How to Calculate a Manufacturing Company's Operating Cycle?

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The operating cycle is the time required for converting sales into cash after converting resources into inventories. The operating cycle of a manufacturing firm is different from non-manufacturing companies because manufacturing companies need to resource raw materials and convert them into finished goods. While non-manufacturing companies can go directly from the acquisition of services or products to sales, manufacturing companies need to consider the time required for manufacturing the goods. So, generally, the operating cycle of a company is more prolonged than non-manufacturing companies.

The operating cycle of a manufacturing company is made up of three phases −

Acquisition of Raw materials and resources − In this phase, the company acquires the raw materials, labor, fuel, power, etc.

Manufacturing the product − This phase contains the actual manufacturing of the finished goods from the raw materials.

Sales − This phase includes the conversion of finished goods into sales and collection of cash. Sales can be made on credit which creates accounts receivables.

Calculation

The total length of the operating cycle of a manufacturing company is made up of

  • Inventory conversion period, and

  • Debtors conversion period

Operating cycle = Inventory conversion period + Debtors conversion period

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

This formula of calculation of the operating cycle usually provides the gross operating cycle. So, we can write −

Gross Operating Cycle = Inventory conversion period + Debtors conversion period

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

The inventory conversion period contains the time durations required for all the steps that are needed in producing and selling the product. Therefore, the inventory conversion period is made up of the following −

  • Raw Materials Conversion period (RMCP)

  • Work in process conversion period (WIPCP), and

  • Finished goods conversion period (FGCP)

Therefore, we can write GOC = RMCP + WIPCP + FGCP + DCP

Raw Materials Conversion Period (RMCP)

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 −

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

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

Concluding Notes

  • It is notable that the gross operating cycle is used to calculate the operating cycle of a manufacturing company. As the gross operating cycle takes care of resourcing the raw materials and converting them to work in process, the GOC technique is a better measure for calculating the operating cycle of a manufacturing company.

  • The net operating cycle or cash conversion cycle is not applicable in the calculation of the operating cycle of a manufacturing company as it does not need to calculate the Cash Deferral period. However, if a manufacturing company sells its products on credit, its NOC can be calculated.

  • Generally, when someone talks about operating cycles, it is generally referred to as the Gross operating cycle (GOC). The net operating cycle is obtained from the GOC by subtracting the deferred cash period. So, NOC is a metric obtained from the GOC.

  • Companies usually tend to reduce the operating cycles in order to convert their resources into sales. Therefore, the companies would try to reduce the length of RMCP, WIPCP, and FGCP as much as possible. However, it is a fact that the operating cycles of a company cannot be shortened for more than a certain limit. Doing so may be harmful to the manufacturing companies in terms of the quality of the products.

raja
Updated on 29-Jun-2022 13:09:07

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