Study: Compute and Understand the Operating Cycle
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Slides 1-2 (0m:40s)
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Welcome to Introduction to Accounting Preparing for a User's Perspective
Compute and Understand the Operating Cycle
What does the operating cycle mean?
A company's operating cycle is the number of days between when the company purchases inventory, through to sales and final collection of cash from customers. For a manufacturer, the inventory holding period includes the holding period for all three types of inventory: raw materials, work-in-process (WIP) and finished goods.
How is the operating cycle computed?
The operating cycle is computed as follows:
Slide 3 (1m:00s)
Links to an external site.If you have forgotten how to compute the days sales in inventory (aka: days sales of inventory) or the days sales in receivables (aka: the accounts receivable collection period) you should stop the video now and fully study this diagram to ensure that you know how to compute all of the noted ratios, including the operating cycle. If you need a review of this material, feel free to review these prior topics in Canvas and watch the related videos titled "Compute and Understand the Inventory Turnover Ratio - Slides 1-21" and "Compute and Understand the Accounts Receivable Turnover Ratio - Slides 1-18". Please ensure that you can compute all of the ratios provided in the diagram below and can solve for any missing variables.
Expanded operating cycle diagram
Next we will use these ratios to compute a company's operating cycle to see how efficient and effective its management is at storing and selling inventory and at granting credit to and collecting payment from customers.
Slide 4 (0m:52s)
Links to an external site.Background: You are dining with your nephew who has been running his own hardware business for the past five years. He is concerned that his management of working capital (i.e. current assets - current liabilities), particularly inventory and receivables, is not very efficient. He apologizes for not knowing all of his numbers like he should but asked if you would at least look at the following numbers for the most recent year and tell him what you think.
Cost of Goods Sold $40,000, Inventory Turnover Ratio 2, Net Credit Sales $200,000; Average Accounts Receivable $125,000
Requirement #1: Compute the following ratios:
a) Average Inventory: _____________
b) Days Sales In Inventory: _____________
c) AR Turnover Ratio: _____________
d) Days Sales in Receivables: _____________
e) Operating cycle: _____________
Requirement #2: Complete the following:
a) What areas should the nephew look into improving?
b) Give two recommendations that could possibly help your nephew improve his operating cycle.
Slides 5-6 (3m:25s)
Links to an external site.Whenever you are given a set of variables and are asked to solve for some unknown variables, I encourage you to use the following four-step process:
1) determine the variables that have been given and determine the variables that are requested.
The given and requested variables were noted in the Background information above.
2) write down the formula into which the given variables can be input and from which the requested variables can be derived.
The best formula for this problem was provided in the expanded operating cycle diagram provided above and as will be filled out below.
3) input all of the known variables into the formula and circle the requested variables so you know what you are solving for.
4) solve for the unknown variables, one at a time. I like to start from the bottom and work my way up using formulas that include 3 variables, one of which I don't know yet.
SOLUTION:
Requirement #1: Compute the following ratios:
a) Average Inventory: $20,000
b) Days Sales In Inventory: 182.5
c) AR Turnover Ratio: 1.6 times per year
d) Days Sales in Receivables: 228.13
e) Operating cycle: Days sales in inventory 182.5 + Days sales in receivables 228.13 = 410.63 days
Slide 7 (0m:43s)
Links to an external site.Requirement #2a: What areas should the nephew look into improving?
Your nephew's operating cycle of 410.63 days seems especially long for a hardware store to keep resources tied up in inventory and receivables. When we dig further into the operating cycle ratio we realize that he takes 182.5 days to sell his average inventory balance and his customers are taking over 228 days to pay him. Even without comparing to his competitors, it already seems clear that something must be done to reduce his operating cycle which he can do by reducing either or both of his days sales in inventory and his days sales in receivables.
Slides 8-9 (2m:08s)
Links to an external site.Requirement #2b: Give two recommendations that could possibly help your nephew improve his operating cycle.
182.5 days sales in inventory: Your nephew should consider reducing the number of units on hand for each unique product type. It appears that your nephew keeps an average of 1/2 year supply (i.e. 182.5 days) of inventory on hand at all times. This seems to be too much for a hardware store. He should evaluate his purchasing process and see what can be done to better match the timing of his purchases to his sales. For example, if he could reduce his days sales in inventory down to 30 days, it would chop off 162.5 days of inventory sitting around waiting to be sold. This 162.5 day reduction would effectively free up $17,808 of working capital to be used for other purposes (i.e. (Cost of Goods Sold $40,000 / 365 days) * 162.5 days saved = $17,808).
228.13 days sales in receivables: Your nephew most likely could reduce his days sales in receivables by improving his billing and collection processes. Maybe his sales invoices do not indicate that full payment is expected within 30 days, or maybe he isn't sending out monthly billing statements to remind his customers what to pay and when. Imagine if your nephew could get his days sales in receivables down to 30 days. This would reduce the number of days that he has to wait for cash payment by 198.13 days. This 198 day reduction could provide him $108,564 of additional interest free cash to be used for other purposes (i.e. (Net Credit Sales $200,000 / 365 days) * 198.13 days saved = $108,564).
Slide 10 (0m:37s)
Links to an external site.How do you use the operating cycle?
The prior example of your nephew's hardware store exhibited how computing and understanding the operating cycle, and its components, can be helpful to evaluating management's efficiency in regards to inventory purchases and sales and credit granting and collections. As long as management can avoid the negative ramifications of an operating cycle that is too short, such as stock-outs, lost sales, and irritated customers, management will benefit by continually striving to minimize its operating cycle.
Slide 11 (1m:47s)
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Let's track a company's operating cycle over a six year period and see what we can learn. As you can see from the data provided, this company's operating cycle declined from 56.62 days in 20X1 down to 43.36 days in 20X3, but then it started to increase, so that by 20X6 it was up to 51.01 days. So why did this company's operating cycle improve up to 20X3 and then worsen up to 20X6? Which area of management appears to need the most help? Hopefully you noticed that the days sales of inventory increased in each year (meaning management was taking more time to sell its inventory) and its days sales in receivables decreased (meaning management was taking less time to collect on its sales). You should have noticed that in years 20X1 to 20X3 that the improvement in the days sales in receivables more than offset the deterioration in the days sales of inventory. However, from 20X4 to 20X6 the deterioration in the days sales of inventory was so large, it more than offset the continued improvement in days sales in receivables. In other words knowing the operating cycle is not enough because in this case, inventory management and sales are becoming so inefficient that they mask the improvements being made in credit granting and collections.
Slides 12-14 (0m:50s)
Links to an external site.Managing the operating cycle is clearly a balancing act between having too much inventory resulting in increased inventory carrying costs and having not enough inventory resulting in missed sales and dissatisfied customers. It is also a balancing act between being not strict enough resulting in less free working capital, increased financing costs, and uncollectible receivables and being too strict, resulting in missed sales dissatisfied and angry customers.
Summary
You should be able to define, compute and interpret the operating cycle
Solve for unknown variables in the operating cycle.
Good luck on the quiz.