Calculate Your Gross Margin Return on Inventory Investment (GMROI)
Are You Getting What You Need From Your Merchandise?
Retail companies often find that the majority of money (cash) 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 (turning) actually costs money.
An important tool in analyzing inventory, sales, and profitability is GMROI (also known as GMROII), which stands for Gross Margin Return on Inventory Investment. The GMROI calculation assists storeowners 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.
What does all that mean? Let's say that within the same year, Madeline's Shoe Store sells boots for $100, which she purchases for $75. Her gross margin is $25, and the inventory's median value throughout the year is $20. Her GMROI then, is $25 divided by $20, or 1.25 percent.
Gross margin return on investment, or GMROI, demonstrates whether a retailer is able to make a profit on their inventory. As in the above example, GMROI is calculated by dividing gross margin by the inventory cost. Keep in mind what 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 Joe's case, the revenue he earns on those boots is 125 percent of his cost.
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 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 Madeline's Shoe Store wants to increase its GMROI on those boots, she could try selling them for $200. But then she runs 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 Madeline thinks customers would pay more.
How Do I Calculate GMROI?
Find the average inventory at cost. Average inventory is item price minus discounts plus freight and taxes. The average is found by adding 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. 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 times that 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 percent gross margin satisfactory, but the numbers imply otherwise.
The GMROI calculation can be used to measure the performance of the entire store, but it is more effective if used for a particular department or category of merchandise. For example, Madeline 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, 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.