Your warehouse is probably filled with repair parts for the equipment you’ve sold. What profit do you make when you sell a part? Well, if you ask a salesman he may say, “That’s easy, we average a 25% gross margin on all of the parts we sell!” 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?
Sure you do. 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 warehouse locations as necessary
- Insurance and taxes on the inventory
- A portion of the warehouse 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. That is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment.
Unfortunately the cost of carrying inventory is not considered in calculating gross margin. Gross margin is calculated by dividing gross profit dollars by sales dollars. Let’s look at two product lines:
| Product Line “A” | Gross Profit $ | $5,000 | = 25% | |||
| Sales Dollars | $20,000 |
| Product Line “B” | Gross Profit $ | $7,500 | = 25% | |||
| Sales Dollars | $30,000 |
At first glance, both lines are equally profitable and provide the “target 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. Are these product lines really equal when it comes to profitability? 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 comes closer to measuring the true 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 Sales Dollars
A conservative annual carrying inventory is 25% of the average inventory investment. If we apply this percentage 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:
| Product Line “A” | $5,000 – $1,000 | = 20.0% | ||
| $20,000 |
| Product Line “B” | $7,500 – $3,125 | = 14.6% | ||
| $30,000 |
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, especially those that call for a tremendous inventory of repair parts, 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!