Operating Cycle in Accounting: Definition & Formula

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  • 0:00 The Operating Cycle Defined
  • 1:15 Industry Operating Cycles
  • 2:27 Calculating The…
  • 4:28 Lesson Summary
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Lesson Transcript
Instructor: Tiffany Crosby

Tiffany has a Masters in Business Administration

In this lesson, we'll learn about managing the operating cycle, its components, how to calculate it, and how accounting is used to determine the costs associated with your operating cycle.

The Operating Cycle Defined

From the time you spend money necessary to acquire inventory to the time you get the money back from customers is called the operating cycle. The ability of leaders to understand and manage the company's operating cycle is one of the most important predictors of long-term business viability. Few things will put companies out of business quicker than spending cash faster than you collect it.

The operating cycle measures how well you managing your cash. Before you can produce a product or service, you need to have the right materials and the right resources (equipment, people, etc.). Acquiring these resources and materials costs money, so you've spent cash before you've produced or sold anything.

The operating cycle breaks down into the following parts:

  • Lead time: how long in advance you have to order the materials you need to produce the product or service.
  • Production time: the amount of time it takes to make the product or deliver the service once all materials are received.
  • Sales time: the amount of time it takes to sell the product once it's been produced.
  • Delivery time: the amount of time it takes to deliver the product to the customer after it's sold.
  • Cash collection time: the amount of time it takes to receive cash from the customer after the product is sold and delivered.

Industry Operating Cycles

Companies may not have every component of the operating cycle. For example, a retail store won't have production time because they buy finished products to sell. However, a manufacturing company would still have production time. Since most retail stores collect money at the time of sale, they won't have delivery time or cash collection time either.

Operating cycles may also last for varying periods. Retailers, for example, may have an operating cycle of up to one year. They may pay out money in January and not receive that money back until December. In the interim, you still have to pay rent, utilities, wages, and other operating costs. For this reason, companies must carefully plan their purchases so they don't have excess inventory on hand. All that excess inventory represents cash down the drain.

Businesses that sell to other businesses often sell on account, which means that the purchaser has up to 30 days to pay for the product or service after they receive it. When they extend credit to their customers for 30 days or more, they've delayed their receipt of cash to cover all their own expenses. This is why they might try shortening the operating cycle (i.e., just-in-time), which involves not accumulating inventory until they are ready to use it in production.

Calculating the Operating Cycle

The easiest way to calculate the operating cycle is by using three common ratios: DIO, DSO, and DPO. The operating cycle is calculated using a simple formula:

DIO + DSO - DPO = Operating Cycle

Let's look at each term in the operating cycle.

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