What it means
Inventory is one of the biggest uses of cash in a retail or wholesale business, so it makes sense to ask what return it generates. GMROI answers that question by comparing the gross margin (sales minus the direct cost of the goods sold) with the average amount invested in inventory at cost.
A result of 3.0 means each $1 invested in stock produced $3 of gross margin over the period. The measure combines two ideas that are often considered separately.
One is the margin percentage, which shows how much profit is made on each sale, and the other is stock turnover, which shows how quickly inventory is sold and replaced. A product with a thin margin can still earn a strong return if it sells very quickly, and a slow product needs a high margin to justify the space it occupies.
Buyers and merchandising teams use GMROI to compare categories that are very different. A supermarket might find that fresh produce has a modest margin but sells so fast that its return is excellent, whereas a rarely bought speciality item looks profitable on margin alone but earns little on the cash it ties up.
The comparison helps in setting buying budgets and shelf space. It also guides decisions about discounts and clearance.
If slow stock is dragging the figure down, a markdown that lowers the margin may still raise the overall return by freeing cash for faster-selling lines. Many retailers set a minimum target, and products or suppliers that fall below it are reviewed.
There are some points to watch. Inventory should be measured at cost, not at selling price, and an average over the period gives a fairer result than a single date.
The figure also says nothing about overheads, so a high GMROI does not guarantee that the store as a whole is profitable.
In practice
Real-world examples.
Example
A hardware retailer reviews its product categories and finds that paint earns a GMROI of 4.2, while garden furniture earns only 1.1. The buyer reduces the space and budget for furniture and increases the range of paint, which sells faster.
Example
A pharmacy chain compares two suppliers of the same vitamins. Supplier A offers a bigger discount but requires a large minimum order, which leaves stock sitting for months, so the return is lower than with Supplier B, whose smaller deliveries turn over faster.
Example
A fashion retailer looks at a slow-selling winter coat line at the end of the season. A clearance sale cuts the margin from 50% to 30%, but it releases $120,000 of cash that is reinvested in faster-selling lines.
Formula
Calculation
GMROI = Gross margin / Average inventory at cost
It can also be written as GMROI = Gross margin percentage x (Sales / Average inventory at cost)
A shop has annual sales of $600,000 and a cost of goods sold of $360,000, so its gross margin is $600,000 - $360,000 = $240,000. Its average inventory at cost across the year is $80,000. GMROI = $240,000 / $80,000 = 3.0, meaning $3 of gross margin for every $1 invested in stock. The second version gives the same answer: the margin percentage is $240,000 / $600,000 = 40%, sales divided by average inventory is $600,000 / $80,000 = 7.5, and 0.40 x 7.5 = 3.0.Case study
Seen in the real world.
Brookfield Home Supplies is an illustrative, fictional chain of five homeware stores. Its owner believed that the kitchen appliances department was the star performer because it had the highest margin, at 45%.
The finance manager calculated GMROI for each department. Kitchen appliances had average inventory of $400,000 and a gross margin of $360,000, a return of 0.9, while small storage items had inventory of only $60,000 and a gross margin of $150,000, a return of 2.5.
The owner shifted $100,000 of buying budget from appliances to storage and household basics. The illustrative lesson is that a high margin percentage can hide a poor return when the stock moves slowly.
Watch out
Common mistakes.
- Valuing inventory at selling price instead of cost, which makes the return look far lower than it is.
- Judging products on margin percentage alone, when slow-moving items can tie up cash and earn little.
- Using a single year-end inventory figure instead of an average, which can distort the result if stock levels changed through the year.
Questions
People also ask.
What is a good GMROI?
It depends on the industry, but a result above 1.0 means the business earns more gross margin than it has invested in stock, and many retailers aim for well above that.
How can GMROI be improved?
A business can raise margin through better pricing and buying, or increase turnover by holding less stock and selling it faster.
Is GMROI the same as inventory turnover?
No, turnover only measures speed of sales, while GMROI includes profit, so it shows both speed and profitability together.
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