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I received an email from a customer this week asking how to handle a salesperson’s request to stock a product.  This would be the only product this new customer would buy:

• Anticipated Annual Sales              \$1,888
• Annual Cost of Goods Sold           \$1,411
• Anticipated Annual Profit \$            \$ 477

Sales management wanted to accept this business.   After all, the projected gross margin (Profit\$ ÷ Sales \$) is 25.3% (\$477 ÷ \$1,888).  But then I received three other pieces of information:

• The distributor would have to pay freight of \$150 to bring the item into stock
• The salesperson would receive a commission equal to 25% of the anticipated annual profit (\$119)
• An entire year’s worth of the product would have to be purchased at one time

If we add the freight and commission to the cost of goods sold (total of \$1,680) the anticipated annual profit is reduced to \$208 which translates into a profit margin of 11.0%.  But the company still has to absorb the cost of carrying inventory of this product and processing six anticipated sales of the item throughout the year.  Is \$208 adequate to maintain the item in inventory as well as process (pick, pack, ship, invoice and collect) six annual orders?

We need a better profitability measurement that simple gross margin calculation.    We have developed one in the “adjusted gross margin”.  The adjusted gross margin subtracts the cost of carrying the average inventory value of an item during the time it takes to sell the entire shipment that must be purchased:

[Annual Profit \$– (Average Inventory Investment * Annual Inventory Carrying Cost%)] ÷ Annual Sales \$

Because a year’s worth of the product would be purchased at one time the average inventory investment would be \$705.50.  This is the annual cost of goods sold divided by two.  During the time it would take to sell the entire quantity half the time you would have more than \$705.50 on the shelf and half the time you would have less than half this amount.  The company’s annual cost of carrying inventory is 18%.  That is it costs 18 cents each year to maintain a dollar’s worth of inventory in the warehouse.  You can have your company’s carrying cost calculated at no charge by filling out the questionnaire on our web site, www.EffectiveInventory.com.

The adjusted margin for this item would be 4.3%:

[\$208 – (18%*705.50)] ÷ \$1,888 = 4.3%

One of our “rules of thumb” is to critically look at any item that produces an adjusted margin less than 7%.  This minimum profitability level normally provides the funds necessary to cover the costs of processing orders and other overhead expenses.  As the customer is not going to purchase other goods from the distributor, they don’t have the opportunity sell other products to change this into a profitable situation.

Remember:  It is critical that you consider all of your expenses when determining the profitability of a product or customer!