Working-Capital Requirement. Suppose that in Example 10.1 the tool-manufacturing company’s annual revenue projection of $100,000 is based on an annual volume of 10,000 units (or 833 units per month). Assume the accounting information in Table 10.3.

Question

Working-Capital Requirement

Suppose that in Example 10.1 the tool-manufacturing company’s annual revenue projection of $100,000 is based on an annual volume of 10,000 units (or 833 units per month). Assume the accounting information in Table 10.3.

Table 10.3 Elements of Working Capital

Price (revenue) per unit	$10.00
Unit variable manufacturing costs:
Labor	$2.00
Material	$1.20
Overhead	$0.80
Monthly volume	833 units
Finished-goods inventory to maintain	2-month supply
Raw-materials inventory to maintain	1-month supply
Accounts payable	30 days
Accounts receivable	60 days

The accounts receivable period of 60 days means that revenues from the current month’s sales will be collected two months later. Similarly, accounts payable of 30 days indicates that payment for materials will be made approximately one month after the materials are received. Determine the working-capital requirement for this operation.

Accepted Answer

Given: Preceding information.
Find: Working-capital requirement.

Figure 10.4 illustrates the working-capital requirement for the first 12-month period. Accounts receivable of $16,667 (two months’ sales) means that in year 1, the company will have cash inflows of $83,333—less than the projected sales of $100,000 ($8,333 [latex] imes[/latex] 12). In years 2 to 5, collections will be $100,000—equal to sales, because the beginning and ending accounts receivable will be $16,667, with sales of $100,000. Collection of the final accounts receivable of $16,667 would occur in the first two months of year 6, but can be added to the year 5 revenue to simplify the calculations. The important point is that cash inflow lags sales by $16,667 in the first year.

Assuming that the company wishes to build up two months’ inventory during the first year, it must produce 833 [latex] imes[/latex] 2 = 1,667 more units than are sold the first year. The extra cost of these goods in the first year is 1,667 units ($4 variable cost per unit) or $6,667. The finished-goods inventory of $6,667 represents the variable cost incurred to produce 1,667 more units than are sold in the first year. In years 2 to 4, the company will produce and sell 10,000 units per year while maintaining its 1,667-unit supply of finished goods. In the final year of operations, the company will produce only 8,333 units (for ten months) and will use up the finished-goods inventory. As 1,667 units of the finished-goods inventory get liquidated during the last year (exactly in the first two months of year 6), working capital in the amount of $6,667 will be released. Along with the collection of the final accounts receivable of $16,667, a total working-capital release of $23,333 will remain when the project terminates. Now we can calculate the working capital requirements as given in Table 10.4.

Table 10.4 Calculation of Net Change in Working Capital

Current assets	Accounts receivable	$16,667
	(833 units/month [latex] imes[/latex] 2 months [latex] imes[/latex] $10)
	Finished-goods inventory	6,667
	(833 units/month [latex] imes[/latex] 2 months [latex] imes[/latex] $4)
	Raw-materials inventory	1,000
	(833 units/month [latex] imes[/latex] 1 month [latex] imes[/latex] $1.20)
Current liabilities	Accounts payable (purchase of raw materials)	(1,000)
	(833 units/month [latex] imes[/latex] 1 month [latex] imes[/latex] $1.20)
	Net change in working capital	$23,333

Comments: During the first year, the company produces 11,667 units to maintain two months’ finished-goods inventory, but it sells only 10,000 units. On what basis should the company calculate the net income during the first year (i.e., use 10,000 or 11,667 units)? Any increases in inventory expenses will reduce the taxable income; therefore, this calculation is based on 10,000 units. The reason is that the accounting measure of net income is based on the matching concept. If we report revenue when it is earned (whether it is actually received or not), and we report expenses when they are incurred (whether they are paid or not), we are using the accrual method of accounting. By tax law, this method must be used for purchases and sales whenever business transactions involve an inventory. Therefore, most manufacturing and merchandising businesses use the accrual basis in recording revenues and expenses. Any cash inventory expenses not accounted for in the net-income calculation will be reflected in changes in working capital.

Question 10.2: Working-Capital Requirement. Suppose that in Example 10.1 th...

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