Page 221 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Southeastern Motors Inc.: Lost Sales
(Thousands of Rupees)
b
a
Policy Inventory level Lost sales Lost contribution Incremental contribution
Current 200 625 250 -
A 278 475 190 60
B 414 303 121 69
C 620 153 61 60
D 868 63 25 36

a Finished goods inventory only.
b Variable costs equal 60 per cent of sales.

The next step in the analysis was to determine carrying costs at each inventory level. Carrying
costs included warehousing, servicing, taxes, insurance, and record-keeping, and amounted to
about 5 per cent of the value of the inventory. This figure excluded financing costs. Incremental
operating profit was estimated as shown in table. By moving to level A, carrying costs would
increase by ` 4,000. Subtracting this figure from incremental contribution ` 60,000 gives a pretax
increase in operating profit of ` 56,000 after taxes.
Southeastern Motors Inc.: Incremental Operating Profit
(Thousands of Rupees)
Incremental
Inventory Carrying Incremental Incremental operation profit
Policy
level cost a carrying cost contribution Before After
b
Tax Tax c
Current 200 10 - - - -
A 278 14 4 60 56 28
B 414 21 7 69 62 31
C 620 31 10 60 50 25
D 868 43 12 36 24 12

a 5 per cent of inventory level.
b From table.
c Taxes at 50 per cent.
From the data in tables discussed so far, expected return on investment was calculated as in table.
Southeastern Motors Inc.: Expected Return on Investment in Additional Inventory
Policy Inventory level Incremental Incremental operating Incremental E(R) on
(Thousand) investment a profit, after investment after tax
b
(Thousands) tax (Thousands) (Per cent)
Current ` 200 ` ` -
A 278 78 28 35.9
B 414 136 31 22.8
C 620 206 25 12.1
D 868 248 12 4.8

a
out-of-pocket outlay.
from table.
b
To move from the current policy to level A, Southeastern must invest an additional ` 78,000 in
finished goods inventory.
We have identified the costs that vary and those that remain fixed as sales expand due to
recovery of lost sales. The validity of the analysis depends on our ability correctly to identify
fixed and variable costs in the range of sales in question.

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