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Operating Cycle Concept

Prerequisites

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1. What is an Operating Cycle?

The Operating Cycle (also called Working Capital Cycle or Cash Cycle) is the average time period between the purchase of raw materials and the realization of cash from the sale of finished goods.

In Simple Terms: It shows how long your money is "stuck" in business operations before it comes back as cash.

2. Stages of the Operating Cycle

A typical manufacturing business goes through these stages:

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3. Components of Operating Cycle

The operating cycle consists of different time periods:

3.1 Raw Material Storage Period

Time for which raw materials remain in storage before being sent to production.

3.2 Work-in-Progress Period

Time taken to convert raw materials into finished goods (Production Cycle).

3.3 Finished Goods Storage Period

Time for which finished products remain in stock before being sold.

3.4 Debtors Collection Period (Receivables Period)

Average time lag between credit sales and cash collection from customers.

3.5 Creditors Payment Period (Payables Period)

Average time lag between purchase of materials and payment to suppliers.

Note: Creditors payment period actually reduces the net operating cycle because we're using suppliers' money during this time.

4. Formula for Operating Cycle

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5. Calculation Methods for Each Component

How to calculate these periods:

Raw Material Storage Period (R):

R = (Average Raw Material Stock / Annual Raw Material Consumption) × 365 days

Work-in-Progress Period (W):

W = (Average WIP / Cost of Production) × 365 days

Finished Goods Storage Period (F):

F = (Average Finished Goods Stock / Cost of Goods Sold) × 365 days

Debtors Collection Period (D):

D = (Average Debtors / Annual Credit Sales) × 365 days

Creditors Payment Period (C):

C = (Average Creditors / Annual Credit Purchases) × 365 days

6. Numerical Problem (Detailed Exam Format)

Problem: Calculate the Operating Cycle for XYZ Manufacturing Ltd. from the following data:

Given:

- Average Raw Material Stock: ₹2,00,000
- Average Work-in-Progress: ₹1,50,000
- Average Finished Goods: ₹3,00,000
- Average Debtors: ₹4,00,000
- Average Creditors: ₹2,50,000
- Annual Raw Material Consumption: ₹24,00,000
- Annual Cost of Production: ₹36,00,000
- Annual Cost of Goods Sold: ₹36,00,000
- Annual Credit Sales: ₹48,00,000
- Annual Credit Purchases: ₹25,00,000

Solution:

Step 1: Calculate Raw Material Storage Period (R)

Formula: R = (Average RM Stock / Annual RM Consumption) × 365

R = (₹2,00,000 / ₹24,00,000) × 365
R = 0.0833 × 365
R = 30.42 days ≈ 30 days

Step 2: Calculate Work-in-Progress Period (W)

Formula: W = (Average WIP / Cost of Production) × 365

W = (₹1,50,000 / ₹36,00,000) × 365
W = 0.0417 × 365
W = 15.21 days ≈ 15 days

Step 3: Calculate Finished Goods Storage Period (F)

Formula: F = (Average FG Stock / Cost of Goods Sold) × 365

F = (₹3,00,000 / ₹36,00,000) × 365
F = 0.0833 × 365
F = 30.42 days ≈ 30 days

Step 4: Calculate Debtors Collection Period (D)

Formula: D = (Average Debtors / Annual Credit Sales) × 365

D = (₹4,00,000 / ₹48,00,000) × 365
D = 0.0833 × 365
D = 30.42 days ≈ 30 days

Step 5: Calculate Total Operating Cycle

Operating Cycle = R + W + F + D
Operating Cycle = 30 + 15 + 30 + 30
Operating Cycle = 105 days

Step 6: Calculate Creditors Payment Period (C)

Formula: C = (Average Creditors / Annual Credit Purchases) × 365

C = (₹2,50,000 / ₹25,00,000) × 365
C = 0.10 × 365
C = 36.5 days ≈ 37 days

Step 7: Calculate Net Operating Cycle (Cash Conversion Cycle)

Net Operating Cycle = Operating Cycle - Creditors Payment Period
Net Operating Cycle = 105 - 37
Net Operating Cycle = 68 days

Answer:

  • Gross Operating Cycle: 105 days
  • Net Operating Cycle (Cash Conversion Cycle): 68 days

Interpretation: The company's money is tied up in working capital for 68 days (after adjusting for credit from suppliers). This means funds invested in inventory and receivables take 68 days to convert back into cash.

7. Significance of Operating Cycle

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Why Operating Cycle Matters:

  1. Determines WC Requirements: Longer cycle = More funds blocked = Higher working capital needed.
  2. Efficiency Indicator: A reducing operating cycle indicates improving operational efficiency.
  3. Comparison Tool: Companies can compare their cycles with industry benchmarks.
  4. Planning Tool: Helps in estimating working capital requirements.

8. How to Reduce Operating Cycle?

  1. Faster Production: Reduce Work-in-Progress period through efficient manufacturing.
  2. Quick Sales: Reduce Finished Goods holding period through better marketing.
  3. Prompt Collection: Reduce Debtors period through strict credit control.
  4. Delay Payments: (Ethically) Negotiate longer credit terms with suppliers.
  5. JIT (Just-in-Time): Minimize raw material and finished goods inventory.

Exam Pattern Questions and Answers

Question 1: "What is Operating Cycle? What factors determine its length?" (6 Marks)

Answer:

Definition (2 marks): Operating Cycle, also known as Working Capital Cycle, is the time duration between the outlay of cash for purchases and the receipt of cash from sales. It represents the period for which funds remain tied up in current assets during the normal course of business operations. The cycle begins when cash is paid for raw materials and ends when cash is collected from customers.

Factors Determining Length (4 marks):

  1. Nature of Business: Manufacturing businesses have longer cycles (involving raw materials, production, and sales) compared to service businesses which have minimal or no inventory.
  2. Production Process: Longer production time (e.g., shipbuilding, wine aging) increases the work-in-progress period, extending the overall cycle.
  3. Credit Policy: Liberal credit terms offered to customers increase the receivables collection period, while lenient terms from suppliers reduce the net cycle.
  4. Inventory Management: Efficient inventory control systems like JIT (Just-in-Time) or EOQ reduce the storage periods for raw materials and finished goods, shortening the cycle.

Question 2: "Calculate Operating Cycle from the following data:" (6 Marks)

Inventory Holding Period: 45 days
Receivables Collection Period: 30 days
Payables Payment Period: 35 days

Given:

  • Inventory Holding Period (includes RM + WIP + FG) = 45 days
  • Receivables Collection Period = 30 days
  • Payables Payment Period = 35 days

Formula:

Operating Cycle = Inventory Period + Receivables Period
Net Operating Cycle = Operating Cycle - Payables Period

Solution:

Step 1: Calculate Gross Operating Cycle

Operating Cycle = 45 + 30 = 75 days

Step 2: Calculate Net Operating Cycle

Net Operating Cycle = 75 - 35 = 40 days

Answer:

  • Gross Operating Cycle = 75 days
  • Net Operating Cycle = 40 days

This means the company's funds are tied in working capital for 40 days (net of supplier credit).

Summary

Key Concepts:

  1. Operating Cycle = Time from cash outflow to cash inflow
  2. Components: R + W + F + D - C
  3. Shorter cycle = Less working capital needed = More efficient
  4. Used for working capital estimation

Formula Memory Tip: "Row With Four Doors minus Credit" (R-W-F-D-C)

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Quiz Time! 🎯

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