Gross Operating Cycle Vs Net Operating Cycle

Banking & FinanceFinance ManagementGrowth & Empowerment

An operating cycle is the time needed to convert sales into cash after converting the resources into inventories. In fact, no company generates sales after the production of a good instantly. It has to wait for some time to sell the goods in the market after purchasing raw materials and other necessary items and producing the finished goods.

An operating cycle is divided into two types as follows −

  • Gross Operating Cycle (GOC).

  • Net Operating Cycle (NOC).

Here’s more about GOC and NOC and their differences.

Gross Operating Cycle

The gross operating cycle of a firm can be expressed as the Inventory conversion period (ICP) plus the debtors' conversion period (DCP).

$$\mathrm{\mathrm{Gross\: Operating\: Cycle}\:=\:\mathrm{Inventory \:conversion\: period\:+\:Debtors\: conversation\: period}}$$

$$\mathrm{\mathrm{GOC\:=\:ICP\:+\:DCP}}$$

Inventory Conversion Period

The Inventory conversion period is obtained by adding the Raw Materials Conversion period (RMCP), the Work-in-process Conversion Period (WIPCP), and the Finished Goods Conversion Period (FGCP).

$$\mathrm{\mathrm{ICP\:=\:RMCP\:+\:WICP\:+\:FGCP}}$$

Raw Materials Conversion Period (RMCP)

Raw Materials Conversion Period is the average time required to convert raw materials into work in process. RMCP depends on

  • Raw Materials Consumed per day

  • Inventory of Raw Materials.

Raw materials consumed per day are obtained by total raw materials divided by 360 (days).

The raw materials conversion period is obtained when raw material inventory is divided by raw material conversion per day.

$$\mathrm{\mathrm{Raw\: Materials \:Conversion \:Period}\:=\:\frac{\mathrm{Raw\: Material\: Inventory}}{\mathrm{Raw\:Material\:Consumption/360}}}$$

$$\mathrm{\mathrm{RMCP}\:=\:\frac{\mathrm{RMI}}{\mathrm{RMC/360}}\:=\:\frac{\mathrm{RMI/360}}{\mathrm{RMC}}}$$

Work-in-Process Conversion Period (WIPCP)

Work in process conversion period is the average time taken to complete the semi-finished work or work in process.

It is given by

$$\mathrm{\mathrm{Work\: in\: Process\: Conversion\: Period}\:=\:\frac{\mathrm{Work\: in\: Process\: Inventory}}{\mathrm{Cost\:of\:Production/360}}}$$

$$\mathrm{\mathrm{WIPCP}\:=\:\frac{\mathrm{WIPI}}{\mathrm{COP/360}}\:=\:\frac{\mathrm{WIPI/360}}{\mathrm{COP}}}$$

Finished Goods Conversion Period (FGCP)

The finished goods conversion period is the average time it takes to sell finished goods.

$$\mathrm{\mathrm{Finished\: Goods\: Conversion\: Period}\:=\:\frac{\mathrm{Finished\: Goods\: Inventory}}{\mathrm{Cost\:good\:sold/360}}}$$

$$\mathrm{\mathrm{FGCP}\:=\:\frac{\mathrm{FGI}}{\mathrm{COGS/360}}\:=\:\frac{\mathrm{FGI/360}}{\mathrm{COGS}}}$$

Debtors Conversion Period (DCP)

Debtors conversion period is the average time taken to convert debtors into cash. It represents the average collection period of a firm.

It is measured as −

$$\mathrm{\mathrm{Debtors\: Conversion \:Period}\:=\:\frac{\mathrm{Debtors}}{\mathrm{Credit\:Sales/360}}}$$

$$\mathrm{\mathrm{DCP}\:=\:\frac{\mathrm{Debtors}}{\mathrm{Credit\:Sales/360}}}$$

Net Operating Cycle or Cash Conversion Cycle

NOC is the difference in time between the gross operating cycle (GOC) and Payables deferral period.

$$\mathrm{\mathrm{NOC}\:=\:\mathrm{GOC-CDP}}$$

Creditors Deferral Period

Creditors deferral period is the average time taken by a firm to pay its suppliers.

It is given by −

$$\mathrm{\mathrm{Creditors\: Deferral \:Period}\:=\:\frac{\mathrm{Creditors}}{\mathrm{Credit\:Purchases/360}}}$$

$$\mathrm{=\:\frac{\mathrm{Creditors}}{\mathrm{Credit\:Purchases/360}}}$$

Difference between Gross and Net Operating Cycle

The differences between GOC and NOC are as follows −

  • GOC considers a firm every time duration in each step of a product’s lifecycle, from the acquisition of raw materials to the conversion of finished goods into cash. NOC considers the inventory of finished goods to the conversion of goods into cash.

  • GOC, by nature, is more elaborate than NOC but many people argue that NOC is a better measure of the operating cycle because acquiring and procuring should not be considered a step in the product formation lifecycle.

  • NOC is by far more focused on the real scenarios a business goes through. However, to be more informed on the real steps in the product lifecycle, GOC is a better measure. It is based on each step of a product being produced and sold in the market so that cash can be generated and can again be invested in the cycle to buy raw materials.

  • The net operating cycle ignores the payables to suppliers and so it is a direct measure that calculates the cash inflows and outflows during the manufacturing and sales of a product. It does not consider accounts payable as a part of the operating cycle.

Conclusion

The two terms Gross Operating Cycle and Net Operating Cycle are different mainly in the sense that GOC offers a closer look at the complete process of converting acquired raw materials to sales, whereas NOC represents the difference between paying for inventory and collection of cash.

raja
Updated on 29-Jun-2022 13:06:29

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