work in progress (1 month) | as above | 4,59,000 |
| Finished goods (½ month, at cost of production) | 3,600 × ½ × 150 | 2,70,000 |
| Debtors (1 month, at total cash cost) | 3,600 × 165 | 5,94,000 |
| Cash (5% of gross working capital) | 21,87,000 × 5 ÷ 95 | 1,15,105.26 |
| Gross working capital required | 21,87,000 ÷ 0.95 | 23,02,105.26 |
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Excess and shortage of inventory | 6 |
| 2 | Basis: cash cost and work in progress | 3 |
| 3 | Raw material, finished goods and debtors | 6 |
| 4 | Cash and gross working capital | 3.75 |
| Total | 18.75 |
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