What Is the Gross Margin Return on Investment (GMROI)?
The gross margin return on investment (GMROI) is an inventory profitability evaluation ratio that analyzes a firm’s ability to turn inventory into cash above the cost of the inventory. It is calculated by dividing the gross margin by the average inventory cost.
Although the exact value may vary depending on different factors, it is broadly used to measure how effectively a company is at turning inventory into sales. GMROI is also known as the gross margin return on inventory investment (GMROII).
Key Takeaways
- GMROI is a key metric in retail that indicates how much profit a business makes on inventory after covering its inventory costs, allowing managers to assess inventory efficiency.
- A GMROI value greater than 1 suggests the company is marking up inventory sufficiently to cover costs and generate profit, making it an important benchmark for retail performance evaluation.
- Significant differences in GMROI can arise due to market segment differences, the duration analyzed, and the types of products in inventory, highlighting the need for context when evaluating this ratio.
- For optimal financial health, a rule of thumb in retail suggests a GMROI of at least 3.2, which indicates that a company is covering all costs and achieving profitability.
- Through an example, the article illustrates that two companies with the same average inventory cost can have vastly different GMROI levels, which can significantly impact their financial standing and investment attractiveness.
Investopedia / NoNo Flores
Breaking Down the Importance of GMROI in Inventory Management
GMROI helps investors or managers see how much inventory returns over its cost on average. A ratio above one indicates the firm sells merchandise for more than its cost, showing a good balance between sales, margin, and inventory cost.
The opposite is true for a ratio below 1. Some sources recommend the rule of thumb for GMROI in a retail store to be 3.2 or higher so that all occupancy and employee costs and profits are covered.
Calculating GMROI: A Step-by-Step Guide
The formula for the GMROI is as follows:
GMROI=Average inventory costGross profit
To calculate GMROI, you need to know the gross margin and the average inventory. Gross profit is calculated by subtracting the cost of goods sold (COGS) from revenue. The difference is then divided by its revenue. Average inventory is found by adding ending inventories over a period and dividing by the number of periods, also factoring in obsolete inventory.
Practical Applications of GMROI in Business Decision-Making
For example, assume luxury retail company ABC has a total revenue of $100 million and COGS of $35 million at the end of the current fiscal year. Therefore, the company has a gross margin of 65%, which means it retains 65 cents for each dollar of revenue it has generated.
The gross margin may also be stated in dollar terms rather than in percentage terms. At the end of the fiscal year, the company has an average inventory cost of $20 million. This firm’s GMROI is 3.25, or $65 million / $20 million, which means it earns revenues of 325% of costs. Company ABC is thus selling the merchandise for more than a $3.25 markup for each dollar spent on inventory.
Assume luxury retail company XYZ is a competitor to company ABC and has total revenue of $80 million and COGS of $65 million. Consequently, the company has a gross margin of $15 million, or 18.75 cents for each dollar of revenue it has generated.
The company has an average inventory cost of $20 million. Company XYZ has a GMROI of 0.75, or $15 million/ $20 million. It thus earns revenues of 75% of its costs and is getting $0.75 in gross margin for every dollar invested in inventory.
This means that company XYZ is making only $0.75 cents for each $1 spent on inventory, which is not enough to cover business expenses other than inventory such as selling, general, and administrative expense (SG&A), marketing, and sales. For that XYZ margins are sub-standard. In comparison to company XYZ, Company ABC may be a more ideal investment based on the GMROI.
