The Importance of Working Capital Management

Working capital management refers to the management of the relation between a company’s current assets and its liabilities. The most frequently used components of working capital are accounts receivables, inventory, and payables, which are OWC, or operating capital (OWC) which is the total of all working capital held by a company, usually in a single year. Fig.1 below shows the interplay between these components of OWC.

The purpose of OWC Management is to make sure that the business has enough cash flow, measured by liquidity, to pay off its short-term obligations and to continue supporting its day-to-day activities. Many books and articles address the importance of OWC to achieve an ideal balance between receivables, inventory, and payables. McLaney E. as well as Atrill P. Accounting: A Comprehensive Introduction (Prentice Hall 2008). Abraham and colleagues., Accounting for Managers, (Cengage, 2008) provide more details on this crucial importance and point out that the majority of companies invest between 25 and 40 percent of their net assets in OWC which is a substantial short-term investment. The books however offer a generic approach to OWC and do not take into account the specific nature of a business, size, or industry. Additionally, the importance of working capital is contingent on the size and composition of the company and can differ between different industries, such as Rolls Royce Plc a manufacturing company that pays the greatest emphasis on its level of inventory and payables, whereas British Airways Plc a service company with no inventory. Thomas M. Krueger, An Analyse of Working Capital Management Results Across Industries, American Journal of Business 2005, vol. 20. The research was using the annual ratings for managing working capital across all industries released in CFO magazine. The results showed that there was a consistent pattern in the working capital measures across industries, however, the measures for working capital were not static in time. In an online article Philip McCoster (2003), Accountancy: The Importance of Working Capital, (http://www.accountancy.com.pk/articles_students.asp?id=77).[Online]. (Accessed 28/03/11) supports the changing nature of working capital. He also explains its importance in a more subtle way. Most organizations can be profitable on paper but have to cease trading due to the inability to meet short-term obligations. In his opinion, small companies particularly are more likely to fail, especially in the initial stages of setting up due to the lack of understanding of the significance of working capital issues.

The importance of the working capital market is undeniable and regardless of whether its elements are managed as a group or separately, its management is crucial to allow an organization to efficiently handle its cash flow in order to maintain its operations. While this is often stated in the written word, however, it is apparent that in actual fact the significance of OWC is often ignored and many firms are on the brink of bankruptcy, as occurred in the game of winning margins.

As a producer in the “Winning Margin” game, I realized that the choices I made particularly in planning and managing machine output were extremely important to the total quantity of finished goods inventory required to attain an increase in OWC. This was evidently demonstrated in the second year of my tenure when I made two crucial decisions were made:

The forecasted output of production was 11 at a cost of $40 (appendix for Sales and Production Plans for the Year Ahead).

Buy two more Mark II machines (See appendix the Balance Sheet)

This led to an expansion in the quantity of inventory to the contracted amount even though certain inventory was tucked away to Work in Progress and Finished items, which resulted in a reduction in the operating working capital (Year two Cash Flow statement). Additionally, the money used to purchase new equipment also caused a decline in the cash flow operating of the company. So, in reality, the role of the production manager is one of strategic importance and has a significant influence on the working capital as well as the overall business goal however, their decisions will only be successful if made in conjunction with the departmental managers.

2.2 BUDGETING

McLaney E and Atrill P. Accounting A Brief Introduction (Prentice Hall 2008) described budgets as a brief-term financial plan that is prepared by a company to be an integral component of its strategic plan. The budget is used by managers to analyze and contrast the actual and the plan through a process called the control of the budget. Through this method, Group E benefited from the budgetary process in numerous ways:

Thinking ahead and identifying issues in the short term: During the planning process for year 2, we realized that we needed to plan for an additional machine as well with additional loans. Being able to do this ahead of time allowed us to look at alternatives and choose the most effective route to follow.

Better coordination: Planning each year meant we needed to coordinate with one another. This was vitally important because it enhanced visibility and decision-taking because the various activities were connected. For instance, decisions about production were based on estimates of sales and the availability of raw materials as well as the ability to help finance it.

It was a method of Control starting at the end of the year we were required to evaluate the year 1 and 2 results and identified areas of concern. This allowed for a system of control as well as better planning for year 3.

It was a way of authorization: By choosing a master plan of actions for each year and setting spending limits, particularly since I, the producer was looking to increase the amount of equipment bought in year 2, however, I was limited.

The budget pushed us to do better by establishing responsibilities for each individual member of the team, it helped the entire team because everyone was convinced that they contributed to the business’s overall goals. Thus, it improved the team’s ability to succeed.

2.3 Absorption Costing

Absorption costing is the process to calculate the complete price of output by charging the direct costs along with an appropriate proportion of indirect expenses. The purpose of absorption costing is to make costs simple and easy for management to make more informed choices. In the “Winning Margin” game, this method was advantageous to our team in a variety of ways:

It was helpful in making decisions about output The absorption costing method made the calculation of planned sales much easier. as a team, we could make more informed decisions regarding production and cash flow.

Control decision exercise absorption costing is typically utilized as a basis for budgeting and control of budgets. It was therefore beneficial for the team since it was the foundation of our budget. We were able to exert oversight over the budget as well as our plan.

Additionally, the method proved to be particularly effective in achieving efficiency because we could make choices that compared different costs for doing the same thing. We compared, for instance, the cost of purchasing the Marked II or Mark III machines in year 2. Marked II or Mark III machine in the year 2 and also deciding between the various kinds of product to create.

Additionally, the absorption costing techniques was important because they allowed us to evaluate the performance of our team. The use of this technique made the calculation of annual production costs, sales, profits, and other financial information simpler. This made it much easier of evaluating our company and team’s performance over any year.

While it is widely used in real life, the application of the absorption costing techniques may not be as straightforward as it is in the game. In addition, the method has been criticized because it relies on past costs, which are deemed to be irrelevant in the process of making decisions because decisions should reflect the future, not the past. Other costing methods, such as variable costing are advised. (Words 300)

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