Share
Explore BrainMass

Operating cycle (OC)and cash conversion cycle (CCC)

In January 2007, Teresa Leal was named treasurer of Casa de Diseño. She decided that she
could best orient herself by systematically examining each area of the company's financial
operations. She began by studying the firm's short-term financial activities.
Casa de Diseño is located in southern California and specializes in a furniture line called
"Ligne Moderna." Of high quality and contemporary design, the furniture appeals to the customer
who wants something unique for his or her home or apartment. Most Ligne Moderna
furniture is built by special order, because a wide variety of upholstery, accent trimming, and
colors are available. The product line is distributed through exclusive dealership arrangements
with well-established retail stores. Casa de Diseño's manufacturing process virtually eliminates
the use of wood. Plastic and metal provide the basic framework, and wood is used only
for decorative purposes.
Casa de Diseño entered the plastic-furniture market in late 2001. The company markets
its plastic-furniture products as indoor-outdoor items under the brand name "Futuro." Futuro
plastic furniture emphasizes comfort, durability, and practicality and is distributed through
wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the
firm's sales and profits in 2006. Casa de Diseño anticipates some additions to the Futuro line
and also some limited change of direction in its promotion in an effort to expand the applications
of the plastic furniture.
Leal has decided to study the firm's cash management practices. To determine the effects
of these practices, she must first determine the current operating and cash conversion cycles.
In her investigations, she found that Casa de Diseño purchases all of its raw materials and
production supplies on open account. The company is operating at production levels that preclude
volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseño usually
receives credit terms of net 30. An analysis of Casa de Diseño's accounts payable showed
that its average payment period is 30 days. Leal consulted industry data and found that the
industry average payment period was 39 days. Investigation of six California furniture manufacturers
revealed that their average payment period was also 39 days.
Next, Leal studied the production cycle and inventory policies. Casa de Diseño tries not to
hold any more inventory than necessary in either raw materials or finished goods. The average
inventory age was 110 days. Leal determined that the industry standard, as reported in a
survey done by Furniture Age, the trade association journal, was 83 days.

Casa de Diseño sells to all of its customers on a net-60 basis, in line with the industry
trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts
receivable, that the average collection period for the firm was 75 days. Investigation of the
trade association's and California manufacturers' averages showed that the same collection
period existed where net-60 credit terms were given. Where cash discounts were offered, the
collection period was significantly shortened. Leal believed that if Casa de Diseño were to offer
credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.
Casa de Diseño was spending an estimated $26,500,000 per year on operating-cycle
investments. Leal considered this expenditure level to be the minimum she could expect the
firm to disburse during 2007. Her concern was whether the firm's cash management was as
efficient as it could be. She knew that the company paid 15 percent annual interest for its
resource investment. For this reason, she was concerned about the financing cost resulting
from any inefficiencies in the management of Casa de Diseño's cash conversion cycle. (Note:
Assume a 365-day year and that the operating-cycle investment per dollar of payables, inventory,
and receivables is the same.)

TO DO
a. Assuming a constant rate for purchases, production, and sales throughout the year, what
are Casa de Diseño's existing operating cycle (OC), cash conversion cycle (CCC), and
resource investment need?
b. If Leal can optimize Casa de Diseño's operations according to industry standards, what will
Casa de Diseño's operating cycle (OC), cash conversion cycle (CCC), and resource investment
need to be under these more efficient conditions?
c. In terms of resource investment requirements, what is the cost of Casa de Diseño's operational
inefficiency?
d. (1) If in addition to achieving industry standards for payables and inventory, the firm can
reduce the average collection period by offering credit terms of 3/10 net 60, what
additional savings in resource investment costs will result from the shortened cash
conversion cycle, assuming that the level of sales remains constant?
(2) If the firm's sales (all on credit) are $40,000,000 and 45% of the customers are
expected to take the cash discount, by how much will the firm's annual revenues be
reduced as a result of the discount?
(3) If the firm's variable cost of the $40,000,000 in sales is 80%, determine the reduction
in the average investment in accounts receivable and the annual savings that will
result from this reduced investment, assuming that sales remain constant.
(4) If the firm's bad-debts expenses decline from 2% to 1.5% of sales, what annual savings
will result, assuming that sales remain constant?
(5) Use your findings in parts (2) through (4) to assess whether offering the cash discount
can be justified financially. Explain why or why not.

Attachments

Solution Preview

A
Firm's Operating cycle = Average age of inventory+Average Collection Period

=110+75
=185 days

What is your firm's cash conversion cycle?

Firm's Cash conversion cycle = Operating cycle -Average Accounts Payable

=185-30
155 days

Resource Investments required will be :

This will be calculated from operating cycle investments
Operating cycle investement for 185 days= 26500000

But now we have to calculate for 155 days as per the cash conversion cycle
=155/185*26500000
$22,202,703

B Operating cycle as per industry standards

Firm's Operating cycle = Average age of inventory+Average Collection Period

=83+75
158 days

What is your firm's cash conversion cycle?

Firm's Cash conversion cycle = Operating cycle -Average Accounts Payable

...

Solution Summary

This provides the steps to calculate the operating cycle (OC), cash conversion cycle (CCC)and resource investment need

$2.19