At the end of every fiscal year or when conducting a financial analysis, a company calculates its profits by subtracting the production cost of a product from the selling price. Production costs include the cost of raw materials, labor, fuel and equipment.

Though the calculation is helpful, it can be misleading. Your company incurs additional costs before the finished product enters the market. Production costs aside, there are marketing, transportation, licensing, insurance, warehouse, and security costs. Adjusted gross margin considers all these additional costs when calculating the company's profit.

Suppose your company made a total of \$100,000 in 2020 from designer shoe sales. Your company paid \$50,000 for raw materials, workers, power, packaging, and shipping to retail stores. You also incurred inventory carrying costs such as taxes, insurance, warehouse rent, and utilities amounting to \$10,000. For the simple gross profit calculation, your company made \$50,000 in profits.

• Total sales-the cost of production
• \$100,000 - \$50,000 = \$50,000.
• The gross margin would be \$50,000 / \$100,000 x 100 = 50%

To calculate the adjusted gross margin, your company will subtract the cost of production and the inventory carrying costs such as taxes, insurance and warehouse rent costs from the total sales. In that case, the profit will be:

• Total sales-(cost of production + inventory carrying costs)
• \$100,000 - (\$50,000 + \$10,000) = \$40,000
• The adjusted gross margin will be
• Adjusted gross profit / total sales = \$40,000 / \$100,000 x 100 = 40%

## Significance of an Adjusted Gross Margin

An adjusted gross margin helps you to evaluate your company's position in the market. The larger the company, the more the inventory carrying costs. Suppose you are competing for the same market with a smaller company. In that case, you need to calculate your adjusted gross margin to correctly position your product's prices without operating at a loss.

The adjusted gross margin is also crucial when determining your company's taxable income. Deducting production, marketing, sales commissions, and insurance costs from your total revenue will reduce your taxable income. Failure to include the inventory carrying costs will make you pay more taxes, thus reducing your business's revenue.

Another importance of calculating adjusted gross margin is it helps your company gauge the profitability of a product. For instance, let's say your company produces school buses. If you decide to introduce a luxury car production line, calculating that line's adjusted gross margin will inform you if the new line is profitable or not.

## Adjusted Gross Margin vs. Gross Margin

Adjusted gross margin represents your actual profits after deducting the cost of goods sold and the expenses you incurred while storing and carrying the inventory. It gives you the exact amount of revenue returned from your products' sale, accounting for all expenses incurred from the production stage until the product sells.

On the other hand, gross margin measures your company's gross revenue after deducting production costs from the total sales. This is selling price minus production cost without considering additional costs such as inventory storage, licensing, insurance or taxes.

The latter gives a false estimate of the return on investment because when the additional costs are deducted, the profit left is lower than the expected earnings. Using the gross margin calculation can hurt your business in the long run by paying more taxes than required and selling products at a loss.