FM – L2 – Q5- Working capital management, Inventory management, Cash management

Compute cash conversion cycle, EOQ, and Miller-Orr model parameters for a manufacturing company's working capital optimization.

Question

a) Bekono Manufacturing LTD is a medium-sized company in Ghana that specialises in producing industrial machinery. The company has recently experienced challenges in managing its working capital efficiently. As a result, Management has decided to review and optimise its working capital strategies to improve cash flow and overall financial performance.

Bekono’s LTD’s financial information:

Annual Sales (on credit): GH¢60 million
Purchases: GH¢32 million
Cost of Goods Sold (COGS): GH¢40 million
Average Inventory: GH¢8 million
Average Accounts Receivable: GH¢12 million
Average Accounts Payable: GH¢10 million
Cash Balance: GH¢2 million

Bekono Manufacturing LTD operates 365 days in a year.

Additional information:

As a policy, the company offers 30 days’ credit terms to its customers.
Suppliers of Bekono Manufacturing LTD have agreed in principle to grant 45 days to settle its payables.
The company currently orders raw materials monthly, with each order costing GH¢500,000. The ordering cost is GH¢1,200 per order, and the carrying cost is GH¢10 per unit.

Required:

i) Compute the company’s cash conversion cycle.

ii) Determine the Economic Order Quantity (EOQ) for Bekono Manufacturing LTD and explain its significance in managing inventory.

iii) Using the Miller-Orr model, calculate the target spread, the return point and the upper cash limit assuming the following:

The standard deviation of daily cash flow is GH¢5,000.
The interest rate on short-term investments is 4% per annum.
The transaction cost of transferring funds between cash and marketable securities is GH¢100 per transaction.

b) The Oti Regional Coordinating Council (ORCC) recently implemented an educational support programme to improve the BECE pass rates among pupils in rural districts, where the historical pass rate was about 10%.

The ORCC organised after-school classes for the pupils in collaboration with RM LTD, an exams preparation tuition company that was procured via a single-source procurement procedure at the insistence of the Regional Minister. The programme was budgeted at GH¢500,000. However, additional costs for feeding the students to sustain attendance led to a budget overrun, bringing the total expenditure to GH¢650,000.
Similar after-school exam preparation programmes sponsored by private sector institutions in Ghana typically cost GH¢450,000.

The Regional Minister has rated the programme highly successful, as 70% of participating pupils passed their exams with distinction, while only 5% failed.

Required:
Using Value for Money Analysis, assess the viability of ORCC’s educational support programme.

Answer

i) Calculation of the Operating Cycle and Cash Conversion Cycle
The operating cycle and cash conversion cycle are critical indicators of a company’s working capital efficiency.

Operating Cycle: The operating cycle is the time it takes for a company to purchase inventory, sell products, and collect cash from customers.

Operating Cycle = Inventory Turnover Period + Receivables Collection Period

$I n v e n t ory T u r n o v er P er i o d = C os t o f G oo d s S o l d A v er a g e I n v e n t ory \times 365$ $I n v e n t ory T u r n o v er P er i o d = 40 , 000 , 0008 , 000 , 000 \times 365 = 73 d a ys$

Receivables Collection Period: This is the average time taken to collect cash from customers.

$R ece i v ab l es C o ll ec t i o n P er i o d = S a l es A v er a g e A cco u n t s R ece i v ab l es \times 365$ $R ece i v ab l es C o ll ec t i o n P er i o d = 60 , 000 , 00012 , 000 , 000 \times 365 = 73 d a ys$ $Op er a t in g C yc l e = 73 + 73 = 146 d a ys$

Cash Conversion Cycle: The cash conversion cycle is the time between when a company pays for its inventory and when it receives cash from sales.

$C a s h C o n v ers i o n C yc l e = Op er a t in g C yc l e - P a y ab l es T u r n o v er P er i o d$

Payables Turnover Period: This is the average time taken to pay suppliers.

$P a y ab l e T u r n o v er P er i o d = C os t o f G oo d s S o l d A v er a g e A cco u n t s P a y ab l es \times 365$ $P a y ab l e T u r n o v er P er i o d = 40 , 000 , 000 G H ¢10 , 000 , 000 \times 365 = 91 d a ys$ $C a s h C o n v ers i o n C yc l e = 146 - 91 = 55 d a ys$

ii) Economic Order Quantity (EOQ)

$EOQ = h 2 D C = 102 \times 6 , 000 , 000 \times 1 , 200 = 37, 947.33 u ni t s$

D = Annual demand = 500,000 x 12 = 6,000,000
C = cost per order = GH¢1,200
h = holding cost = 10% x 8,000,000 = GH¢800,000

iii) Cash Management

daily interest rate = 4% = 0.011%
Standard Deviation = GH¢5,000
Variance = 25,000,000
Transaction cost = 100
Lower limit = 20,000

$Sp re a d = 3 \times (43 \times Daily interest rate T r an s a c t i o n C os t \times Va r ian ce o f c a s h f l o w s)^{3 1}$ $Sp re a d = 3 \times (43 \times 0.00011100 \times 25 , 000 , 000)^{3 1} = 77, 304$

$R e t u r n p o in t = L o w er l imi t + 31 \times Sp re a d$

$R e t u r n p o in t = 2, 000, 000 + 31 \times 77, 304 = 2, 025, 768$ $U pp er L imi t = L o w er l imi t + Sp re a d$ $U pp er L imi t = 2, 000, 000 + 77, 304 = 2, 077, 304$

Programme Overview:

Objective: Improve BECE pass rates among pupils in rural districts with a historical pass rate of 10%.
Budgeted Cost: GH¢500,000
Actual Cost: GH¢650,000 (including additional costs for feeding students)
Pass Rate Achieved: 70% distinction, 5% failure

VFM Analysis:
Economy
Economy refers to cost control and minimisation of resource use while achieving desired outcomes. The programme exceeded its budget by GH¢150,000 (30%) and was 44.4% more expensive than similar private sector programmes, typically costing GH¢450,000.
The RCC’s programme was not economical, as it incurred higher costs than initially budgeted compared to similar programmes. The additional expenses, primarily for feeding students to maintain attendance, contributed to this overrun.

Efficiency
Efficiency measures the relationship between the resources used (inputs) and the results achieved (outputs).
The substantial improvement in pass rates suggests that despite the higher cost, the resources were effectively converted into significant educational outcomes. The additional costs helped to sustain the programme, indicating that the resources were well-utilized to achieve the desired educational outcomes.
In the absence of data on the outcome of similar programmes sponsored by private institutions to compare, it can be concluded that the programme demonstrated high efficiency.

Effectiveness
Effectiveness evaluates how well the programme achieved its intended objectives.
The programme’s objective was to improve the BECE pass rates among rural pupils.
The programme resulted in 70% of students passing with distinction, a significant improvement from the historical pass rate of 10%. The outcome exceeded the historical performance, indicating that the programme successfully met its goals.
Thus, it can be concluded that the programme was highly effective, achieving and surpassing its primary objective of improving BECE pass rates among students in rural districts.

Equity
Equity assesses the fairness and inclusiveness of the programme, ensuring that the benefits are distributed appropriately, especially to disadvantaged groups.
The programme’s target group were pupils in rural districts, who historically had low pass rates in the BECE (10%).
The programme was equitable as it specifically targeted and benefited a historically disadvantaged group, rural district pupils with low pass rates. The programme promoted fairness and inclusiveness in educational opportunities by significantly improving their academic outcomes.

Conclusion:
Despite the lack of economy, the programme provided substantial value for money in terms of efficiency, effectiveness, and equity. The investment significantly improved educational outcomes for a disadvantaged population, justifying the additional costs incurred.

Tags: Cash Conversion Cycle, Cash Management, Economic Order Quantity, EOQ, Inventory Management, Liquidity, Miller-Orr Model, Payables, Receivables, Working Capital
Level: Level 2

Topic: Cash management, Inventory Management, Working Capital Management
Series: JULY 2025

Uploader: Samuel Duah