Using GMROI To Evaluate Your Inventory Investment
The goal of any business is to make money by selling its goods or services at a profit. For savvy retailers, that means treating inventory like an investment in the stock market. You try to buy at the lowest possible price and sell at a profit when demand is high. A simple calculation called Gross Margin Return on Investment (GMROI) can help you determine if you are getting the best return on that investment.
Donaldson Brown, a young electrical engineer who began his career as a salesman with DuPont in 1912 and finished in 1946 as the vice president of finance for General Motors, introduced the concept of return on investment (ROI) in 1914. It worked so well, DuPont adopted the formula (ROI = (Gain from Investment – Cost of Investment)/Cost of Investment) and used it to monitor the performance of virtually all the its investments. It became known as the DuPont Method, or Model, was taught in business schools across the country and used by many companies. GMROI has evolved from Brown’s simple investment measurement.
The North American Retail Hardware Association’s Cost of Doing Business Study considers GMROI one of the most important tools in determining how profitable your business can be. And by knowing the GMROI of your store, a department, or a specific product, you can make decisions and take steps toward improving your business’ bottom line.
How to Calculate GMROI
Dividing gross profit by inventory investment and multiplying the result by 100 gives you the GMROI on a specific item. The calculation can be made simply from information pulled from your sales and inventory data, and it tells you if the products you buy are making money.
Gross Profit Dollars ÷ Inventory Investment × 100 = GMROI
How does the GMROI calculation work? Let’s say a hardware store buys an electric drill for $50 and sells the product for $150. The gross profit on the item is $100. Because of variables such as discounts, shipping costs and taxes, the inventory’s median value throughout the year is $75.
An inventory’s monthly median value, also known as average inventory, is an item’s price minus discounts, plus freight and taxes. It is determined by adding the beginning cost of inventory for each month to the ending cost inventory for the previous month and dividing by 2.
The GMROI for this drill is $150 divided by $75, or 2.00. Multiply that by 100 and it means the store is getting a 200% return on its investment. If items are being sold with a GMROI value of greater than 100%, the store is making a profit, however it is typical to see a well-run store with a GMROI over 300%.
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What Knowing GMROI Does for Your Business
No matter how experienced you are at managing inventory, there are going to be times when some items won’t move. Maybe you buy too much. Maybe demand drops for a historically strong item. Maybe an unusual cold snap or heatwave kills sales of season items. How do you track thousands of items? Whatever happens, the time those products sit on your shelves ties up cash that could be used to purchase new inventory. So, the key for retailers comes down to a simple concept: You must have the right products at the right time to make productive sales.
Since up to 80% of a typical retailer’s total assets are made up of inventory, knowing what a store’s GMROI is crucial to understanding its inventory investment. Calculating the GMROI also allows retailers to see how the big-box practice of buying in bulk isn’t always the prudent way to stock a store. Suppliers routinely offer lower per-item prices to retailers who place larger orders. But if those items aren’t all sold in a typical sales cycle and remain in inventory, the money spent on getting a better deal could be a wasted investment, tying up cash that could be used on future orders. So, knowing a product’s GMROI at various price points can make paying more for fewer items a wiser inventory investment strategy.
To illustrate the impact of order quantity on GMROI, consider an item that typically requires a $48 investment due to high order minimums, and how paying a slightly higher purchase price results in a higher GMROI.
|Supplier’s Minimum Order Quantity||2|
|Purchase Cost Per Unit||$4.50|
|Retail Price Per Unit||$12.00|
|Inventory Stocking Depth (in weeks)||2|
|Sales of This Item Per Week||3|
|Hambone’s Order Quantity Per Cycle||6|
|Total Sales [$12.00 × 6]||$72.00|
|Inventory Investment [$4.50 × 6]||$27.00|
|Gross Profit Dollars [$72.00 − $27.00]||$45.00|
Supplier 1 requires a minimum order of 24 units at $2.00 each. Supplier 2 has no minimum, and sells the same unit for $2.35 each. Supplier 3 requires a minimum order of 6 and a purchase price of $2.15 per unit. A higher purchase price more than doubled GMROI when using Supplier 2 or Supplier 3. Yes, the profit (in dollars) was lower. However, we have $33.90-$35.10 left to invest in another product in the two scenarios with higher purchase costs and lower order minimums. If we invest those dollars in another item that meets our required 300% GMROI, the profit dollars are recouped.
While the GMROI calculation can be used to measure the profitability of a single item, a department or an entire store, the Retail Owners Institute, a self-help financial management resource for retailers, says the use of GMROI to compare the productivity of different departments within a store is probably its most valuable use. For instance, in the example below, a department with low annual sales, low annual gross margins, and low average inventory costs but a high turn rate (Department D), could be as valuable to a retailer as a department with high annual sales, a higher gross margin, and higher average inventory costs, but a low turn rate (Department A). Comparing those two department’s GMROI allows retailers to see how each one contributes to the success of a business. The same comparisons can be made on individual products or entire businesses.
|Department||Annual Sales||Annual Gross Margin %||Average Inventory Cost||GMROI|
Source: The Retail Owners Institute
For the past 100 years, the NRHA’s Cost of Doing Business Study has analyzed the sales data of hardware stores, home centers and lumber yards. The 2016 study came from information provided by 1,077 independent home improvement stores. It says GMROI calculations allow retailers to improve sales by:
- Comparing their prices to those of competitors so they can consider raising their margins.
- Finding ways to reduce inventory investment by eliminating duplicate products that might be wasting shelf space.
- And adjusting inventory to fit their customers’ needs.
Similar information for other retail segments is available from The Retailers Owners Institute and the National Retail Federation.
POS Makes GMROI Work
Strong sales and inventory (point of sale (POS)) systems supported by robust retail technologies can provide you the information to calculate GMROI which allows you to analyze and more clearly understand your sales cycles and trends.
Entrepreneur.com says: “Inventory software programs now on the market let you track usage, monitor changes in unit dollar costs, calculate when you need to reorder, and analyze inventory levels on an item-by-item basis. You can even control inventory right at the cash register with point of sale systems. POS software records each sale when it happens, so your inventory records are always up to date.”
Simply put, strong retail technology solutions help you calculate GMROI which allows you to predict future sales cycles and customize your inventory to meet consumer demand. They also give you greater insight into your inventory investments, showing which are paying off and which are costing you money.
The GMROI formula isn’t a magic elixir that will cure all your business ills. It is a tool to check on the health of your ordering and inventory processes. Much like when your doctor tells you that you have high blood pressure. It’s up to you to take steps to remedy that issue. You eat a balanced diet, exercise more and have follow up exams. GMROI is a simple calculation that helps you determine your business’ financial health. It can tell you how profitable certain items or departments are, but it’s up to you to make changes if they are necessary.