But how do you know whether you should cut back on basics and build up your inventory of new items? GMROI can be a very useful tool in your analysis. GMROI stands for gross margin return on inventory investment. It's a measure of inventory productivity that expresses the relationship between your total sales, the gross profit margin you earn on those sales and the number of dollars you invest in inventory.
We express GMROI either as a percentage or a dollar multiple that tells you how many times you've gotten your original inventory investment back during one year.
Here's a step-by-step method of calculating GMROI that you can use for your business, for each department within it and even for any individual item you handle. Using GMROI as a measuring tool, you can compare the relative value of every piece of merchandise you carry and draw conclusions about where you should be concentrating your efforts to achieve maximum profitability.
Of course, GMROI is not the only factor you should consider in setting up your inventory mix. Cost of sales and overhead also are important factors in determining profitability, as are subjective factors such as personal preferences and knowledge of your customers. But GMROI gives you a valuable objective ruler you can use to measure the performance of items and departments.
How It Works
There are two formulas for calculating GMROI. The first expresses your return as a percentage of your inventory investment. The second expresses it as a multiple, in dollars, of your inventory investment. Let's work through an example of GMROI as a percentage of inventory investment.
The formula for finding GMROI as a percentage is: GMROI (%) = gross margin (%) x [sales divided by average inventory at cost]. Finding GMROI for any item involves four steps:
Step 1: Calculate your gross margin and gross margin percentage. The formula for calculating gross margin is: gross margin = sales - cost of goods sold. To keep it simple, we'll work with round figures. Let's assume your total sales of vertical blinds in 1995 came to $500,000. Assume you paid $260,000 for them. That means your gross margin was $240,000.
Because we want to express GMROI as a percentage in this example, we have to express gross margin as a percentage of total sales. To do that, divide your gross margin by your total sales. The result is 48 percent ($240,000 divided by $500,000 = .48, or 48 percent.)
Step 2: Calculate your average inventory at cost. To figure your average inventory for a year, add up your ending inventories (at cost) for every month of that year, plus the ending inventory (at cost) for the previous year. Then divide the total by 13 (the number of inventories in the sum).
Let's assume the sum of all those ending inventories for 1995 (including year-end 1994) was $1.3 million. Dividing that figure by 13 gives you $100,000, which is your average inventory at cost.
Step 3: Calculate your sales-to-inventory investment ratio. Determine your sales-to-inventory ratio by dividing total sales by average inventory at cost: $500,000 divided by $100,000 = 5. (Don't confuse this figure with inventory turnover rate. Turnover is the ratio of totals sales to average inventory at retail, or cost of goods sold to average inventory at cost. Inventory turnover also is a useful measure of inventory activity, but not part of the GMROI calculation).
Step 4: Calculate the GMROI percentage. Using the above figures: GMROI (%) = 48 percent x 5 = 240 percent. In this example, your gross margin return on inventory investment was 240 percent. That means for every dollar of investment you made in vertical blinds in 1995, you got a 240 percent return, or $2.40 in gross margin return.
Now you have an objective measure of your vertical blind inventory productivity to compare to other merchandise categories.
You can get the same result by calculating GMROI as a multiple of your inventory investment dollars. That formula is: GMROI ($) = [gross margin ($) divided by average inventory at cost] This simpler calculation saves you a couple of steps because you calculate the multiple directly.
First, figure your gross margin dollars as you did in the first example: $500,000 - $260,000 = $240,000. Then divide your gross margin by your average inventory at cost ($240,000 divided by $100,000 = $2.40). Again, for every original dollar of inventory investment, you're getting $2.40 back in gross margin.
Suppose, on the other hand, that you sold $10,000 worth of draperies in 1995 on an average cost inventory of $3,000. Assume your cost of goods sold was $6,500. How does your return on draperies compare with your return on vertical binds?
First, calculate your gross margin for draperies (sales - cost of goods sold): $10,000 - $6,500 = $3,500. Second, divide your gross margin dollars by your average inventory at cost: $3,500 divided by $3,000 = $1.17
According to this example, your gross margin return on inventory investment for draperies in 1995 was $1.17. If these were actual figures, vertical blinds would return more than twice the gross margin dollars than draperies.
By calculating GMROI for every merchandise category you carry you can rank them according to their rates of return. Don't automatically conclude, on the basis of GMROI alone, that you should reduce your stock of low-returning merchandise or replace it with higher-returning merchandise. You need an overall mix of inventory for your customers. GMROI helps in managing that mix, but you must decide how much weight to give it against other factors influencing your choice of inventory.
Who Can Use It?
The beauty of the GMROI calculation is that it works for any size business, and for any department or merchandise classification within the company. If your accounting system is computerized, you can get GMROI reports automatically as part of your monthly accounting reports.
GMROI is not only a valuable financial management tool, but it can be a very effective personnel management took as well. You can tie GMROI to incentives as a motivating force for your employees. Get your staff involved in improving your GMROI by developing goals for gross margin and sales-to-inventory investment for each merchandise classification you carry. During your sales meetings, let your employees know the goals you have set, your reasons for setting them and any rewards you are offering for departments that meet those goals. Encourage employees to come up with ideas to help everyone meet goals and reward them with appropriate recognition when they do.
Give your employees updated information about how they are doing. Let them know at least monthly, and weekly if possible, where they stand in comparison to the targets. A little competition among departments can help spur them on, so long as it doesn't become intrusive.
GMROI is a useful management tool because it combines two important profitability factors: your gross margin and your ratio of sales-to-inventory investment. With the cost of facility space and inventory constantly rising, you must get the highest return possible from every dollar you invest in inventory. Keeping a close watch on GMROI will help you reach that goal.
Richard F. Outcalt and Patricia M. Johnson, Certified Management Cons-ultants, are principals of Outcalt & Johnson: Retail Strategists. A Seattle, WA-based consulting/speaking team. They provide an array of strategic retailing services to owners and presidents of retail businesses. For more information, call (206) 623-3974.