Margin is a key metric for any business. It represents the delta between a company’s revenue and expenses, from which emerges cash to reinvest in the growth of the business or to return to shareholders. Without sufficient margin, businesses run the risk of not growing as fast, innovating too slowly, failing to attract top talent, or disappointing shareholders. So we can all agree that margin is good, right?

Well, when it comes to excess inventory, margin can be a sensitive topic, particularly when viewed through the lens that any type of inventory discounting hurts a company’s full margin earnings potential. Layer in the fact that different individuals or teams within an organization are often responsible for optimizing different levers that feed into it, and suddenly you have a potentially political situation. To avoid any potential conflict, we’ve outlined different ways to look at margin and how to create a margin alignment plan for closeouts.

Understanding margins

In the world of B2B liquidation, the key source of potential conflict is the difference between gross margin and operating margin. So what’s the difference? Let's start by defining some terms and calculations to understand the difference between the two margins. We’ll then layer in how unsold inventory impacts them. (Warning: math ahead!)

Gross margin

Gross margin is comprised of two components: revenue and the cost of good sold (COGS). Revenue represents the amount paid by buyers for a set of goods, and COGS represents the costs (ingredients, labor, packaging, etc.) incurred by a manufacturer to produce those goods. COGS does not include other expenses critical for selling, marketing, and distributing these goods, nor does it include other elements of business overhead.. To calculate one’s gross margin, simply subtract the cost of goods sold (COGS) from your revenue. For example, if you sell a case of goods for $40, and they cost $10 to manufacture, then your gross margin is $30.

Gross margin = Revenue - COGS

Example: $40 - $10 = $30

To look at your gross margin rate, take your gross margin and divide it by your revenue. In the example above, that means $30/$40, or a gross margin rate of 75%.

Gross margin rate = Gross margin / Revenue or (Revenue - COGS) / revenue

Example: $30 / $40 = 75% or ($40 - $10) / $40 = 75%

The important thing to note here is that this metric focuses on your total goods sold, regardless of the price they were sold at. It doesn’t account for any goods that went unsold entirely. So how do you factor in those unsold goods?

Operating margin

Operating margin factors in business expenses that aren’t otherwise included in COGS. This includes freight costs and disposal fees, as well as the costs associated with manufacturing  inventory that went completely unsold (and was ultimately donated or destroyed). To calculate operating margin, simply subtract operating expenses from gross margin:

Operating margin = Gross margin - operating expenses

To calculate operating margin rate, simply divide your operating margin by total revenue, just like you did with gross margin:

Operating margin rate = Operating margin / revenue or

(Gross margin - operating expenses) / revenue

To assess the impact of unsold inventory on a company’s operating margin, you’ll need to account for both the operating expenses associated with manufactured but unsold inventory, plus any handling or disposal fees associated with its end of life. To arrive at the former, simply multiply the unit cost of a case of inventory by the amount of unsold cases.

Operating expense of unsold inventory = COGS per case * # of cases of unsold inventory + disposal fees

A hypothetical example

To summarize what we’ve learned up to this point: gross margin only includes inventory that is sold, whereas operating margin includes the impacts of inventory that isn’t sold. But therein lies the source of conflict: the sale of discounted inventory has the potential to improve operating margin but lower gross margin, just as a decision not to discount excess inventory (and instead donate or dump) can improve gross margin but lower operating margin. What?! 

Let’s take a look at how these numbers play out with a complete example. For the sake of easy math, we’ll use round numbers, assume freight and hauling costs are comparable between different scenarios (and therefore exclude from the calculations), and exclude all other operating costs.

Let’s say you have 100 cases of inventory, which each have a cost of goods of $5 per case. Normally, a manufacturer sells these cases at the wholesale price of $10 per case. In a perfect world, you’d sell all 100 cases at $10 each. As a result, you’d wind up with a revenue of $1,000 from a cost of goods sold (COGS) of $500. That means $500 in gross margin, or a rate of 50%.

Revenue - cost of goods sold = gross margin

$1000 - $500 = $500

Gross margin / revenue = gross margin rate

$500 / $1000 = 50%

Your operating margin is also $500, or 50%, so in this case gross margin (GM) and operating margin (OM) are the same. This is because there’s no unsold inventory impacting the operating margin. This is, of course, the ideal outcome.

Operating margin = Gross margin - Operating expenses

$500 - (0 cases * $5 per case) = $500

Operating margin rate = Operating margin / revenue = 

$500 / $1000 = 50%

Now, let’s say that you only sell 80 cases of that inventory and dump the other 20. You’ve sold 80 cases at $10 per case, generating $800 in revenue on $400 COGS (80 cases at $5 per case). While this results in $100 of less gross margin than had sold all 100 cases ($400 vs. $500), it is at the same gross margin rate (50% vs. 50%).

Revenue - cost of goods sold = gross margin

$800 - $400 = $400

Gross margin / revenue = gross margin rate

$400 / $800 = 50%

If you’re only looking at gross margin rate, you’ve hit the same number as if you had sold all 100 cases, and you could simply dispose of the remaining 20 cases. But that’s not the right decision, right?

We don’t think so! By doing that, this hits your operating expenses from writing off unsold inventory and lowers your operating margin by $100 (20 cases @ $5 COGS per case). Combined with your lower gross margin from less revenue, this results in a lower operating margin and operating margin rate.

Operating margin = Gross margin - Operating expenses

$400 - (20 cases * $5 per case) = $300

Operating margin rate = Operating margin / revenue

$300 / $800 = 37.5%

Alternatively, instead of destroying those extra 20 cases, you could choose to sell them at a discount. Again, for the sake of easy math, let’s say you discount them 50%, so now you’re liquidating them for $5 per case, or at the same level as your COGS. In this scenario, you’ve sold 80 cases at $10, and now 20 cases at $5, for a combined revenue of $900 ($800 full price, $100 from discounting). This results in a gross margin of $400, and a gross margin rate of ~44%.

Gross margin = Revenue - cost of goods sold = gross margin

$900 - $500 = $400

Since no cases are being dumped, there are no operating expenses associated with written off inventory.

Operating margin = Gross margin - Operating expenses

$400 - (0 cases * $5 per case) = $400

Operating margin rate = Operating margin / revenue

$400 / $900 = 44.4%

Intuitively, it would make sense that this is a better outcome for the business than simply throwing those 20 cases away. This comes through in the operating margin rate of 44.4% versus 37.5%. But… 

Let’s also look at gross margin rate in this scenario. Instead of  a 50% gross margin rate, you’re now at a 44.4% gross margin rate.

Gross margin rate = gross margin / Revenue

$400 / $900 = 44.4%

Your gross margin rate actually got worse from selling more product, because you sold them at a discount. Through the narrow lens of gross margin rate, selling excess inventory at anything other than full price will have detrimental impacts (which is why companies invest a lot of time and energy into demand planning to prevent excess in the first place).

Conflicting priorities

And thus, the source of conflict emerges: the person or team responsible for gross margin rate is actually at odds with the person or team who owns operating margin rate. 

On the one hand, you have a closeouts team looking to increase operating margin by selling as much product as they can, even if that means discounting it. On the other, you have stakeholders that are “accidentally” being motivated to destroy excess product instead of discounting it, all to preserve gross margin rate.

How to get gross margin leaders on board with closeouts

From our perspective, in instances where excess inventory is inevitable, it’s pretty much never good to dump product when you could sell it. Any revenue you can recover will help your bottom line, and that’s great for shareholders. But this takes acknowledgment from senior leadership that a tension exists. Once you’re aware of these potential conflicts, what can you actually do to resolve them? Here are five tips to help you come to an agreement with your gross margin stakeholders.

1. Address conflict head on

Trying to dance around the topic is only going to prolong any potential conflict. Instead, clearly outline the problem and involve other stakeholders in the process from the start. You’re on the same side here, so acknowledge your colleague’s point of view and approach it like teammates to find a solution that works for everyone.

2. Choose the right metrics

Highlighting operating margin, rather than gross margin, can paint a more complete picture of the financial impacts of an excess inventory management program. Because gross margin omits the costs of goods that aren’t sold, it can misrepresent the reality of your financial situation. Everyone wants to see operating margins improve, so focusing on it can paint you in a good light.

3. Get executive buy-in

Nothing goes further than getting a company’s senior most leaders to acknowledge that it is okay to see negative gross margin impact from a corporate commitment to minimize waste and boost operating margin. Better yet is the introduction of performance incentives that motivate this behavior.

4. Present numbers in context

You can absolutely still emphasize gross margin and operating margin when you report numbers up the chain. The important thing is that you provide proper context. Make it clear to executives why it looks like gross margin dropped, and support it with increased revenue and increased operating margin.

5. Agree on a maximum discount rate

Work with your finance team and other stakeholders to set a maximum discount rate. Once you hit that threshold, you can instead find a donation partner to send the goods to. You’ll get tax benefits to recoup some of your costs, and it can be a great way to meet everyone’s goals. Where this threshold falls will depend on your COGS, margins, buyer partners, state tax credits and more, so it will take some research, but it’s worth the effort.

Being aware of any potential conflicts can help you resolve them quickly. Focusing on working together, rather than as competing stakeholders, and you can gain support for liquidation efforts across the business.

For more on some of the challenges and harsh realities of CPG liquidation, download our eBook, 7 Truths about excess inventory in CPG.