Baumol Cash Management Model - Definition, Formula, and Examples
CPA Innocent MUGISHA
Apr 10, 2024
5 min read
Cash Management
The Baumol model is based on the idea that deciding on optimum cash balances is like deciding on optimum inventory levels. It assumes that cash is steadily consumed over time and a business holds a stock of marketable securities that can be sold when cash is needed.
The cost of holding cash is the opportunity cost i.e. the interest foregone from not investing the cash. The cost of placing an order is the administration cost incurred when selling the securities.
The Baumol uses an equation of the same form as EOQ formula for inventory management.
Baumol suggests that two types of costs are associated with cash balance.
The first type is transaction costs, which is incurred when marketable securities are converted into cash.
The second one is holding cost, this is the benefit foregone due to holding cash balances.
Both costs are variable in nature, when one reduces the other type increases and vice versa.
The minimum cash balance will be reached when the total cost is minimized.
Similar to the EOQ, costs are minimized when:
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Zeal Uganda Limited (ZUL) deals in production and supply of soft drinks in the West Nile. ZUL has been realizing profits since incorporation and would like to expand its operations to North Eastern Uganda as market research indicated that there may be viable opportunities in this region as well.
ZUL’s normal planning period is one (1) year and generates surplus cash of shs. 3.0 million per month which it invests in short term securities. The interest earned from short term securities is 8% with associated carrying cost per transaction of Shs 120.
Required: Calculate for ZUL
(a) Optimum amount of cash to be invested in each transaction.
(b) Number of transactions that will arise each year.
(c) Carrying cost of the transactions.
Solution:
(a) Using the Baumol formula as indicated above
Therefore, the optimal amount of cash to be invested in each transaction is shs. 328,654
(b) The number of transactions that will arise each year can be determined as below;
(c) Carrying cost of the transactions
= Number of transactions x cost of the transaction
= 110 transactions x shs. 120
= shs. 13,200
Drawbacks of the Baumol model
In reality, it is unlikely to be possible to predict amounts required over future periods with much certainty.
No buffer inventory of cash is allowed for. There may be costs associated with running out of cash.
There may be other normal costs of holding cash which increase with the average amount held.
CPA Innocent Mugisha is a Professor of Finance and Accounting with over 10 years experience in teaching Accounting and Finance related courses including Financial Accounting both at University and Professional level. His qualifications are: PhD (candidate), MBA(Finance), CPA(U), FCCA, CIPS, CTA and BCOM (Accounting). Innocent has also published various books on most topics in Accounting and Finance for Business and Professional Studies.
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