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

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    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
    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.

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    Solution Preview

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

    =185 days

    What is your firm's cash conversion cycle?

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

    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

    B Operating cycle as per industry standards

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

    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