Gross Margin Analysis and Impact to Inventory Changes

Gross margin is a commonly cited measure of business performance and is often used as a proxy for evaluating the overall business model. The business model is a function of sales and the direct costs associated with generating those sales. Included in the costs of sales is the cost of inventory. There are several ways management can make changes to inventory that affect gross margin analysis to include: increasing the amount of sales made in the same period of time, spending less money on inventory by asking for price breaks from suppliers and increasing unit price.

Gross margin is calculated by taking the difference between sales and the cost of goods of sold, dividing the difference by sales and then multiplying the quotient by 100. For example, if the cost of goods sold is $10,000, and sales are $20,000, the gross margin is 50 percent. A high gross margin equates to a good business model. As the cost of goods sold -- inventory -- increases in value, gross margin decreases and vice versa. Likewise, if sales go up, gross margin increases and vice versa.

One option for a business with weak gross margins is to focus on increasing the number of times inventory turns in a given time period. This is also referred to as inventory turnover. Assuming every sale is profitable, and there are favorable economies of scale, more sales generates a higher level of profitability.

Another way gross margin analysis can impact inventory is through supplier relationships and pricing. The more power and control suppliers have, the higher pricing will be. Consider renegotiating inventory prices, delivery costs, transaction costs or any other cost associated with inventory purchases that the supplier has control over. A decrease in the cost of inventory will lead to an in increase gross margin.

Pricing has a direct impact on inventory turnover; the lower the price, the more times inventory will turn. An increase in price will also lead to an increase in gross margin as long as the demand for inventory remains the same. As a result, gross margin analysis can lead to a focus on inventory that is in high demand with low competition.