Estimation of Working Capital - Operating Cycle Method
Prerequisites
Before studying this chapter, make sure you understand:
- Operating Cycle Concept - CRITICAL: You must understand how to calculate operating cycle in days.
- Estimation of Financial Requirements - Basic estimation concepts covered in Unit I.
- Working Capital: Meaning and Kinds - Understanding current assets components.
1. What is the Operating Cycle Method?
The Operating Cycle Method is the most accurate and widely used technique for estimating working capital requirements. It calculates the funds needed based on the actual time period for which money remains tied up in each component of current assets.
Logic: If you know:
- How much you spend daily on operations (Cost per day)
- How long money stays locked in each stage (Operating Cycle in days)
Then: Working Capital = Daily Cost × Number of Days in Cycle
2. The Complete Formula
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3. Step-by-Step Calculation Method
Step 1: Calculate Daily Costs
You need to know the annual costs for each component and convert them to daily costs:
Daily Raw Material Cost = Annual RM Consumption / 365
Daily Production Cost = Annual Production Cost / 365
Daily Cost of Goods Sold = Annual COGS / 365
Daily Sales = Annual Sales / 365
Daily Purchases = Annual Purchases / 365
Step 2: Calculate Investment in Each Component
A. Raw Material Investment:
RM Investment = Daily RM Cost × RM Storage Period (days)
B. Work-in-Progress Investment:
WIP Investment = Daily Production Cost × WIP Period (days)
C. Finished Goods Investment:
FG Investment = Daily COGS × FG Storage Period (days)
D. Debtors Investment:
Debtors = Daily Credit Sales × Collection Period (days)
E. Creditors (Deduct this):
Creditors = Daily Credit Purchases × Payment Period (days)
Step 3: Calculate Net Working Capital
Working Capital = (A + B + C + D) - E
4. Comprehensive Numerical Problem (Exam Format)
Problem: ABC Manufacturing Company provides the following information for the coming year. Estimate the Working Capital requirement using the Operating Cycle Method.
Given:
Estimated Annual Production: 52,000 units
Production Cost per unit:
- Raw Materials: ₹40
- Direct Labour: ₹20
- Overheads: ₹30 (excluding depreciation ₹10)
Total Production Cost: ₹90 per unit
Selling Price: ₹120 per unit
All sales are on credit
Operating Cycle Details:
- Raw Material Storage Period: 30 days
- Work-in-Progress Period: 15 days
- Finished Goods Storage Period: 25 days
- Debtors Collection Period: 40 days
- Creditors Payment Period: 20 days
Additional Information:
- Lag in payment of wages: 10 days
- Lag in payment of overheads: 15 days
- Cash in hand (minimum required): ₹50,000
Solution:
Step 1: Calculate Annual Figures
Annual Production = 52,000 units
Annual RM Consumption = 52,000 × ₹40 = ₹20,80,000
Annual Wages = 52,000 × ₹20 = ₹10,40,000
Annual Overheads (cash) = 52,000 × ₹20 = ₹10,40,000
[Note: Overhead ₹30 - Depreciation ₹10 = ₹20 cash overhead]
Annual Production Cost (for valued stock):
= 52,000 × ₹80 = ₹41,60,000
[RM ₹40 + Wages ₹20 + Cash Overhead ₹20 = ₹80]
Annual Cost of Goods Sold = 52,000 × ₹80 = ₹41,60,000
Annual Sales = 52,000 × ₹120 = ₹62,40,000
Step 2: Calculate Daily Costs
Daily RM Consumption = ₹20,80,000 / 365 = ₹5,699.44 per day
Daily Wages = ₹10,40,000 / 365 = ₹2,849.72 per day
Daily Overheads = ₹10,40,000 / 365 = ₹2,849.72 per day
Daily Production Cost = ₹41,60,000 / 365 = ₹11,397.26 per day
Daily COGS = ₹41,60,000 / 365 = ₹11,397.26 per day
Daily Sales = ₹62,40,000 / 365 = ₹17,095.89 per day
Step 3: Calculate Investment in Current Assets
A. Raw Material Inventory:
= Daily RM Cost × Storage Period
= ₹5,699.44 × 30 days
= ₹1,70,983
B. Work-in-Progress:
For WIP, materials enter at the beginning, but wages and overheads are added gradually over the production period. Therefore, we take:
- Full material cost for entire WIP period
- 50% of wages and overheads (average)
WIP (Materials) = ₹5,699.44 × 15 days = ₹85,492
WIP (Wages) = (₹2,849.72 × 15 days) × 50% = ₹21,373
WIP (Overheads) = (₹2,849.72 × 15 days) × 50% = ₹21,373
Total WIP Investment = ₹85,492 + ₹21,373 + ₹21,373 = ₹1,28,238
Alternatively (simpler approach for exams):
WIP = Daily Production Cost × WIP Period
= ₹11,397.26 × 15 days
= ₹1,70,959 (if assuming uniform cost addition)
C. Finished Goods Inventory:
= Daily COGS × FG Storage Period
= ₹11,397.26 × 25 days
= ₹2,84,932
D. Debtors (Accounts Receivable):
= Daily Sales × Collection Period
= ₹17,095.89 × 40 days
= ₹6,83,836
E. Cash Balance (Given):
= ₹50,000
Step 4: Total Current Assets
Total Current Assets = RM + WIP + FG + Debtors + Cash
= ₹1,70,983 + ₹1,28,238 + ₹2,84,932 + ₹6,83,836 + ₹50,000
= ₹12,17,989
≈ ₹12,18,000
Step 5: Calculate Current Liabilities
F. Creditors for Raw Materials:
= Daily RM Cost × Payment Period
= ₹5,699.44 × 20 days
= ₹1,13,989
G. Outstanding Wages:
= Daily Wages × Lag Period
= ₹2,849.72 × 10 days
= ₹28,497
H. Outstanding Overheads:
= Daily Overheads × Lag Period
= ₹2,849.72 × 15 days
= ₹42,746
Total Current Liabilities:
= Creditors + Outstanding Wages + Outstanding Overheads
= ₹1,13,989 + ₹28,497 + ₹42,746
= ₹1,85,232
Step 6: Calculate Net Working Capital
Net Working Capital = Current Assets - Current Liabilities
= ₹12,18,000 - ₹1,85,232
= ₹10,32,768
≈ ₹10,33,000
Answer: The estimated Working Capital requirement for ABC Manufacturing Company is ₹10,33,000.
5. Key Points to Remember
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Critical Valuation Rules:
- Raw Materials: Valued at Raw Material Cost
- WIP: Valued at incomplete Production Cost
- Finished Goods: Valued at full Production Cost (COGS)
- Debtors: Valued at Selling Price (because customers owe us the sale amount)
6. Common Adjustments in Exams
Depreciation
- Exclude from cash costs: Depreciation is a non-cash expense
- If problem gives "Total Overheads ₹30" including depreciation of ₹10, use only ₹20 for WC calculation
Work-in-Progress Valuation
- Materials: 100% of cost (added at beginning)
- Wages & Overheads: 50% of cost (added gradually) - unless stated otherwise
Credit Sales Percentage
- If "80% sales on credit", then:
Debtors = (Daily Total Sales × 80%) × Collection Period
Profit Margin
- Sometimes problems give "Profit = 20% on cost"
If Cost = ₹100, then Selling Price = ₹120 If Cost = ₹100, and Profit = 20% on Sales, then: Let SP = x, then 0.20x = x - 100 SP = ₹125
Exam Pattern Questions and Answers
Question 1: "What are the advantages of the Operating Cycle Method for estimating working capital?" (4 Marks)
Answer: The Operating Cycle Method has several advantages:
- Accuracy: It considers the actual time period for which funds remain locked in each component of current assets, providing a realistic estimate.
- Comprehensive: It covers all components - raw materials, WIP, finished goods, and debtors - giving a complete picture.
- Dynamic: It can be easily adjusted for seasonal variations or changes in the business cycle by altering the holding periods.
- Practical: It directly links working capital to operating efficiency metrics, making it useful for both estimation and performance analysis.
Summary
Operating Cycle Method is the most reliable approach because:
- It considers the time dimension (how long money stays locked)
- It values each component correctly (RM at cost, Debtors at sale price)
- It adjusts for credit from suppliers (reduces our WC need)
Formula: Daily Cost × Days Locked = Investment Needed
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Quiz Time! 🎯
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