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Products making only small positive gross margin percentages, are not doing enough to justify their existence, for the following reason.
Product A is making a gross margin of 1%. The combined selling, administrative, and finance expenses, for the business equals 12% of sales. We argue then that 12% of each sales dollar generated has to cover the indirect overheads, consisting of all selling, administrative, and finance expenses. Therefore Product A is effectively making an 11% net loss.
Gross Margin (1%) MINUS Indirect overheads (12%) = NET LOSS -11%.
If the product in the above example is to be kept, the following would need to occur
to enable it to have a net profit-
We have come across those that firmly believe that any product earning a small gross positive margin is still offering a valued contribution to their business. What they fail to understand is that the small margin is only reducing a net loss that has already been incurred by the business. If we change the above example and assume that every product sold had a gross margin of 1%, then the net loss for the business would be 11%.
There is only one situation where it would be justified to keep product A. That would be a situation when there were other products sold to the same customer with high profit margin percentage’s. To avoid upsetting the customer, and risk losing a substantial amount of profit generated by that customer (if that customer went to another supplier), it may pay to carry the net loss that product is contributing to.