Gross Margin Return on Inventory (GMROI) is a "turn and earn" metric that measures inventory performance based on both margin and inventory turnover. In essence, GMROI answers the question, "For every dollar carried in inventory, how much is earned in gross profit?"
GMROI can be calculated at the organization level and, if the proper data is collected at the item level, all the way down to an individual item.
GMROI = $ Gross Profit X $ Sales
$ Sales $ Avg Inventory at cost
The earn term, $ Gross Profit / $ Sales, is simply the gross profit margin % (GPM%).
The turn term, $ Sales / $ Average Inventory at cost, is not the same as inventory turnover, which is the $ Cost of Sales or Cost of Goods Sold divided by $ Average Inventory at cost.
The GMROI formula can be simplified to address this difference and use Inventory Turnover (ITO) with the following formula:
GMROI = GPM% X ITO
1 - GPM%
This can be restated as:
GMROI = GPM % X ITO
where CGS % = Cost of Goods Sold % or 1 - GPM %.
An item has Sales of $10,000 and Gross Profit of $1,000. The GP % = 10%.
The Cost of Sales is $9,000 and the CGS % = 90%.
If the average inventory is $900, then ITO = 10.
This item earns 1.11 in Gross Profit for every dollar carried in inventory ($1,000 Gross Profit / $900 average inventory).
Using the restated formula, GMROI = GPM % X ITO,
GMROI = 10% X 10 or .11 X 10 = 1.10
A novel application of this technique is to evaluate the profitability of an individual item based on its purchase price and minimum order quantity. In many cases, profitability declines when a larger lot size is purchased at a reduced price. This presents an interesting organizational dilemma: is the goal least cost or greatest profitability?
See the OnLine Store - BONUS page for a FREE downloadable tool to help you evaluate the profitability of various purchase price/quantity break calculations. There is also a paper on this concept.
In addition, you can compute the GMROI for an organization using the Interactive Strategic Profit Model (SPM) spreadsheet tool which is now available FOR FREE in the On-Line Store BONUS page. Enter in financial information from the Balance Sheet and Income Statement and the spreadsheet computes and presents two versions of the SPM for an organization including the GMROI calculation.
GMROI use by retailers and wholesale distributors
GMROI has been a traditional measurement used by retailers and wholesale distributors. Many are able to measure and report GMROI down to the item level. Since these organizations typically resell the items they purchase without any manufacturing value added, the calculation is straight forward.
GMROI use by manufacturers
GMROI has been used much less frequently in manufacturing organizations, most likely because of the difficulty of associating raw material inventory with specific end item products. However, with much more extensive databases and data collection along with a shift to the greater use of contract manufacturing, it can be possible to calculate and track GMROI in manufacturing organizations as well.
At a minimum, GMROI can be computed at the organizational level based on published financial statements. And if inventory is categorized in a way that allows discrete chunks of inventory to be grouped together, such as by product line, project or program, GMROI can be categorized and evaluated on that basis.
What is a good number?
Generally the higher the better.
To set a benchmark for the organization, use either current financial statements or budgets for the future. Calculate the GP %, ITO and compute the existing or target GMROI.
Measure every appropriate segment against this target. You will identify groups that are exceeding the targets and also those that are not pulling their own weight.
While most organizations have some "loss leaders", it is important to understand which items/groups that are under-performing. Choices are to live with the performance, improve the margin, improve the turnover or in extreme cases, discontinue the poor performing product.
In one organization, a product line extension was under way. Part of the financial evaluation was to project the margin and the turnover. Historically, these had been plugged numbers, identical for all items in the product line. However, when better estimates of turnover at the item level was calculated based of historical demand history (which was highly reliable), coupled with the lot sizes required for production, the GMROI for some items was very low. A decision was made not to include the low GMROI items in the line extension.
Is a high GMROI always good?
Not always. If a product or group of products has an abnormally high turnover, there may be service issues not reflected in the GMROI.
In one organization, a product line had margins over 50% and a turnover rate over 50 turns. The GMROI was astronomical. However, in reality, the products were only made once a week, immediately shipped out and were backordered the balance of the week. There were severe penalty costs associated with the poor in-stock service levels. Production was increased to reduce the turnover to more rational levels, service improved and GMROI still exceeded the target.
Do you have questions on how GMROI can be applied within your organization? You may contact me at David.Armstrong@inventorycurve.com.
Looking at inventory performance improvement through a different lens.