How to use GMROI
Let’s see how GMROI works with a quick-and-dirty calculation:
Take a retail business that had $500,000 in annual sales, and the cost of goods sold was $300,000, with an average inventory cost of $100,000.
Your gross margin is $500,000-$300,000= $200,000, which is then divided by your average inventory cost: $100,000, giving you a GMROI of 2.0.
This means the revenue you earn on your inventory is 200% of your cost, which is good. Remember, you want your GMROI to be above 1. Each industry has a different average GMROI, which means you should consider that in determining your inventory health as well.
Now, let’s say you opened a pet supply store. You’ve finished your second year of operation, and sales have increased over last year, but you want to run GMROI to see how well you are managing your inventory and if you’re bringing in a profit.
Your books show annual sales of $750,000 and a cost of goods sold of $500,000, with an average inventory cost of $200,000:
Gross margin ($750,000 – $500,000) / $200,000 = 1.25
For the past fiscal year, your pet store is turning a profit of $1.25 for every $1.00 you’ve spent on inventory, which is good. However, if you look at the industry average, in 2017, pet supply stores brought in $3.38 for every dollar spent on inventory — which means your store is not performing as well relative to your industry.
This could mean several things. Maybe you are simply carrying too much inventory month-to-month and can pare it down for the next year. It may mean less topline revenue growth, but you can increase your profits by significantly decreasing your average inventory cost.
The inventory analysis doesn’t have to end there. You can do an ABC inventory analysis to slice up your inventory into classifications to see what items are performing the best. Maybe you are selling a lot of pet food, but the margins are low, while your highest profit margin is in high-end pet clothes & costumes.
You can focus on clothing, looking for the best products in the coming year, and negotiating better prices and terms with vendors. Or, you can simply raise prices on pet food and monitor sales to see if your demand dips. Maybe you start stocking less pet food or have frequent markdowns to increase your turnover rate.
Remember, there are different GMROI benchmarks for each retail sector — not all retail businesses are created the same. The best way to find standards for your industry is to ask your retail association. Retail Owners Institute is also an excellent resource for finding benchmarks for retail.