What is an Operating Cycle?

An operating cycle is the length of time between the acquisition of inventory and the sale of that inventory and subsequent generation of a profit. The shorter it is, the faster a business gets a return on investment (ROI) for the inventory it stocks. As a general rule, companies want to keep their operating cycles short for a number of reasons, but in certain industries, a long one is actually the norm. These cycles are not tied to accounting periods, but are rather calculated in terms of how long goods sit in inventory before sale.

When a business buys inventory, it ties up money in the inventory until it can be sold. This money may be borrowed or paid up front, but in either case, once the business has purchased inventory, those funds are not available for other uses. The business views this as an acceptable tradeoff because the inventory is an investment that will hopefully generate returns, but keeping the operating cycle short is still a goal for most businesses so they can keep their liquidity high.

Keeping inventory during a long operating cycle does not just tie up funds. Items must be stored and this can become costly, especially with inventory that requires special handling, such as humidity controls or security. Furthermore, inventory can depreciate if it is kept in a store too long. In the case of perishable goods, it can even be rendered unsaleable. Inventory must also be insured and managed by staff members who need to be paid, and this adds to overall operating expenses.

There are cases where keeping a lot of inventory for a long time in unavoidable. Wineries and distilleries, for example, keep inventory on hand for years before it is sold, because of the nature of the business. In these industries, the return on investment happens in the long term, rather than the short term, and such companies are usually structured in a way that allows them to borrow against existing inventory or land if funds are needed to finance short-term operations.

Operating cycles can fluctuate. During periods of economic stagnation, inventory tends to sit around longer, while periods of growth may be marked by more rapid turnover. Certain products can be consistent sellers that move in and out of inventory quickly, while others, like big ticket items, may be purchased less frequently. All of these issues must be accounted for when making decisions about ordering and pricing items for inventory.