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 and is used often in the retail industry. GMROI is also known as the gross margin return on inventory investment (GMROII).
- The GMROI shows how much profit inventory sales produce after covering inventory costs.
- A higher GMROI is generally better, as it means each unit of inventory is generating a higher profit.
- The GMROI can show substantial variance depending on market segmentation, the period, type of item, and other factors.
Gross Margin Return On Investment
Understanding the Gross Margin Return on Investment (GMROI)
The GMROI is a useful measure as it helps the investor or manager see the average amount that the inventory returns above its cost. A ratio higher than one means the firm is selling the merchandise for more than what it costs the firm to acquire it and shows that the business has a good balance between its sales, margin, and cost of inventory.
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.
How to Calculate the Gross Margin Return on Investment (GMROI)
The formula for the GMROI is as follows:
GMROI=Average inventory costGross profit
To calculate the gross margin return on inventory, two metrics must be known: the gross margin and the average inventory. The gross profit is calculated by subtracting a company's cost of goods sold (COGS) from its revenue. The difference is then divided by its revenue. The average inventory is calculated by summing the ending inventory over a specified period and then dividing the sum by the number of periods while considering the obsolete inventory portion scenarios as well.
How to Use the Gross Margin Return on Investment (GMROI)
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.