In retail, it may seem evident that increased sales will result in increased profits. But that is not always the case, which is why Gross Margin Return On Investment (GMROI) is one of the most revealing profitability metrics for retailers.
GMROI measures the efficiency with which your retail operation transforms inventory into gross profit. Effectively managing inventory can mean the difference between finishing in the red or black in any given period. GMROI can tell you how well your inventory is working for you, acting as a leading indicator of how healthy your operations are. It tells you for every dollar you’re investing in inventory, how much it’s making you in gross profit.
What is GMROI for inventory analysis?
Retailers most commonly use GMROI, and its importance is hard to overstate in that field: This key performance indicator is one of several that indicate whether a retail business is on track to become profitable or not.
For such an important metric, GMROI is very simple to assess. It involves dividing gross margin (profit) by average inventory cost over a certain period.
Considering that retail companies often invest much of their capital in inventory, the question of how effectively they can leverage that inventory for profit becomes a very pressing question.
Underestimating the cost of inventory can cost a company precious resources that could have been used in other ways to improve GMROI and increase profitability.
For example, if a particular product languishes on the shelves, a retailer needs to identify why and correct it to avoid losing any more money than necessary. But without robust inventory analysis based on metrics such as GMROI, the retailer might not become a problem for weeks or months and will continue taking a loss on that product.
Why is GMROI important for retailers?
GMROI is essential for retailers because it allows them to analyze how they are using their inventory and make improvements that can boost their bottom line.
What is a good GMROI for retailers?
There is no one specific GMROI target that all retailers should strive for. While some suggest that a GMROI in the vicinity of 2 or 3 is a good rule of thumb, what constitutes “good” GMROI will depend on many factors, including one’s sector, inventory type, and inventory turnover.
On a basic level, however, one should always aim to have a GMROI above 1. If a retailer’s GMROI ratio is above 1, they are selling that inventory at a higher price than they bought it for, resulting in a profit. A GMROI below 1 indicates they’re selling at a loss — an indicator that profitability is suffering and efficiency needs improvement.
How to improve GMROI in retail
If your GMROI is below 1 for the inventory you’re measuring, that means you’re losing money on the investment, selling products for less than they cost. This allows you to adjust based on what you know about your business — maybe it means stocking less of that product or increasing the price to see if you can increase your margins.
If a particular segment of your inventory is doing well under GMROI, you can buy more stock, get quantity discounts, or negotiate better terms with your suppliers.
Shortcomings of GMROI
While GMROI is a powerful tool for retailers, it has some drawbacks worth considering as you use this key performance indicator (KPI).
There are some items that retailers stock to bring customers in the door (called loss leaders) but may have a low GMROI. For example, a grocer may carry low margin items that customers regularly buy, even if the GMROI on that product is less than 1. The customers who come to buy that product typically also buy a range of other higher-GMROI products when they visit, so deciding not to stock the loss leader on GMROI alone would be a net loss for the business.
Similarly, a product that sells a lot of volume will be valuable to a retailer, even if its GMROI is not as high as another product that sells less robustly. In this case, the GMROI doesn’t indicate the product’s entire value to the company’s bottom line.
Another shortcoming is that there are likely costs related to selling each product that are not accounted for in the GMROI, such as rent for the retail space, utilities, and handling costs. These costs can be relatively high and can skew the relative GMROI figures for various products.
How to calculate GMROI
All retailers can effectively determine their profitability based on their inventory costs with the GMROI investment formula. The GMROI calculation is a popular way to analyze inventory in retail businesses since 70 to 80% of their cash can be tied up in inventory.
The basic GMROI formula is:
GMROI = Gross Margin / Average Inventory Cost
Your gross margin is your sales revenue minus the cost of goods sold, or the difference between what you pay for an item and what you sell it for. This is your profit and where most people look to judge their bottom line. But again, GMROI goes a step further to reveal how your inventory investment is working for you.
To calculate your average inventory cost, you take the inventory cost at the beginning of every month, along with the ending inventory cost for the final month of your sample. GMROI is most useful when measuring over a year, so you should add up all of these costs and divide by 13 (12 months plus last end of month cost). If you were calculating for a quarter, you would divide by 4.
When you divide your gross margin by your average inventory cost, you get your GMROI, which should be over 1.
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.
Excess inventory and GMROI
Even when retailers keep careful track of their inventory levels, they are likely to end periods with excess inventory. Cash is tied up in that inventory, which sits on the shelf, preventing them from doing anything else with that money.
And the longer this inventory sits on the shelf, the lower its GMROI, especially if it started at a fairly low level to begin with. The more considerable excess inventory a retailer maintains, the less efficient the business is in turning investment into profit.
It’s hard not to focus solely on getting the sale in retail. But we can see there’s more to being a successful retail business than generating more revenue. Inventory metrics like GMROI enable retailers to see their business from a different perspective, focusing on inventory management and efficiency rather than the next transaction.
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