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Explain operation cycle method in estimation of working capital.
Operation cycle method considers total cycle of operations, from raw materials to finished goods, from accounts payable to net cash.
The times taken to complete these operations are called operating cycle time.
If the operating cycle is long then, requirement of working capital is less, if the operating cycle is less then, requirement of working capital is less.
Formulas
- Working capital = CGS(E)* D/365 + CB
Here, CGS (E) = estimated cost of goods sold, D = days in operating cycle, CB = Cash/Bank balance
- RM Stock = PU(E) * Cu * (Hp/365)
Here, PU(E) = production units estimated, Cu = cost per unit, HP = holding period of RM
- WIP = P(E) * {Cu – RM + L+OH} * {WIP/365}
Here, P(E) = production estimated, Cu = unit cost, RM (100%), L(50%) =Labour, OH (50% = overheads), WIP = work in progress
- Finished goods = P(E)*CGSp*(HPfg/365)
Here, P(E) = production estimated. CGSp = unit cost of goods produced, HPfg= holding period of finished goods
- Accounts receivables = P(E) * SP *(CP/365)
Here, P(E) = production estimated , SP = selling price, CP = Collection period
- Accounts payables = P(E)* RMu * (PP/365)
Here, P(E) = production estimated, RMu = RM cost per unit, PP = payment period
Operating cycle = IP + ARP
Here IP = Inventory period, ARP = Accounts receivable period
Advantages of this method include −
- It is precise.
- Provides detail report.
Disadvantages of this method include −
- It is long process.
- More calculations are required.
Example
Cost of goods sold = Rs.5000000/- Operating cycle = 100 days Cash/bank balance = 600000/- Now, calculate the working capital.
Solution
The solution is mentioned below −
Working capital = CGS(E)* D/365 + CB Here CGS (E) = estimated cost of goods sold, D = days in operating cycle, CB = Cash/Bank balance Working capital = 5000000 * 100/365 + 600000 Working capital = Rs1969893/-
Working capital is further divided into each component (inventory, cash etc.)
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