Many organizations assess profitability by calculating the gross margin of products. Gross margins are calculated with the formula:
Annual Profit Dollars ÷ Annual Sales Dollars
The problem with this metric is that the amount of inventory maintained in stock is not considered in the calculation. Whether $1,000 or $100,000 is maintained in stock the gross margin will be the same. This may encourage buyers to overbuy to receive a lower cost per piece and increase the gross margin.
The adjusted margin is similar to the gross margin in that it divides profit dollars by the average inventory investment. But the adjusted margin:
- subtracts the cost of carrying the average inventory investment from the profit dollars and
- is a more accurate predictor of profitability.
The adjusted margin is calculated with the formula:
[Annual Profit Dollars – (Average Inventory Value * Carrying Cost %)]÷ Annual Sales Dollars
The average inventory value is the average amount of inventory you will have on hand during the time it takes to sell or use the entire purchased quantity. For example, if you buy six month’s supply of inventory the average inventory value would be a three month supply.
The carrying cost percentage is the cost of maintaining a dollar’s worth of inventory for an entire year. Your organization’s carrying cost percentage can be calculated by answering the questionnaire in the resources section of www.EffectiveInventory.com.
Let’s look at the gross margin and adjusted margin of two products:
Product “A”
Annual Sales $12,500
Annual Cost of Goods Sold $ 9,500
Average Inventory Value $ 7,500
Annual Inventory Carrying Cost 20%
Gross Margin = ($12,500 – $9,500) ÷ $12,500 = 24%
Adjusted Margin = [($12,500 – $9,500) – ($7,500 * .20)] ÷ $12,500 = 12%
Product “B”:
Annual Sales $12,500
Annual Cost of Goods Sold $10,000
Average Inventory Value $ 2,500
Annual Inventory Carrying Cost 20%
Gross Margin = ($12,500 – $10,000) ÷ $12,500 = 20%
Adjusted Margin = [($12,500 – $10,000) – ($2,500 * .20)] ÷ 16%
Even though “Product B” has a lower gross margin, its adjusted margin is higher thus showing that Product B contributes more to the company’s profitability!