Adjusted average gross margin: Meaning, Criticisms & Real-World Uses

What Is Adjusted Average Gross Margin?

Adjusted Average Gross Margin is a sophisticated metric within financial accounting that provides a more granular view of a company's profitability by factoring in various costs often overlooked in a standard gross margin calculation. Unlike the basic gross margin, which primarily considers only the direct cost of goods sold (COGS), the Adjusted Average Gross Margin incorporates additional expenses related to maintaining and managing inventory over a period. This enhanced measure offers a clearer picture of the true profit derived from sales, particularly for businesses with significant inventory holdings or complex supply chain management.

History and Origin

The evolution of profitability metrics has seen a continuous refinement to provide more accurate insights into a business's operational efficiency. While gross margin has long been a fundamental measure, its simplicity can sometimes mask the full cost burden associated with inventory. The concept of "adjusted" financial measures, including Adjusted Average Gross Margin, gained prominence as companies and analysts sought to understand the impact of various "off-balance sheet" or less direct costs on core performance. This need became particularly evident in industries where inventory carrying costs significantly influence overall profitability.

The broader adoption of such adjusted metrics often aligns with the increasing use of non-GAAP financial measures by companies to supplement their GAAP-compliant financial statements. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), have provided extensive guidance over the years regarding the appropriate presentation and reconciliation of non-GAAP measures to ensure transparency and prevent misleading disclosures. The SEC's Compliance & Disclosure Interpretations (C&DIs) on non-GAAP financial measures have been updated multiple times since their initial adoption in 2003, with further revisions in 2010, 2016, 2018, and 2022, reflecting the ongoing efforts to clarify how companies should present these alternative metrics.⁵, ⁶

Key Takeaways

Adjusted Average Gross Margin provides a more comprehensive view of profitability by including inventory carrying costs in addition to the cost of goods sold.
This metric is particularly relevant for businesses that manage substantial inventory, such as retailers and manufacturers.
It helps reveal the true efficiency of a company's sales operations after accounting for costs like warehousing, transportation, insurance, and obsolescence.
Understanding Adjusted Average Gross Margin can inform pricing strategies, inventory management, and overall business strategy.
As a non-GAAP measure, it requires careful consideration and reconciliation to comparable GAAP metrics for proper financial analysis.

Formula and Calculation

The Adjusted Average Gross Margin refines the traditional gross margin by incorporating various inventory carrying costs. These costs typically include expenses like warehousing, transportation, insurance, taxes on inventory, and potential shrinkage or obsolescence.

The formula can be expressed as:

\text{Adjusted Average Gross Margin} = \frac{(\text{Average Revenue} - \text{Average COGS} - \text{Average Inventory Carrying Costs})}{\text{Average Revenue}} \times 100\%

Where:

Average Revenue: The total revenue generated from sales over a specific period.
Average COGS (Cost of Goods Sold): The direct costs attributable to the production of the goods sold by a company over the same period.
Average Inventory Carrying Costs: The aggregate expenses associated with holding and managing inventory over the period. These can include:
- Warehousing costs (rent, utilities, maintenance)
- Transportation and logistics costs (inbound and outbound)
- Insurance on inventory
- Taxes on inventory
- Obsolescence or spoilage costs
- Opportunity cost of capital tied up in inventory

The "average" component of the Adjusted Average Gross Margin signifies that these figures are typically calculated over a designated reporting period (e.g., quarter, year) or across multiple product lines to provide a smoothed, representative value.

Interpreting the Adjusted Average Gross Margin

Interpreting the Adjusted Average Gross Margin involves assessing the efficiency with which a company generates profit from its sales after accounting for a more comprehensive set of direct and inventory-related costs. A higher Adjusted Average Gross Margin generally indicates better cost control and more efficient inventory management. Conversely, a declining or lower Adjusted Average Gross Margin suggests that the costs associated with producing and holding goods are eroding a greater portion of the revenue.

For example, two products might have identical standard gross margins, but their Adjusted Average Gross Margins could differ significantly due to varying inventory carrying costs. One product might be more expensive to transport, require specialized storage, or have a higher risk of obsolescence, leading to a lower adjusted margin. This metric helps management identify products or segments that are less profitable when all relevant costs are considered, informing decisions about pricing, product mix, and supply chain optimization. It offers a more accurate reflection of true product-level or business-segment profitability than the simpler gross margin alone.

Hypothetical Example

Consider a hypothetical company, "GadgetCo," which sells two types of electronic gadgets: "Gizmos" and "Widgets."

For the last quarter:

Gizmos:

Revenue: $1,000,000
Cost of Goods Sold (COGS): $600,000
Inventory Carrying Costs (storage, insurance, minor obsolescence): $50,000

Widgets:

Revenue: $1,000,000
Cost of Goods Sold (COGS): $600,000
Inventory Carrying Costs (specialized refrigerated storage, higher insurance, faster obsolescence): $150,000

First, calculate the standard Gross Margin for both:

\text{Gross Margin (Gizmos)} = \frac{(\$1,000,000 - \$600,000)}{\$1,000,000} \times 100\% = 40\%

\text{Gross Margin (Widgets)} = \frac{(\$1,000,000 - \$600,000)}{\$1,000,000} \times 100\% = 40\%

Next, calculate the Adjusted Average Gross Margin:
For Gizmos:

\text{Adjusted Average Gross Margin (Gizmos)} = \frac{(\$1,000,000 - \$600,000 - \$50,000)}{\$1,000,000} \times 100\% = \frac{\$350,000}{\$1,000,000} \times 100\% = 35\%

For Widgets:

\text{Adjusted Average Gross Margin (Widgets)} = \frac{(\$1,000,000 - \$600,000 - \$150,000)}{\$1,000,000} \times 100\% = \frac{\$250,000}{\$1,000,000} \times 100\% = 25\%

Even though both products have the same 40% gross margin, the Adjusted Average Gross Margin reveals that Gizmos are significantly more profitable (35%) than Widgets (25%) once the specific inventory carrying costs are factored in. This insight allows GadgetCo to make more informed decisions regarding pricing, promotions, and future product development, moving beyond a superficial assessment of profitability.

Practical Applications

Adjusted Average Gross Margin serves as a vital tool across various business functions and industries, offering a more nuanced perspective on profitability.

Retail and Manufacturing: In retail, particularly for grocery stores, Adjusted Gross Margin is a component in calculating Direct Product Profit (DPP). DPP takes adjusted gross margin and subtracts direct selling costs (like stocking labor, refrigeration electricity, and store space costs) to determine a product's true contribution to profit. This granular analysis helps retailers optimize shelf space, merchandising, and pricing strategies for individual items.³, ⁴ Manufacturers use it to assess the actual profitability of different product lines, taking into account unique storage, handling, and distribution costs associated with each.
Pricing and Product Strategy: By clearly identifying the full costs associated with producing and holding inventory, companies can set more accurate pricing strategies. Products with higher adjusted gross margins might warrant increased marketing efforts, while those with lower margins might need cost reduction initiatives or even discontinuation.
Supply Chain Optimization: Understanding the impact of inventory carrying costs on the Adjusted Average Gross Margin can drive improvements in supply chain management. Businesses can identify inefficiencies in warehousing, transportation, or inventory turnover that are eroding profitability and implement strategies to reduce these costs.
Mergers and Acquisitions (M&A) and Valuation: During M&A due diligence, analyzing the Adjusted Average Gross Margin provides potential buyers with a more realistic view of the target company's operational efficiency and underlying profitability, beyond what standard financial statements might immediately convey.

Limitations and Criticisms

While Adjusted Average Gross Margin offers a valuable, deeper look into profitability, it is crucial to recognize its limitations and potential criticisms.

First, as a modified metric, Adjusted Average Gross Margin is often considered a non-GAAP financial measure. This means it is not prepared in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), which are standardized accounting frameworks. Companies have flexibility in how they calculate such measures, which can lead to inconsistencies in definitions, labeling, and presentations across different companies or even within the same company over time.² This lack of standardization can make comparisons between companies challenging and potentially misleading for investors.

The U.S. Securities and Exchange Commission (SEC) has issued guidance to address potential issues with non-GAAP financial measures, emphasizing that they should not be presented in a way that is misleading or more prominent than comparable GAAP measures. The SEC specifically cautions against adjustments that exclude normal, recurring operating expenses necessary for a business's operations.¹ If companies are not transparent about the adjustments made, the Adjusted Average Gross Margin could obscure underlying operational weaknesses rather than illuminate them.

Furthermore, the calculation of inventory carrying costs can be subjective and may involve estimations, such as the opportunity cost of capital tied up in inventory. If these estimations are not consistently applied or are overly aggressive, the resulting Adjusted Average Gross Margin might not accurately reflect the true economic reality. While it provides a more comprehensive view than standard gross margin, it still does not account for all operating expenses, such as marketing, research and development, or general and administrative costs. Therefore, it should be used in conjunction with other profitability metrics, such as operating margin and net income, for a holistic view of financial performance.

Adjusted Average Gross Margin vs. Gross Margin

Adjusted Average Gross Margin and Gross Margin are both measures of profitability, but they differ significantly in the scope of costs they consider, offering distinct insights into a company's financial health.

Feature	Gross Margin	Adjusted Average Gross Margin
Calculation Basis	Revenue minus Cost of Goods Sold (COGS)	Revenue minus COGS minus Inventory Carrying Costs
Cost Scope	Limited to direct production costs.	Includes direct production costs plus various costs associated with holding inventory.
Primary Insight	How efficiently a company produces its goods or services.	The true profitability of a product or product line after accounting for full inventory burden.
Detail Level	A more general, top-level profitability metric.	A more detailed, refined profitability metric, particularly useful for inventory-heavy businesses.
GAAP Compliance	Typically a GAAP-compliant metric.	Often a non-GAAP financial measure, requiring careful disclosure and reconciliation.

The core distinction lies in the inclusion of inventory carrying costs. While gross margin reveals the percentage of revenue left after covering the direct costs of production, Adjusted Average Gross Margin goes a step further by subtracting expenses like warehousing, transportation, insurance, and obsolescence. This additional layer of cost analysis provides a more realistic picture of a product's or business segment's contribution to overall profitability, particularly where inventory management is a significant operational factor.

FAQs

What types of costs are included in inventory carrying costs for Adjusted Average Gross Margin?

Inventory carrying costs for Adjusted Average Gross Margin typically include expenses such as warehousing (rent, utilities, maintenance), transportation and logistics, insurance on inventory, taxes on inventory, and costs related to obsolescence or spoilage. It can also include the opportunity cost of capital tied up in inventory.

Why is Adjusted Average Gross Margin important for businesses?

Adjusted Average Gross Margin is important because it provides a more accurate understanding of a product's or company's true profitability by factoring in hidden or less obvious costs associated with managing inventory. This helps businesses make more informed decisions about pricing, inventory management, and business strategy.

Is Adjusted Average Gross Margin a GAAP metric?

No, Adjusted Average Gross Margin is generally considered a non-GAAP financial measure. It is a customized metric that companies use to supplement their standard financial reporting. As such, it is not prepared in accordance with Generally Accepted Accounting Principles (GAAP) and requires clear reconciliation to the most comparable GAAP measure.

How does Adjusted Average Gross Margin differ from Operating Margin?

Operating Margin is a broader profitability metric than Adjusted Average Gross Margin. While Adjusted Average Gross Margin focuses on revenue minus cost of goods sold and inventory carrying costs, Operating Margin subtracts all operating expenses (including sales, general, and administrative expenses, and research and development) from revenue to arrive at operating income. Operating Margin gives insight into a company's profitability from its core operations before interest and taxes.

Can Adjusted Average Gross Margin be negative?

Yes, Adjusted Average Gross Margin can be negative. This would occur if the combined cost of goods sold and inventory carrying costs exceed the revenue generated from sales. A negative adjusted gross margin indicates that a company is losing money on its products even before accounting for other operating expenses.