Where is my profit???

Discussion in 'Growing and Managing a Business' started by JAC, Nov 7, 2012.

  1. JAC

    JAC
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    This is a very basic question about retail sales that puzzles me. I hope someone can help me understand how this works.


    If my cost on an item is $100.00 and I mark the item up 100% (sale price $200.00 which is suggested retail price by supplier), then I pay my sales associate a 10% commission ($20.00), and my cost of goods sold is $5.00 then I should realize a profit for each item sold of $75.00, right?

    $200 < sale price
    -$100 <cost of item
    -$ 20 <employee commission
    -$ 5 <other costs of goods sold
    $75 <profit

    But wait, now I have sold the item and I have to replace it, so I have to spend another $100.00 to replace the inventory.

    $200 < sale price
    -$100 <cost of item
    -$ 20 <employee commission
    -$ 5 <other costs of goods sold
    $ 75 <profit
    -$100 <replacement cost
    <$25> < loss

    Does this mean I lose $25.00 on every item I sell?

    Of course if I do not replace the item I will keep the $75. profit, but that can only happen once (when I go out of business and do not replenish any inventory.)

    Please explain how one can make a profit with this model? A mark up of greater then 100% would make me less competitive and thereby lose sales, but if I am losing $25.00 on each item sold,
    obviously I will be out of business very soon.

    Explain it to me like I am a 6 year old please :)
     
  2. ArcSine

    ArcSine
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    Where the wheels come off your analysis is when you deduct the cost of the replacement item against the net profit of the first item. In so doing, your "mini income statement" has the revenue of just one item, less the cost of two items.

    Instead, the cost of the replacement unit should be viewed as a deduction against its own revenue, when that occurs.

    Equivalently, you could look at it this way: Having deducted the cost of the second item from the net profits of the first, then the revenue from the second item has only the $5 COGS and the $20 commission remaining to be deducted (you can't deduct the $100 cost of the second item twice!). So the "mini income statement" of the second item reads,
    200 - 5 - 20 = 175 net profit.

    Hence you lost 25 on the first item, made 175 on the second, for a total of 150 net profit on two items, averaging 75 per.

    Note, the foregoing alternative viewpoint is not theoretically correct, it's just a way of showing that your incorrect deduction of the replacement item's cost against the first item's revenue still yields a final correct result, when you follow the thinking through to the end.

    One more equivalent way of looking at it: The purchase of an inventory item is not an expense per se, it's just a swap of one asset (cash) for another (inventory item). As a result of that swap you haven't lost anything; total assets are unchanged. It's only when that asset (i.e., the replacement item) goes out the door under a customer's arm that it becomes an expense, but at that moment you've also earned $200 of revenue against which to deduct the $100 item cost.
     
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  3. JAC

    JAC
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    Thank you ArcSine, you made that very understandable and clear.
     

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