An important tool in analyzing inventory, sales, and profitability is gross margin return on inventory investment (GMROI)—also known as GMROII. The GMROI calculation assists store owners and buyers in evaluating whether a sufficient gross margin is being earned by the products purchased compared to the investment in inventory required to generate those gross margin dollars.
Retail companies often find that the majority of their money can be tied up in inventory. It can be a company's biggest asset and biggest liability at the same time. Retailers underestimate the cost of inventory in their stores and often fail to realize that a product on the shelf that's not selling—known as not turning—and can cost them money.
Let's say that within the same year, XYZ Shoe Store sells boots for $100, which were purchased for $75. The firm's gross margin is $25 per pair of boots and the inventory's median value throughout the year is $20. The average inventory is the item price minus discounts plus freight and taxes.
The firm's GMROI, then, is $25 for the boots divided by the median value of $20, which equals 1.25% (GMROI is $25/$20 = 1.25).
To calculate the median inventory value the firm would calculate the total value of all goods on hand at specific dates throughout the year. If they do this calculation four times a year, they would total the four values together and divide the result by four.
GMROI demonstrates whether a retailer can make a profit on their inventory. As in the above example, GMROI is calculated by dividing the gross margin by the inventory cost. Keep in mind that gross margin is the net sale of goods minus the cost of goods sold.
As long as the GMROI is higher than 1 (i.e., not in the negative), the company in question is selling its merchandise for more than its cost. So, in XYZ Shoe Store's case, the revenue they earn on those boots is 1.25% of their cost.
Find the average inventory at cost. Remember, the average inventory is item price minus discounts plus freight and taxes. To calculate the average value, add the beginning cost inventory for each month plus the ending cost inventory for the last month of the period in question. If calculating for a season, divide by 7. If calculating for a year, divide by 13.
Calculate the gross margin of the item—or the net sale of goods minus the cost of goods sold. This is the difference between what an item costs and what it sells for. It's also known as the gross percentage of profit, or the margin.
Divide the sales by the average cost of inventory and multiply that sum by the gross margin percentage to get GMROI.
The result is a ratio indicating the inventory investment 's return on gross margin.
Here's how that looks:
- Annual Sales = $150,000
- Avg Inventory Cost = $65,000
- Gross Margin = 49%
$150,000 / $65,000 X 49% = $1.13
So in this scenario, the retailer is making $1.13 for every $1.00 invested in inventory. Which is not great. GMROI highlighted an issue. The retailer might consider a 49% gross margin satisfactory, but the numbers imply otherwise.
Why GMROI Matters for Retailers
Retailers need to be well aware of the GMROI on their merchandise because it allows them to determine how much they are earning on for every dollar they invest. If the inventory isn't selling, it may be priced too high, but marking it down too much will lead to a smaller gross margin.
Of course, if XYZ Shoe Store wants to increase its GMROI on those boots, they could try selling them for $200. But then they run the risk of overpricing them and hurting potential sales. It's not worth the risk if the boots are a good seller at that price, but it may be worth it if sales are slowing, or if the demand is so great that the firm thinks customers would pay more.
The GMROI calculation can be used to measure the performance of the entire store. However, it is more effective if used for a particular department or category of merchandise.
For example, XYZ would check GMROI for boots and shoes and accessories individually to ensure she is getting the most return on her investment. Calculating GMROI by category is powerful because overall numbers may initially seem good. However, the closer examination could show products that are a "drain" on investment. If this is the case, the retailer can take action to resolve the problem.