Gross margin return on inventory investment (GMROI) is a tool used to analyze business profitability In recent years, this method has become increasingly popular as a way to measure a retail business's profitability. It's easy to get into a rhythm of looking at the top line sales number when you are a retailer. People oftentimes measure the value of their business based on year-over-year (YOY) sales gains, which is an unrealistic assessment of the health of your business.
For example, a new business owner has a great pro forma. However, the first year comes to a close and sales are much lower than predicted. Typically, this would be a time to panic, however, because the GMROI method was used to evaluate the business instead of solely looking at revenue and expenses, the business is actually in a better place than if it had met the pro forma. The gross margin was much higher than planned, and inventory controls kept the business profitable despite the lower revenue.
Typically, inventory makes up about 70 percent to 80 percent of a retail operation's financial assets, meaning that it can be the largest drain on your cash. So, it makes sense that the health of your business is directly linked to how well you manage your inventory.
Turnover is another way to view inventory. In this calculation, you can determine the number of months it takes to sell your inventory when viewed over a calendar year. Therefore, if you have 12 of one stock-keeping unit (SKU) in stock and sell them in 12 months, you "turned" your inventory 1 time over the year (related as 1.0). If you sell all 12 SKUs in 6 months, your turnover is 2.0.
The formula for calculating inventory turnover is:
Sales (at retail value)/Average Inventory Value (at retail value)
Alternatively, if your accountant carries inventory value at cost, you can calculate inventory turnover this way:
Cost of Goods Sold/Average Inventory Value (at cost)
Therefore, for example, if your store has a sales volume of $1,000,000 a year on an average inventory of $500,000, some would say that is good. However, $1,000,000 on an average inventory of $200,000 would be more impressive. Somewhere in between is where you will likely end up.
Normally, this information can be used as a way to control inventory. Managing your turnovers helps you become efficient. But, an even turnover is not a holistic view of the health of your retail business. Therefore, you will need to calculate GMROI.
In this calculation, you are taking your gross margin and dividing it by your inventory value. What you are trying to assess is how much money (cash) your inventory generated. This number must be greater than 1.0 or your costs are exceeding sales. The formula for calculating GMROI is:
Gross Margin (dollars)/Average Inventory Cost
There is no "right" number for inventory turnover or GMROI. While there are certainly industry ranges for both inventory turnover and GMROI, every small retailer is unique in their customer bases, merchandise assortments, and vendor structures. The key is to measure your productivity and then work to improve it.
One great resource for benchmarking is retail associations. Every two years, association members receive a business performance report of the association's member stores. This is a useful tool for receiving a benchmark against which to measure your business. However, if you find that your turnover is 1.5 and your GMROI is 1.7 and the other stores in your association have a 2.5 turnover, then going from 1.5 to 1.6, while an improvement, indicates that your business is still drastically underperforming. State retail associations can also be a good resource. If you do not have an association to join, try the retail owners group.
A short-coming of GMROI analysis is that it can be impacted by items such as final stock levels involving closeouts or fashion versus basic merchandise. Fashionable items sell well, while basic items, such as black socks, are kept at a stocking level all year.