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Measuring Profitability

By Matt and Jon Schreibfeder

Besides customer service (i.e, having those quantities of stocked items available, when customers want them), EIM considers profitability to be the most important metric available to our clients.  If your customer service is not at an acceptable level, your customers will go elsewhere for their needs.  But, if you are not actually making money, while your customers might not leave, you will find yourself on a path for business failure.

Historically many companies judge their profitability by calculating gross margin.  The gross margin metric is easy to understand, clean and tidy, but inadequate.  Gross margin omits a terribly important aspect of your true profitability, the amount of inventory that you have or are required to have on hand.

Gross Margin = (Sales \$ – Cost of Goods Sold \$) ÷ Sales \$

EIM recommends using what we refer to as the Adjusted Gross Margin.  It is a modification of the gross margin formula where the cost of carrying Inventory is subtracted from the sales dollars along with the cost of goods sold.

Adjusted Gross Margin = (Sales \$ – Cost of Goods Sold \$ – Cost of Carrying Inventory) ÷ Sales \$

The Cost of Carrying Inventory (commonly known as the “K Cost”) is the calculated value of the expense of maintaining inventory in your warehouse.  It is expressed as a percentage, reflecting what it costs to maintain a dollar’s worth of inventory in your warehouse for an entire year.  The more inventory of an item you keep in stock, the higher your carrying cost.  The K Cost has been discussed in previous newsletters, and there is a questionnaire for calculating your K Cost in the Resources section of our web site, www.EffectiveInventory.com.

Consider the examples in the table below.  In each case the only thing changing is an increasing value of the average on-hand quantity which causes a higher carrying cost.  We are using an annual carrying cost of 20%, a common value for the current cost of carrying inventory:

 Example 12 Months Sales 12 Months COGS Avg Inventory on Hand Inventory Carrying Cost Day’s Supply of Invty Gross Margin Adjusted Gross Margin 1 \$100,000 \$60,000 \$10,000 \$2,000 61 40% 38% 2 \$100,000 \$60,000 \$40,000 \$8,000 244 40% 32% 3 \$100,000 \$60,000 \$70,000 \$14,000 426 40% 26% 4 \$100,000 \$60,000 \$100,000 \$20,000 609 40% 20% 5 \$100,000 \$60,000 \$130,000 \$26,000 792 40% 14%

Notice that the gross margin is completely unaffected by the level of inventory and changing carrying cost, even when we maintain a 792-day supply (more than two year’s worth of stock)!

EIM applies this analysis to every product we analyze: items with sporadic usage, recurring usage, seasonal demand, it does not matter.  You have to be sure that everything you stock is profitable or leads to other profitable sales.

In previous months, we have been talking about ranking items.  We have found that many buyers will feel comfortable filling replenishment order to achieve the vendor’s target order requirement by buying more of their “A” ranked products, because they “know this material will sell”.  Yes, the material might keep on moving through inventory, but as you add additional and perhaps unnecessary inventory, you are going to start eating away at your adjusted margins and real profits.

We live in interesting times where items can go from being in short supply to surplus within a month.  In all probability, many of you are going to start to get offers from your vendors to take very large quantities of your best-selling products at what seems like the deal of the century.  Are these suppliers really interested in your profitability?  If they are offering a huge discount, it is for a reason.  It might make total sense to take advantage of an opportunity and stock up on inventory.  But this should be done only after careful thought and analysis.