Understanding Landed Costs & The Profit Margin Formula

Working out your profit margins should be simple. If you buy a product for $x, and sell it for $x + $y, then $y is your profit – right? Unfortunately, it’s not quite so easy. In order to accurately gauge your profit margins, you need to be able to answer two questions:

• What is the profit margin formula?
• What is landed cost?

To answer these, we first need to look at gross margins.

What Are Gross Margins?

First, let’s look at what gross profit is. Gross profit is the revenue you earn minus the costs of production or purchasing items. These costs go beyond the purchase price of the items, and we’ll get to that later. For now, it’s enough to understand that:

Gross Profit = Revenue – Costs

The gross profit is a quick way of understanding how your business is doing at a basic level. It differs from net profit, as net profit takes into account operating costs (salaries, rent, marketing, and so on), whilst gross profit is solely about what you’re selling.

Gross profit margins show the percentage of revenue above the costs of goods sold. The higher the margin, the better, as your company is earning more money per dollar spent on goods. So how do you calculate profit margin formula? It’s easier than it sounds. Simply take the gross profit and divide it by revenue. We can express this in two ways:

Gross Profit Margins = Gross Profit / Revenue

or

Gross Profit Margins = (Revenue – Costs) / Revenue

Let’s plug in some numbers to see how this works. For ease, we’re going to take some simple figures rather than something more representative of actual business costs.

• Company A earned $1000, and spent $400 on goods. Their gross profit is therefore $1000 – $400, so $600.
• Company B earned $800, and spent $200 on goods. Their gross profit is therefore $800 – $200, so $600.

In terms of gross profit, they’re both doing equally well. But this isn’t the best way of looking at it. Now let’s look at their gross profit margins.

• Company A’s gross profit is $600, and their revenue is $1000. If we divide 600 by 1000, we get 0.6. That means that for every dollar of revenue, 60% was profit.
• Company B’s gross profit is $600, and their revenue is $800. If we divide 600 by 800, we get 0.75. That means that for every dollar of revenue, 75% was profit.

It’s clear here that Company B are doing much better than Company A – they have a much higher ratio of profit to expense. Of course, it’s possible that by considering other metrics we might see other differences. Perhaps B has higher operating costs than A, so their net profits (which take that into account) might be lower. But in terms of making money off product, B are excelling. 

If you wanted to repeat this with net profits rather than gross profits, you can adjust the formula like so:

Net profit = Revenue – Total Expenses

Where total expenses = cost of goods, operating costs, etc

Net profit margins = (Revenue – Total Expenses) / Revenue

What Are Landed Costs?

Landed cost definition (from Business Dictionary): The total cost of a landed shipment including purchase price, freight, insurance, and other costs up to the port of destination. In some instances, it may also include the customs duties and other taxes levied on the shipment.

In order to accurately fill in profit margin formulae, you need to account for landed costs. Calculating landed costs can seem tricky at first, and it requires a certain amount of estimation, but it’s something you’ll grow familiar with over time. Brightpearl does have a feature that can allocate landed costs for you.

Let’s look through a simple example to show why landed costs matter. In this case, you’re looking to buy an item – let’s say you want 5000 HDMI cables – and weighing up which supplier to choose.

• Supplier A charges $1 per HDMI cable, with a 10% discount on bulk orders over 1000 items. This would cost you $4,500. If you sell each cable at $5, your profit margin is 0.82. ((25,000 – 4500) / 25,000).
• Supplier B charges $1.05 per HDMI cable, and has no bulk discounts available. This would cost you $5,250. If you sell each cable at $5, your profit margin is 0.79. ((25,000 – 5,500) / 25,000).

Looking at the purchase price alone, it makes sense to choose Supplier A. However, let’s take a look at the additional costs that might come up.

• Supplier A charges a flat rate of $500 per shipment. They’re based in a country that has no preferential agreements with yours, and so has an import duty rate of 25%.
• Supplier B bases their shipping fee on weight, and it comes to $250. They’re based in a country that has a preferential agreement with yours, and the import duty rate is only 10%.

Let’s use these in our simplified landing cost formula. Instead of costs = purchase price, cost now equals the total.

• Supplier A’s costs: $4,500 + $500 + ($4,500 x 0.25) = $6125
• Supplier B’s costs: $5,250 + $250 + ($5,250 x 0.1) = $6025

You can already see here that Supplier B’s landed costs are less. If we re-do the gross profit margin formula with these new costs, you’ll see the difference even more.

• Purchasing from Supplier A gives us (25,000 – 6125) / 25,000 = 0.755 
• Purchasing from Supplier B gives us (25,000 – 6025) / 25,000 = 0.759

You might look at these and think that they’re very similar, so why did we bother adding in this landed costs formula? If you take a step back and compare them to the original assessment, you can see the difference more clearly.

Without landed costs taken into account, purchasing from A gave us an assumed profit margin of 0.82, compared to the more accurate 0.755. Supplier B gave us 0.79, compared to 0.759. If you had used the figure without landed costs in your assessment for the year, your budget would be out.

If you’d bought from A and estimated your profit margin without taking landing costs into account, you might end up in the following situation. You expect to sell 500,000 HDMI cables over the course of a year. Your profit margin is 0.82, so you expect to see $410,000 profit. You budget with this in mind. Unfortunately, the accurate margin including landed costs leads to you only seeing $377,500 in profit. That’s an overestimation of $32,500 to account for.

An Accurate Landing Costs Formula

The above example is a very simplified one – it doesn’t break down exactly how you get the total costs. In order to do that, you need to look at everything that could possibly play into it. The definition earlier states that it should include item price, shipping, insurance, customs duty, and other taxes. We can capture this in the following landed costs formula:

Item Price + Shipping + Customs + Risk + Overhead = Landed Cos

1. Item Price.

This is simple – it’s the rate you’re charged for the item, and nothing else. Make sure to take into account bulk or wholesale discounts here.

2. Shipping.

This is where you count any costs associated with freight. That can be the packaging, the handling, and the transportation itself. It’s worth making sure you speak to your freight forwarder, so that you understand exactly what is included and what the total cost might be.

3. Customs.

Here, customs is a stand-in for any import duty, harbor fee, and similar. If it’s something the customs agency deals with, plug it into the formula here. These rates can change, so you need to keep up to date on what trade deals your country has, what ports are used, and other things that might impact the cost.

4. Risk.

No matter how good the supplier and freight company, accidents happen. Covering risk with insurance or buying extra stock in case of faults are things that would go in this category. 

5. Overhead.

Overhead is the ‘anything else’ part of the equation, but that doesn’t mean it isn’t important. Exchange rates, additional travel, and due diligence costs go in here.

Looking back to our HDMI cable example, let’s add in a couple more stand-in figures. The shipment is insured for $200, and the additional overhead is $100. The formula for calculating landed cost with Supplier A would look like this:

$4,500 + $500 + (4,500 x 0.25) + $200 + $100

Using Landed Costs In The Profit Margin Formula

This is where it starts to look complicated, but hopefully by working through it step by step you can see how it all fits together. Here’s the gross profit margin formula with the landing costs formula in place of costs:

Gross Profit Margin = Revenue – (Item Price + Shipping + Customs + Risk + Overhead) / Revenue

By using landed costs to work out gross profit margins, you can create more accurate assessments of your business’ financial future. It may still rely on estimation, but that estimation covers all the potential costs, not just the base price of a product. Using software like Brightpearl to account for inventory gives you the option to calculate landed costs automatically – avoiding having to manually use this formula every time.