 this class we will be spending some time to understand the importance of the cash conversion cycle and how in that cycle the concept of planning inventory is very critical because inventory relates to cost and the purpose of this second part of this accounting is related to cost when we talk about management accounting how there is one model that we use for proper inventory planning is necessary to optimize the cost elements as a result of which you have a better cash conversion cycle. Now to understand the cash conversion cycle let us begin to first understand a normal business cycle any business entity whether it is engaged in selling goods or providing services will have three elements an input that gets converted into an output that gets sold for which cash is received and then again we buy inputs and this process keeps on repeating the input to output is your production the output to cash receiving is your selling plus collection and this will be your purchasing. So if you look at it from this perspective you will understand that any organization to execute a particular order it needs to source raw material and based on the payment policy it might pay immediately or pay after a period of time. But the first thing that it will do is it will source raw materials and then use labor and other form of resources convert that raw material into a saleable finish good and then that finish good gets sold and while the conversion from raw material to finish good happens sometimes there again is a deferral period where I would pay for the labor consume immediately or defer it over a period of time remember when we talked about accrued wages which means that yes I engage labor and then I pay them later inventory gets consumed the rate at which it gets consumed depends on how quickly we are processing the inventory and once the finish good is available it is being sold there again it is sold for cash which means I get immediate cash as and when a sale happens or I get my cash after a period of time more often than not what happens is the time that is taken to collect the cash out of a sale need not be earlier than the time that is required to pay my raw material vendors or my labor wages which means even before I the entity starts getting a cash inflow there is a prospect that a cash outflow will happen now under these circumstances what we do is what we meaning the entity will do is we will get some short term financing and use that proceeds to pay the vendors or pay the laborers the wages and when we receive cash out of the sales we again repay the short term finances and the financing charges and use or not use the surplus that we have an again sourcing raw materials and again the cycle keeps on repeating itself. So there are 5 critical elements I source raw material I engage labor and convert to finish good I sell it I have to pay my accounts payable I have to collect my accounts receivable. So these 5 important transactions are very critical when it comes to understanding what a cash conversion cycle is all about before we understand this there are 3 key terminologies which we already saw when we discuss the fundamentals of accounting but nevertheless the cost of repetition let me again recapture those 3 terminologies. The first thing is the inventory conversion period the inventory conversion period is the average length of time is the average length of time that is required to convert raw material into finish good and then sell them as finish goods that is my inventory conversion period. Now this is the technical definition but then we need to know how to calculate this inventory conversion period since this is inventory conversion period then it means that it has to be expressed by a unit of time and usually we express this in days. So how do we calculate this average length of time that is required to convert raw materials to finish good and then sell them. So the inventory conversion period I CP is simply inventory divided by sales per day. Suppose I have the average inventory in a balance sheet it says the average inventory is 2 million rupees and the annual sales is 10 million then the average inventory the inventory conversion period will be 2 million divided by 10 million divided by 360 which is 72 days. Now what is this 72 days implied it means that it takes for me an average 72 days to convert raw material to finish good and sell them. So this is what is inventory conversion period. The next that you need to understand is the receivables collection period after inventory conversion period receivables collection period. Here again it is a period and hence we would be expressing it in unit of time and again days which is again the average length of time required to convert receivables that arose out of sales into cash. Or in typically we call this also days sales outstanding which means when you calculate this receivables collection period expressed as days it tells you that for a particular sale that is being made it takes so many days for that sale to be realized into cash. How do we calculate this RCT is receivables divided by sales divided by 360 or the sales per day. Here again for the purpose of example let us say if the receivables is 6,66,000 and the sales as we already said is 10 million the receivables collection period is 24 days which means it takes 24 days after a sale to convert receivables into cash. This is receivable collection period. Now the next important terminology that you need to understand is the payables deferral period. Again please note that this is a period and hence we will be expressing this in unit of time and in this case days is again the average length of time between the purchase of raw material and the time that we actually pay for the raw material. Now in the case of receivables collection period we know the outstanding accounts receivable and link it with sales because accounts receivable is linked with sales. In the case of deferral period extending the same logic we are going to see the outstanding payables and link it with cost of goods sold because payables is linked with cost of goods sold because we are talking about raw materials, inventories that we purchase, labour that has been engaged all of these being the elements in the cost of goods sold. So if you are going to calculate the payables deferral period PDP is the average accounts payable divided by cost of goods sold divided by 360. Again let us say for the example the payables also is 66667 and the cost of goods sold is 8 million then in this case the payable deferral period is 30 days which means it requires it I am able to prolong a purchase for whose for whom the payment that I am making I will be able to prolong it for 30 days. So for every dollar that I purchase as raw material I pay after 30 days. So these three things the inventory conversion period, the receivables period and the payments deferral period are important terminologies that you need to understand before we get into the concept of cash conversion cycle. Now then what is cash conversion cycle? The cash conversion cycle nets out these three periods remember these three are all expressed in days. So the cash conversion cycle finds the net effect of these three periods it means it finds the number of days that is required again it is expressed in days between the firms actual cash expenditure because it incurs expenditure when it starts buying resources and that time it actually gets cash receipts after a sale is being made. So that period is the cash conversion cycle and then from these three terminologies it is easy to understand that this will be equal to the inventory conversion period plus receivables collection period minus payables deferral period this gives your cash conversion cycle. Now let me just put this in an illustration for you to understand better. Let this be days and I will indicate activities and the days it takes to complete a particular activity. Now we receive raw materials and then even before a sale is being made there are occasions where we have to pay for the raw materials pay cash for raw materials and then a sale is being made and then finally we collect receivables and during this time I also finish good. Now let us see how I can capture this cash conversion cycle in this illustration between the time that I receive the raw material and the time that I pay for the raw material is my cash deferral period and between the time that I receive a raw material and I sell finish good is my inventory conversion period and the time that I take to do this is my receivables collection period. Now in this example that we just saw before this is 30 days the inventory conversion period was 72 days and the receivables collection period was 24 days and let us put this into the formula that we saw to calculate the cash conversion cycle. So the cash conversion cycle will be my inventory conversion period which is 72 days plus my receivables 24 minus this thing the deferral period of 30 will be 66 days. Now this 66 days can be explained looking at it from various perspectives but from a financing perspective it tells me that when I know that I will have to start producing or start delivering some service I will have to finance an outlay for a minimum 66 days period because for that 66 days period I do not have finances this is what this cash conversion cycle explains. Then the question is what would you do as a first step measure any prudent financial manager would say that I would like to reduce the financing requirement and I can reduce that by reducing the cash conversion cycle to as much as possible to see whether I can reduce it from 66 to 60 to 50 and what not. Now to do that I either increase this or reduce this or reduce this which means I prolong the time that I take to pay my vendas to pay my laborers or increase my collection activities. So that the average collection period comes down from the existing 24 of these two things we got nothing to do with the production per se it has got nothing to do with what is happening inside the organization these two are something that is outside to the organization. It has got to do with how skillful I am as a negotiator if I am able to tell my vendor that I am going to take more number of days than this 30 or if I am going to aggressively follow my customers and ensure that I get the receivables in less number of days than this 24 and in both these cases understand this is something that is happening outside the process. So I am not saying I am not concerned about it but from the perspective of looking at it from cost management, management accounting I am not going to look at these two elements but then let us see how this inventory conversion period is critical. How can I reduce this 72 from 70 to 70 to 65 to 60 if it is possible then that is something that has got to do with processes that are internal to an organization the inventory conversion period how quickly am I able to convert raw material into finished goods and sell them converting raw material to finished goods we will stop with that because selling them is against the sales activity so let us not even get into that converting it from raw material to finished goods how quickly can I do this. There are different ways of doing this one I have best practices manufacturing practices that can be constant constantly improved as a result of which I am able to convert inventory to finished goods at a faster rate that has got to do with technology or process efficiencies if I am able to do that fine let for a moment assume that I am not going to get into that as well. One key element that I am looking is whether I am able to source my inventory just when I need it process them and sell them so I source the inventory just when I need it which means I have the inventory only at a time that I need it and then convert it quickly because of the best manufacturing practices into finished goods and that is where I am going to spend my remaining time of the class to see whether I have better inventory planning mechanisms in place so that I just get inventory when I actually require it. Now why is that that that is important planning inventory is very important because inventory per se is cost to an organization which means that I should have some economics behind the inventory ordering mechanism to ensure that this cost that is involved in inventory is minimized. So I need to know then in that case is there something called an economic order quantity. Yes there is something called an economic order quantity about which I will be talking now. The reason that this is important is because as I told you before inventory is cost. Now what do you mean by inventory is cost? What are the cost associated with inventory? Inventory cost there are two broad costs one is the carrying cost of an inventory the other is the ordering cost of inventory. Now let us begin with carrying cost. The carrying cost generally rises in direct proportion to the average amount of inventory that I actually hold or I carry. So carrying cost is directly proportional to average inventory carried. Now inventory carried again depends on the frequency with which we order inventory. Now let us for example say I will just give you some illustrations. If I sell s units per year and then a firm places equally sized orders throughout the year and let us say I do this n times a year. So n times a year I place equally sized orders for inventory which means that assume that there is no safety stock. Then the average inventory a will be the number of units that I order per order that is the equal sized units that I order when I actually make every order divided by 2. I will tell you why. Now first let us say how we calculate the units per order which means the total sale units a year divided by the number of times a order gives you the number of units per order and divided by 2 will give you the average inventory. Because if we look at the time scale if this is let us say we started with 30,000 and drop down to 0 and the next time you order this 30,000 the amount of inventory that is available will increase to 30,000. But then the average inventory is 30,000 plus 0 divided by 2 which is 15,000 then that is what I have expressed as a formula. Now let us say take for an example that if I sell 120,000 units every year and that to sell this over one year let us say I consume inventory in a uniform pattern consistently throughout the year and then I order inventory 4 times a year which means since I consume inventory consistently throughout the year my inventory at the beginning of a quarter will be 30,000 ending of a quarter will be 0 and again I order I get beginning of the quarter 30,000 quarter because the number of times that I make this order is 4. So what is my average inventory in that case the average inventory will be 30,000. So this is my average inventory now with this let us see what my carrying cost is going to be since we are talking about carrying cost how to calculate the carrying cost now this 15,000 average inventory. Now with this let us see what my carrying cost is going to be since we are talking about carrying cost how to calculate the carrying cost. Now this 15,000 average inventory is the number of units now let us say that the cost at which I purchase this unit is 2 rupees so the purchasing price is 2 per unit then the average inventory value will be 2 times 15,000 which is 30,000 rupees 30,000 you need to appreciate the difference this 15,000 is the number of units and this 30,000 is the value of the average inventory which is 2 times the average inventory. Suppose I have a cost of capital which means there is 10 you know for sourcing this inventory I get loans which is financed at a rate of 10 percent. So the cost of capital is 10 percent and I incur 3,000 rupees as financing charges 10 percent of this 30,000 assume that this is this entire 30,000 I am going to finance as loan and then I incur cost of capital 10 percent at the rate of 10 percent is 3,000 then storage cost let us say is another 2,000 storage cost means space security insurance and all associated cost with that that is another 2,000 and other miscellaneous storage cost or miscellaneous cost associated with this inventories 500 it could be cost of the security the cost of labor engaged in ensuring that the inventory is stored properly whatever may be the reason let us say that miscellaneous fixed cost then I also mark down inventories at the rate of 1,000 every quarter as depreciation. So depreciation mark down which means the total carrying cost within this particular period is 6,500. So the total cost of carrying this inventory whose value is 30,000 is 6,500 or let us express this as an annual percentage cost it will be 6,500 divided by 30,000 which is closely 21.7 percent. So if I am going to express this as a percentage and let us assume that every such inventory carrying cost can be expressed as a percentage of the total inventory value then the total carrying cost T C C is the percentage carrying cost C in this case it is 21.7 percent times the price per unit in this case 2 rupees per unit times the average number of units in this case is A. So if we just rework this back 0.21 percent 7 times 2 times 15,000 this is the average carrying cost the total carrying cost of the inventory have this in one corner of your mind. This is the total carrying cost now just as we have total carrying cost we will have something called ordering cost for an inventory and just as carrying cost was directly proportional to the average inventory that I was holding the ordering cost will be directly proportional to the number of times that I actually order. And what is this basically it will be your office cost the processing cost the paper work the calls that you make to make this order and make sure this is been delivered. So these are all your ordering cost and let say that the cost that is fixed to make this order is f it is kind of a fixed cost then my total ordering cost will be that fixed cost times the total number of times that I order in a given particular year f n or if I am able to break this f into s by 2 a remember this is linked the a is s by 2 n and hence I can express n as s by 2 a just go back to see this you are not able to understand a is s by n divided by 2 as a result of which n can be expressed as s by 2 a. Now again let me just give you a mathematical illustration to understand what will be the total ordering cost if I say that the fixed cost per order is 100 and you know that I am selling 120,000 units in a given year and that the average inventory size is 1,500 then the ordering cost will be 100, 120,000 divided by 2 times 15,400. So this is my order. So let us assume that I am not going to deal with stock out cost which is the cost of which is the cost that I will incur because I do not have inventory that or the inventory I am running out of inventory I am not interested in that and so I will restrict my calculations to the extent that the total inventory cost is equal to my total carrying cost plus total ordering cost which in this case is my now again the c p a can be expressed as q by 2. Now the average inventory is q by 2 or one half of the size of the each order quantity this q is the size of each order quantity in this case it is 30,000 or in the general case q is the size of each order quantity and so the average inventory is opening inventory plus closing inventory divided by 2. So q by 2 because here we are not having any safety stock which means the closing inventory is 0 plus f into s divided by q because q is 2a. So I am just expressing the total inventory cost in terms of the size of the each order that I make that is the intent for me to arrive at the total inventory cost as c p into q by 2 plus f into s by q. Now we can see that this can be expressed that is the carrying cost associated with the average order size and the ordering cost is also associated with the average order size. Now here we are trying to express this inventory cost with the order quantity the reason that we are doing this is because we need to understand how the inventory cost behave with changes in quantity. The more and more you keep ordering the more and more times you keep ordering the more and more you will face in terms of the ordering cost. But the argument is the more number of less quantity orders that you make will also drive your carrying cost because your carrying cost is directly proportional to the inventory on hand. So we need to strike a balance and understand how much of inventory we need to order each time and how many times we need to order in a given period and that is the balance that we are trying to achieve here. Now if I am going to express this as a graph for you to understand this better let us say this is order size. Order size expressed in number of units and let us say this is cost which is both ordering as well as carrying cost and I told you that the carrying cost is directly proportional to the average inventory. So let us say this is the carrying cost on that the ordering cost will come down with order sizes higher the order sizes then the ordering cost come down because the number of times you start making an order also keep coming down if your order size is huge. So this will be your total ordering cost. So there will be a point of intersection and the sum of these two the carrying cost and the total ordering cost will be your total inventory cost that is the mathematical expression and here in the graph you will find that this is the total inventory cost whose behavior will be like this and whose cost will be minimum at this crossover let us say this is minimum. Now it is that minimum cost that we are interested to understand and it is at that minimum cost we have some quantity which we call the economic order quantity which is simply the order quantity at which the total inventory cost is minimum. Now what is the total inventory cost it is my CPQ by 2 plus FS by Q. Now when will this CPQ by 2 plus FS by Q be minimum when my differential of this with respect to Q which is CP by 2 minus FS by Q square is equal to 0 this is the principle of minimum using differentiation which means FS by Q square is equal to CP by 2 or Q square is equal to 2 FS by CP or Q is equal to root of 2 FS by CP and this Q is my economic order quantity. So mathematically the economic order quantity is root of 2 FS by CP and FS CP stands for what they are which means that at economic order quantity the total inventory cost is minimum and not only is the total inventory cost minimum at economic order quantity the carrying cost will be equal to your ordering cost. Now how we will use this relationship to study how we set inventory targets safety stock levels and all this we will understand it at a greater length by picking up a small example to see how at the real purchasing level activity what triggers an order when an ordering is placed and why this is the order quantity this economic order quantity is important because it is at this economic order quantity the total inventory cost is minimum and an inventory cost is minimum means that the cost that we are incurring is minimum not only that but also we are able to get inventory only when we want. So we are reducing unwanted cost and if we are able to get inventory inventory just at the time that we want and we are able to process this and convert it into good sold then link that with your inventory conversion period to see how much we are able to contribute to reduce the inventory conversion period as a result of which my cash conversion cycle is also improved to that extent and it is for that particular purpose that I am explaining the concept of economic order quantity though there are various other models that are essential for management accounting but I am going to restrict only with this economic order quantity and when we meet next class I will take some illustrations to also bring into a bring inside another dimension of lead time and another dimension of safety stock level and how when there is a particular lead time and also when there is a particular safety stock level where will the trigger in terms of time when will the economic order quantity be triggered that we will understand in next class.