Adjusted Gross Margin: Overview, Formula, Example

What Is an Adjusted Gross Margin?

Adjusted gross margin is a calculation used to determine the profitability of a product, product line or company. The adjusted gross margin includes the cost of carrying inventory, whereas the (unadjusted) gross margin calculation does not take this into consideration.

The adjusted gross margin thus provides a more accurate look at the profitability of a product than the gross margin allows because it takes additional costs out of the equation that affects the business's bottom line.

The Formula for Adjusted Gross Margin Is

 $\begin{aligned} &\text{Adjusted Gross Margin}_n = \frac{GP_n - CC_n}{S_n} \\ &\textbf{where:}\\ &n=\text{period}\\ &GP=\text{gross profit}\\ &CC=\text{carrying cost}\\ &S=\text{sales}\\ \end{aligned}$​Adjusted Gross Marginn​=Sn​GPn​−CCn​​where:n=periodGP=gross profitCC=carrying costS=sales​

What Does the Adjusted Gross Margin Tell You?

Adjusted gross margin goes one step further than gross margin because it includes these inventory carrying costs, which greatly affect the bottom line of a product's profitability.

For example, two products could have identical, 25% gross margins. Each, however, could have different associated inventory carrying costs. One inventory item might be more expensive to transport or carry a higher tax rate, get stolen more often, or need refrigeration. Once the cost of each of these factors is included, the two products could show significantly different margins and profitability. Analysis of adjusted gross margin can help identify products and lines that are underperforming.

Inventory carrying costs include receiving and transferring inventory, insurance and taxes, warehouse rent and utilities, inventory shrinkage, and opportunity cost. For companies that carry large inventories or incur high inventory costs, the adjusted gross margin is a better metric of profitability since carrying costs are not ordinarily accounted for in inventory.

Carrying costs would include items such as inventory insurance and all other costs of storing and safeguarding the inventory supply. Other common inventory-carrying costs include:

• receiving and transferring inventory
• insurance and taxes
• warehouse rent and utilities
• security systems and monitoring
• inventory shrinkage
• opportunity costs

Once these items are included, the adjusted gross margin can fall substantially compared to the unadjusted gross margin. Inventory costs run generally between 20% and 30% of the cost to purchase inventory, but the average rate varies based on the industry and size of the business.

Example of How to Use the Adjusted Gross Margin

For example, if a company's fiscal year gross profit is $1.5 million dollars and sales of $6 million. At the same time, it has an inventory carrying cost of 20% and the average annual value of inventory is $1 million, then the annual carrying cost of inventory would be $200,000. The gross margin would be:  $\$1,500,000 \div \$6,000,000 = 25\%$$1,500,000÷$6,000,000=25%

The adjusted gross margin, however, would be:

 $\frac{(\$1,500,000 - \$200,000)} {\$6,000,000} = 21.67\%$$6,000,000($1,500,000−$200,000)​=21.67%