Operating cycle is defined in terms of the average time an organization takes between spending money for operational activities and later collecting the amount of money from that particular operating activity.
In business, the focus of an operating cycle is specific to sales and purchase of assets as it determines the cash flow. Short operating cycle means consistent cash flow, and longer ones mean fewer profits and more loans.
Meaning of Operating Cycle
The period required to produce and sell goods and receive the due cash in exchange for the goods is known as an operating cycle.
It is also explained as an activity ratio that measures the average time required for turning the inventories into cash. It is very useful in assessing the working capital that every organization needs for its daily activities and growth.
It is a fact that a business entity with a small operating cycle will need less cash for its operations and can still show remarkable growth.
Conversely, a business entity might have good margins and still need extra funding to grow at even a small pace if its operating cycle is very long.
In the case of resellers, the operating cycle of the company includes the day of the initial cash outlay until the day of cash receipts derived from its customer.
It is important to keep the operating cycle as short as possible in business to meet the cash requirements of a business. Most of the companies keep their operating cycle within one financial year or less.
The length of an operating cycle is an indicator of the asset-utilization and liquidity of a company.
Factors affecting the operating cycle
There are several factors and management decisions that have a direct impact on the duration of an operating cycle. It includes-
- Payment terms – If the payment term is of long duration it will shorten the operating cycle as the company can easily afford a delay in paying the cash amount
- Order fulfillment policy – When the initial fulfillment rate is high, it increases the inventory amount and ultimately, the operating cycle.
- Credit policy – loose credit policy results in a long interval between the payments made by customers and this automatically extend the operating cycle
Examples of the operating cycle
The operating cycle of every industry and related business entity is different from the other industry. The operating cycle of a retailer is the time between the purchase of merchandise inventory and later selling the same.
Manufacturer’s operating cycle is the time between the raw materials purchased until they are sold, and the amount is received.
For example, ABC Company deals in manufacturing of orange juice.
Its operating cycle is the day it starts purchasing oranges and related things to make the juice to the time they deliver it to the retailer and get back the due amount whereas the operating cycle of the retailer starts from the time he makes the payment to the manufacturer for the orange juice until he sells it to the customers and gets back his due amount.
The formula of the operating cycle
The operating cycle is calculated through a simple formula
Operating Cycle = DIO + DSO – DPO
The DIO stands for Days Inventory Outstanding, DSO for Days Sales Outstanding and DPO for Days Payable Outstanding.
Calculating Operating Cycle with the help of this formula, is very easy. Suppose ABC Company manufacturers soap, and it is kept in warehouses for ten days. It takes 20 days to collect on the sales and another 15 days to pay invoices to its vendor.
As per the formula
Operating Cycle = (DIO + DSO) – DPO
Operating Cycle = (10 + 20) – 15
Operating Cycle = 15 days
There are two types of the operating cycle
- Gross Operating Cycle – It is the average period that takes between the purchase of raw materials to cash received for it.
- Net Operating Cycle – It refers to the average time between paying for the inventory and collection of cash through the sale of receivables.
13 Reasons for a longer operating cycle
The reasons for prolonged operating cycles are as follows-
- When the purchase of raw materials is either in short or excess requirements
- When a company fails to get a cash discount as well as a trade discount
- Use of technology and machinery that has become outdated
- If a business entity purchases defective or inferior quality materials
- When the inventory policy of an organization is not up to the mark
- When raw materials are not purchased during certain seasons when their prices are down compared to other times
- Delay in the manufacturing cycle
- Absence of proper coordination, planning, and control
- Inequality between demand and production policy
- Unable to get credit from employees and suppliers
- Wrong credit policy and weak collection policy
- Absence of proper maintenance of infrastructure facilities and equipment
- Absence of proper monitoring of the external environment
10 Reducing the operating cycle
An organization can reduce its operating cycle in the following ways-
- Fast sale of inventories would lead to a decrease in the operating cycle
- Let the company collect its credit sales quickly as it will result in a shorter operating cycle
- It is the responsibility of a purchase manager to ensure the purchase of quality materials. His role includes buying them at the right time when the prices are down and from the right place, that is the wholesalers so that the costing is less.
- Reorganization if inventory policies and credit from suppliers is necessary if a company wants to shorten its operating cycle
- Proper planning and coordination at every level
- Maintenance of plant, machinery, equipment and infrastructure facilities
- Upgrading the technology
- Synchronized production as well as sales policies
- Production of quality materials at lower costs
- Effective sales promotion activities to enhance sales figures.