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8.7 Cost of Goods Sold to Inventory to Ratio Analysis Questionnaire

What is the Cost of Goods Sold to Inventory ratio and why should it be included in a business plan for a Full Service Restaurant?

The Cost of Goods Sold to Inventory ratio is a key liquidity ratio that must be included in a business plan for a small business like A Touch of Tuscany This ratio calculates the Cost of goods sold to the Inventory of the small business and denotes how many times the cost of sales are being turned over when looking at the inventory of goods. The result is a measure of the number of times a small business like A Touch of Tuscany is able to turn over its inventory during an year. This ratio is also known as the Inventory turnover ratio.

Generally speaking since the cost of goods sold to inventory ratio measures how efficiently a small business like A Touch of Tuscany is converting its inventory to sales, the higher the ratio the better it is for the business although not always and vice versa. Thus if we find a high inventory turnover ratio, it could indicate that the turnover is good or that the inventory level is very low and the business may run the risk of losing out sales if a large order were to show soon - usually if the inventory levels are in line with the historical numbers and the turnover ratio is high, it means that the business is turning over its inventory well.

What does a low Inventory turnover ratio imply for a small business like A Touch of Tuscany?

A low Inventory turnover ratio generally indicates poor liquidity and possible overstocking by the business. Thus the small business could be stocking obsolete inventory that they are stuck with and refuse to sell at discounted prices thereby tying up their cash; it could also mean that the inventory value has gone down recently due to a of shortage of raw materials in the wholesale market resulting in a lower ratio. In order to ascertain which diagnosis is accurate, a small business owner like Jack Gordon will have to make sure that the inventory levels are in accordance with normal levels - if that is the case than a lower Inventory turnover ratio would certainly indicate a sluggish sales environment and would require Jack Gordon to think about moving the inventory by giving incentives and discounts rather than keeping all the company cash locked in.

Why is the movement of Inventory so important to a small business like A Touch of Tuscany?

Cash is king and the only way to generate cash is to make the sale and collect from the customers. Successful small business owners like Jack Gordon know this and thus focus on moving the merchandise and booking sales rather than worrying about sticking to a certain price for their goods and services. Even in the services industry, booking the sale is much more important than worrying about price. We are not suggesting that small business owners not watch their margins and pricing, but we certainly don't recommend that they sacrifice sales and keep their valuable cash locked up in their inventories.

Additionally some industries have different dynamics than others. The retail jewelery industry has inventory that is of a very different nature than the fast food business or the apparel business. Anybody who has shopped for clothing knows that fashions change every season and hence the retailer has to focus on moving their merchandise since in a few months, their inventory will be useless. In other businesses like automotive repair, the inventory of parts is relatively small and durable - which is to say that it can last longer or in some instances only ordered from the dealer when there is a need.

A car dealer has to deal with a very different dynamic for their inventory - as the model year comes to a close in the summer, you will find that most car companies will start blowing out their inventories and offer steep incentives to customers to get the older models off their lots and make room for the next years models.

What are the Cost of goods sold? Do all industries have a cost of goods sold?

The Cost of Goods Sold is the direct costs borne by the small business for the production of the goods sold by them. In the case of service businesses the cost of goods sold is the operating expenses themselves. The cost of goods sold include all the material costs that went in to create the goods along with the direct labor costs associated with the creation or manufacturing. The cost of goods sold does not include indirect expenses like distribution cost, marketing and sales costs.

The cost of goods sold for the maker of a sandwich would be the raw materials that went in to making the sandwich like bread, cheese, mayo, tomatoes and the direct labor cost that went into creating the sandwich. The cost of goods sold for an attorney will simply be included in their operating expenses since their is little or no direct cost associated with the production of the service. The cost of goods sold is subtracted from the Sales to arrive at the Gross Margins for the business.

The cost of goods sold for a small business like A Touch of Tuscany is calculated by taking the opening inventory and adding to it the additions made during the year and subtracting inventory at the end of the year. Inventory is usually classified as raw material, work in process and finished goods waiting to be sold. There are many ways to value inventory for a small business like A Touch of Tuscany: they can use the cost method or the cost of market whichever is lower method.

Quick Links:

  1. Go to the Corresponding Template section for this industry.
  2. Go to the Corresponding Business Plan section for this industry.

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