May 23, 2006
Volume 2 Issue 63

Adjusted Margin: A Better Measurement of Profitability     by: Jon Schreibfeder

Your warehouse is probably filled with all sorts of products. What profit do you make when you sell a particular item? Well, if you ask a salesman he may say, “That’s easy; we average a 25% gross margin on all of the products we sell!” Gross margin is a common method of profitability and is calculated with the equation: 

(Sales $ - Cost of Goods Sold $) ÷ Sales $

 For example if we had sales of $2,000 and cost of goods sold of $1,500 (i.e. a gross profit of $500) the result would be a gross margin percentage of 25% =

$500 / $2,000  =  25%

But does your gross margin directly relate to your profitability? Don’t you experience costs, besides what you pay the vendor, in maintaining inventory in your warehouse? And doesn’t it seem logical that the more inventory you maintain in your warehouse the greater these expenses will be? The accumulation of costs you incur in maintaining inventory is called the inventory carrying cost. These costs include: 

·          Putting received material to its proper bin location and moving it to other storage locations as necessary

·          Insurance and taxes on the inventory

·          A portion of facility rent and utilities (the balance is considered a sales expense)

·          Physical inventory and cycle counting

·          Inventory shrinkage and obsolescence

·          The opportunity cost of the money invested in inventory.  If you are borrowing money to finance your inventory, this is your interest expense.  If you are financing your purchases out of corporate funds this is how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment.

The sum of all of these expenses is divided by your average inventory investment to arrive at your annual cost of carrying inventory. Typically an annual carrying cost ranges from 21% to 25%. That means that it costs anywhere from 21 cents to 25 cents to maintain a dollars worth of inventory in your warehouse for an entire year. Unfortunately the cost of carrying inventory is not considered in calculating gross margin.  Let’s look at two product lines:

At first glance, both lines are equally profitable and provide the target gross margin percentage return our salesman previously mentioned. But, the average inventory investment in product line “A” is $4,000 while the average investment in stock for product line “B” is $12,500. These are not equally good investments. For the first product line, we receive $5,000 in profit for the $4,000 we have invested. The second product line provides a $7,500 return on an investment of $12,500.

The adjusted gross margin percentage is a much better measurement of the profitability of a product, product line, branch inventory, or the entire company. It applies the cost of carrying inventory to the equation for calculating gross margin:

Annual Gross Profit $ – (Annual Carrying Cost % * Average Inventory $)

Annual Sales $ 

If we apply an annual carrying cost percentage of 25% to the first product line, the annual carrying cost is $1,000 ($4,000 * 25%). Using the same percentage, the annual carrying cost of the second product line is $3,125 ($12,500 * 25%). With this information let’s calculate the adjusted margin percentage for the two product lines and see which is a better investment:

The product lines aren’t equally profitable.  In fact, if our company experiences typical industry operating expenses of 15% of sales, we’re actually losing money on product line “B”. And that’s not even considering the commissions we pay our salespeople! Many product lines require a substantial investment in inventory. This investment must be considered when you establish your selling prices and the profit you must receive from each sale. Get your employees in the habit of talking about a product line’s adjusted margin rather than its gross margin. They will have better job security as the adjusted margin concept helps guide your company to greater profitability! Next week's newsletter will discuss a software technique that loads your cost properly to help maintain company margin goals.

THE ADJUSTED MARGIN CONCEPT BRINGS REAL PROFITABILITY TO LIGHT!

©2006 Effective Inventory Management, Inc. Effective Inventory Management is a consulting firm dedicated to helping distributors maximize the productivity and profitability of their investment in stock inventory. Jon Schreibfeder, president of EIM is author of the recently published Achieving Effective Inventory Management – 3rd Edition. Contact Jon Schreibfeder at (972) 304-3325 or jons@effectiveinventory.com.

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