operating cycle concept

Operating Cycle Concept, computation of length of Operating Cycle

Operating Cycle Definition – It is the time duration required to convert the sales after the conversion of resources into inventories, into cash.

The operating cycle concept in a manufacturing firm usually involves the following –

  • Procurement of resources such as raw material, land, labor, capital, etc.
  • Conversion of raw material to work in progress to finished products.
  • Sale of finished good either for cash or in credit.

All the three activities mentioned above involves the inflow and outflow of cash which is most of the time uncertain. The inflows of the cash depends upon the sales and collection period which is difficult to predict accurately. On the contrary cash outflows are certain. So firm requires to invest in current assets for the smooth functioning of the day to day affairs of the business. Firms require constant liquidity for the purpose of purchasing raw material and work in progress. Cash is also needed to meet out the future contingencies. In addition to this, firm also require to maintain an appropriate amount of finished good inventory in case of increase in demand of the customers.

There is hardly any business organisation which does not requires working capital. However, firms may differ in the requirements of the working capital. Firms objective is to maximize the wealth of the shareholders. For this, it is important that firm earns sufficient amount of profit from its operations. For earning profit, it is important that firm should make steady sales. In order to make sales, current assets are needed as sales does not immediately turn into cash. There involves a operating cycle which involves conversion of sales into cash.

How to Determine Length of Operating Cycle?

In operating cycle concept, the length of operating cycle of a manufacturing firm is the sum of –

  1. Inventory Conversion period (ICP)
  2. Debtors conversion period (DCP)

Inventory conversion period is the time required to produce or sell the product. Inventory conversion period is the sum of –

  1. Raw material conversion period (RMCP)
  2. Work in process conversion period (WIPCP)
  3. Finished goods conversion period. (FGCP)

While debtors conversion period concerns with the time required to collect the outstanding amount from the customers. The sum of inventory conversion period and debtor’s conversion period is known as gross operating cycle.

Well, firms have limited amount of cash with them, hence they requires the resources on credit. Now the time interval the firm is able to defer payments on various resource purchases is known as Creditors deferral period.

The difference between gross operating cycle and credit deferral period is Net operating Cycle. If depreciation is excluded from the expenses that come in operating cycle, the net operating cycle becomes cash conversion cycle (CCC).