Computing Working Capital in Project Cost Statement

In an earlier article (Small Business Loan Financial Statements), we indicated the financial projections that typically accompany a small business loan proposal. Working capital cost was one of these projected estimates.

Estimating working capital cost is not a straightforward exercise, like estimating the cost of plant and machinery. For bought-out items like machinery, you have the supplier invoice, transportation rates, etc. to compute the landed cost at the project site.

Working capital is another kind of animal altogether. Estimating working capital involves a number of steps. To illustrate the issues involved, we look at a manufacturing small business - where the complexity is significantly more than, say, a retail business.

In a manufacturing business, working capital would typically include the following items:

-- Cost of raw materials and consumable stores held in stock -- Cost incurred on the stocks of finished products remaining unsold -- Cost incurred on the semi-finished products lying on the factory floor -- Moneys receivable from buyers who have bought on credit -- Advance payments to suppliers and deposits with utilities -- Cash and bank balances Part of the above costs could be met by getting credit from your own suppliers, as in the case of raw material purchases.

The major issue at this stage is how much of each item is needed. What quantity of each raw material item should be kept in stock? What would be the typical quantities of semi-finished production lying on the factory floor? How many months of credit would have to be extended to customers? Technical and marketing aspects determine the answers to such questions.

Next come the issue of determining the cost of each item. Raw materials stocks, accounts receivable etc are comparatively simple to cost. It is for the finished and semi-finished production that cost estimating becomes a real headache. You have to estimate how much of the following types of costs have gone into each unit of finished product or semi-finished product:

-- Raw materials -- Consumable supplies like cleaning materials, lubricants, etc.

-- Labor costs of production workers -- Labor costs of maintenance workers -- Power and Fuel costs -- Water supply costs -- Supervisory salaries -- Other overhead costs like depreciation of equipment, cost of built-up space occupied, storekeeping expenses and so on A look at the list would make it immediately clear that allocating some of these costs to a unit of product or semi-finished product is far from easy. How much of the maintenance salaries, water supply costs or storekeeping expenses do you allocate to a unit of unfinished production lying on the shop floor?

It is in this context that cost accountants come into the picture. They would work out complex formulae to allocate "indirect" costs to production units. These would seek to relate costs to production on some "reasonable" grounds, instead of "hard evidence".

Most of the above issues become relevant only after you start operations. During project planning stage, you might be able to do with some quick estimates using shortcuts. However, you should be aware of the issues involved.

For project cost estimates, there is also another issue. The working capital requirements and costs go up as your production levels increase. At which level do you "freeze" the working capital costs and include that cost as an item in the project cost?

Project cost estimates are made mainly for identifying financing needs. So it is this need that would determine the "freezing point". You take the working capital cost at that level of operations when "cash breakeven" is achieved. That is, when your cash inflows equal or exceed your cash outflows.

Up to the breakeven level, you would need funds infusion to finance any increase in working capital. After reaching cash breakeven, the increases could be financed internally.

In summary, estimating working capital cost for a project involves:

-- Estimating the quantities involved, -- Estimating the costs of these quantities, and -- Deciding the level of working capital cost that should be included in the project cost statement.



Computing Working Capital in Project Cost Statement - To learn more about this author, visit Gopinathan Thachappilly's Website.

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