Is Your Inventory in the Sweet Spot?: Using GMROI and Inventory Turnover Rate

by Greg Manning, ABCP | October 12, 2021

Managing Inventory Turns in a Business

Inventory is the lifeblood of many businesses. Your business will often live or die based on the productivity of your inventory. Too much inventory and you risk excessive markdowns and lower gross margins. Too little inventory and you risk lower gross margin dollars, missed sales, and unsatisfied customers. Inventory is a balancing act and you need to take it seriously for your company’s health. Companies can get into a “cash crunch” if too much capital is tied up in unproductive inventory. On the other hand, having the discipline to manage your inventory correctly can free up money to invest in other aspects of your business to help grow revenues.

How do you measure the productivity of inventory?

Historically, Inventory Turnover Rate (also called inventory turn) has been the standard measure of productivity. The formula for inventory turnover is:

((Beginning inventory at cost) + (Purchases at cost) – (Ending inventory at cost)) / (Cost of Goods Sold)

An example might be:

($200,000 + $1,000,000 – $220,000) / $450,000 = 2.18

The preceding example would indicate that your inventory was replaced 2.18 times over the year. In general, retailers face a risk of diminishing value the longer it takes to sell their merchandise. Therefore, the higher the number of inventory turns, the better. The more you turn your inventory, the more productivity you are getting out of your asset. If you turn your inventory 12 times a year and get 30 days to pay for the inventory, you will sell all your inventory before it comes due. This is a great place to be. However, it is  pretty unusual. Every company that sells inventory should integrate inventory turn improvement as part of the annual planning process.

Let’s explore another scenario. What if your inventory turns are inflated because you sell too much merchandise at low or negative margins? On paper, your inventory turn rate is high. However, your cash in the bank is not growing. Theoretically, you could run out of money with a very high inventory turn rate. So what should you do?

Managing Inventory through Gross Margin Return on Inventory (GMROI)

In comes Gross Margin Return on Inventory (GMROI). This is sometimes called Gross Margin Return on Inventory Investment (GMROII). GMROI is an alternative view of inventory productivity. The formula for GMROI is:

((Annual Sales) / Average inventory at Cost)) x (Gross Margin %)

An example might be:

($1,500,000 / $550,000) x 50% = $1.37

The preceding example would indicate that $1 invested in inventory returned $1.37 to your company. Positive GMROI is good. However, as a measure of inventory productivity, the larger the number the better. The GMROI calculation looks at the amount of money we are making (gross margin) on the sale of each piece of inventory, not just the sale itself. In most businesses, the more gross margin dollars you accumulate without adding additional expenses, the more successful you will be.

What is the correct GMROI?

Each industry is different and it is important to understand the unique cost structures and selling costs of your industry. Planning the increase of your GMROI is an effective tool to increase your company’s success. The gross margin dollars you retain from the sales you generate will help determine the amount of money available to invest in other aspects of your business. Additionally, if your GMROI drops, you will be able to see areas that need improvement. Finally, if a product category has a GMROI of less than one, you are returning less than you are investing in inventory. Fix this category immediately or get out and invest in something different. GMROI will give you the insight to make changes before it’s too late.

Add GMROI to Your Annual Planning

Don’t abandon Inventory Turnover Rate. However, you should add GMROI calculation to your annual planning and evaluation sessions. Without it, you run the risk of underproductive inventory and poor financial performance.