What Is the Gross Margin Return on Investment (GMROI)?
Let me explain GMROI directly to you: it's an inventory profitability evaluation ratio that analyzes your firm's ability to turn inventory into cash above the cost of that inventory. You calculate it by dividing the gross margin by the average inventory cost, and it's commonly used in the retail industry. You might also hear it called the gross margin return on inventory investment (GMROII).
Key Takeaways
Here's what you need to know: GMROI shows how much profit your inventory sales produce after covering inventory costs. A higher GMROI is generally better, as it means each unit of inventory generates a higher profit. Keep in mind that GMROI can vary substantially depending on market segmentation, the period, type of item, and other factors.
Understanding the Gross Margin Return on Investment (GMROI)
GMROI is a useful measure because it helps you see the average amount that your inventory returns above its cost. If the ratio is higher than one, your firm is selling merchandise for more than what it cost to acquire it, indicating a good balance between sales, margin, and inventory cost. The opposite holds for a ratio below 1. Some sources suggest aiming for a GMROI of 3.2 or higher in a retail store to cover all occupancy, employee costs, and profits.
How to Calculate the Gross Margin Return on Investment (GMROI)
To calculate GMROI, use this formula: GMROI = Gross profit / Average inventory cost. You need two metrics: the gross margin and the average inventory. Calculate gross profit by subtracting your cost of goods sold (COGS) from revenue, then divide that difference by revenue. For average inventory, sum the ending inventory over a specified period and divide by the number of periods, accounting for any obsolete inventory scenarios.
How to Use the Gross Margin Return on Investment (GMROI)
Let me walk you through an example. Suppose luxury retail company ABC has total revenue of $100 million and COGS of $35 million at the end of the fiscal year. That gives a gross margin of 65%, or $65 million. With an average inventory cost of $20 million, the GMROI is 3.25, meaning it earns 325% of costs and sells with a markup over $3.25 per dollar spent on inventory.
Now compare that to competitor XYZ with revenue of $80 million and COGS of $65 million, resulting in a gross margin of $15 million or 18.75%. With the same average inventory cost of $20 million, XYZ's GMROI is 0.75, earning just 75% of costs and only $0.75 per dollar invested in inventory. This isn't enough to cover other expenses like SG&A, marketing, and sales, making XYZ's margins sub-standard. Based on GMROI, ABC looks like the better investment.
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