As Peter Drucker said, “What’s measured, improves.” Today, retail store owners rely on metrics to make crucial decisions and steer their business in the right direction.
Measuring inventory turnover, for example, you can gauge whether you’re ordering enough products. And by calculating gross margin return on investment (GMROI), you can easily tell how much profit your inventory investment generates.
In this article, we’ll take a closer look at GMROI—a key indicator of your retail store’s success.
What is gross margin return on investment?
Gross margin return on investment (GMROI) is a metric used to evaluate the profitability of every dollar you invest in inventory. To calculate GMROI, divide the gross margin by the average inventory cost.
GMROI is a crucial indicator of whether a retail business is on track to end the year in the black or the red. Considering that 70% to 80% of a retailer’s assets are tied up in inventory, GMROI helps you to see if that inventory is driving profit.
For instance, you might start losing money if a particular product isn’t moving off the shelves and you don’t see how to correct course. This is where inventory analysis comes into play—metrics like GMROI will help you determine whether this particular product is worth your investment.
GMROI is a versatile metric as well. You can calculate and compare GMROI for two stores, five product stock-keeping units (SKUs), or even color variants within a particular SKU. GMROI can take you as broad or as deep as you need to go to measure your store’s profitability.
How to calculate GMROI
There are multiple ways to calculate GMROI depending on a retailer’s business model and the accounting systems they use. But the standard method, according to Investopedia, is simply:
GMROI = Gross profit / Average inventory cost
Let’s break it down.
The gross profit accounts for variable costs like labor and supplies. Here’s the formula to calculate gross profit:
Gross profit = Revenue – Cost of goods sold (COGS)
Measuring gross profit helps you see how your company can get the most value from its variable costs.
Average inventory cost
Retailers use the average inventory cost metric to measure how much inventory they have had over a specific period of time.
Measuring average inventory cost helps you understand the amount of inventory needed to support sales. It’s also used to determine inventory losses from theft, shrinkage, damages, and product expiration.
Manage inventory from one back office
Shopify POS comes with tools to help you manage warehouse and store inventory in one place. Forecast demand, set low stock alerts, create purchase orders, know which items are selling or sitting on shelves, count inventory, and more.
The standard formula to calculate average inventory cost is:
Average inventory cost = (Current inventory + Previous inventory) / Number of periods
However, if you wish to calculate the average inventory cost for a year, first, you must add the inventory cost at the beginning of every month, along with the ending inventory cost of the last month of the time period, and then divide it by 13.
Average inventory (over a year) = (Sum of beginning inventory cost for every month [Jan.–Dec.] + Ending inventory cost for December) / 13
💡 PRO TIP: Want to skip the manual calculations? See your entire product catalog’s gross profit, beginning and ending inventory cost, and more, view the Profit by product report in Shopify admin.
Example: calculating GMROI
Let’s imagine that Sarah’s Family Clothing, a retail clothing store, needs to calculate GMROI for a year, based on the following figures:
- Annual revenue: $400,000
- COGS: $75,000
- Inventory cost of the year:
From the above data, let’s calculate GMROI using the formulas above:
STEP 1: Find gross profit
- $400,000 – $75,000 = $325,000
STEP 2: Find average inventory cost (for the year)
- $1,561,520 / 13 = $120,117
STEP 3: Find GMROI
- $325,000 / $120,117 = $2.70
This shows that for every dollar she spends on inventory, Sarah’s business makes $2.70.
GMROI should always be more than one, which would indicate that the business is profitable. However, you should also consider the industry’s GMROI benchmarks to ensure your business is competitive.
Fortunately, retailers have many reliable benchmarks. In 2021, the average GMROI for family clothing stores was $2.56.
With a $2.70 GMROI, Sarah’s Family Clothing is well above the industry average, indicating a healthy retail business that is efficiently managing its inventory.
Why GMROI matters so much to retailers
Some retailers rejoice after seeing stellar gross profit reports without taking the time to calculate GMROI, which may well reveal problems in their inventory management.
There are many reasons why retailers should always keep an eye on GMROI, but the two main reasons are: understanding profits on inventory and making informed product decisions.
Understand profits on inventory
If Sarah’s Family Clothing had a GMROI of $2.70 this year, which is well above the industry benchmark, does that mean all of the business’s products are performing equally well?
No. If, for example, the GMROI for anime tees is 92¢, that would suggest that Sarah isn’t selling enough anime tees to profit from them.
Sarah could solve this problem by finding a way to reduce the cost of anime tees. She could also clear out her inventory by bundling the tees with fast-selling products to finish the month/year in the black for that category.
Informed product decisions
GMROI can be used to make smarter product decisions.
GMROI helps you tailor your merchandising strategy to your most profitable items.
Kondrat is right—GMROI data can strengthen your balance sheet by helping you decide when to ramp up production on high-selling SKUs and cut prices on low-selling ones until they sell out.
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What is a good GMROI for retail businesses?
While a GMROI above one is necessary to profit off your inventory, Investopedia considers $3.20 to be a strong showing.
However, determining a good GMROI for retail businesses is difficult, as it tends to vary by geography (Los Angeles, California vs. Scottsdale, Arizona), vertical (hardware store vs. clothing store), and market segment (consumer packaged goods [CPG] vs. luxury).
It also depends on the type of products you’re selling. While a clothing retailer with high-selling products typically operates with low margins, a luxury watchmaker typically waits a significant amount of time to sell through its products, which reduces GMROI.
Fortunately, independent studies provide reliable benchmarks that can help gauge your niche’s GMROI performance.
Here are a few examples of GMROI in common industries based on 2021 data:
- Family Clothing: $2.56
- Furniture: $2.50
- Convenience: $6.69
- Sporting goods: $2.10
- Electronics: $6.21
- Cosmetics, beauty supply: $2.68
- Hardware: $1.77
How to improve GMROI
Beside following the standard industry benchmarks, you should maintain internal GMROI reports based on past data. Because if you’re not happy with the profits you’re making from existing inventory, you’ll want to study and take concrete steps to improve your GMROI, such as:
Reduce inventory costs
For small retailers, an increase in sales is great news—but it comes with higher overhead costs. And when adding new products, you’re also incurring additional purchasing costs (supplier charges), carrying costs (warehouse fees), and shortage costs (when a product goes out of stock).
Follow these three steps to increase your GMROI by cutting inventory costs:
- Forecast your true demand by accounting for past data, seasonal buying patterns, competitive landscape shifts, and any other factors that bring consumers to you. If you’re using the Shopify POS, you can easily forecast demand with all these factors in mind.
- Leverage past data to effectively time your inventory purchases. Be vigilant of what—and when—you buy. For instance, if you buy inventory too early without predicting demand appropriately, you might end up with deadstock.
- Shed any deadstock immediately. You may want to bundle deadstock with fast-moving products, return them (if your supplier agreement allows), or donate them to charity and enjoy tax rebates.
Price modification can be tricky. Increasing product prices may seem like a reliable way to drive up both sales and GMROI, but this isn’t always the case.
Suppose you visited Sarah’s Family Clothing on a Monday and found a polo shirt you liked priced at $35, but when you returned on Tuesday to make the purchase, the price of the same shirt had jumped to $60. You would probably walk out of the store and buy the polo somewhere else.
However, from Sarah’s perspective, since A-list celebrity LeBron James had recently been seen wearing her polo shirt, its perceived value went up, and she decided to charge more for it.
Alternatively, you could also reduce your product price. If your deadstock is eating up shelf space and you estimate a price that should move it all, then this may be a viable option.
You might also negotiate down your supplier costs to automatically increase your margins.
Leverage sales data
Historical sales data can provide helpful insights for improving GMROI.
Identify the products that your repeat customers are buying, talk to your manufacturers to get those costs reduced, and in turn, get a hike on the margins.
Kondrat says you can leverage sales data to get more out of top-selling products, accurately predict demand, and increase your GMROI.
Leveraging sales data is especially crucial for business owners with multiple stores. Using past sales data, you can estimate the number of SKUs you need to allocate toward each location.
Take control of your GMROI
At any given time, 70% to 80% of a retailer’s assets are tied up in inventory. Measuring how profitable your inventory is—by calculating GMROI—isn’t just helpful, it’s practically essential.
GMROI is a powerful metric that can differentiate winning products from deadstock, successful product categories from losing ones. It can also tell you which of your stores is likely to bring in the greatest ROI this year. Take control of your GMROI, and you’ll be set for success.
Manage your inventory with confidence
Only Shopify POS helps you manage warehouse and retail store inventory from the same back office. Compare inventory costs to revenue, see which items are selling out or sitting on shelves, forecast demand, and more.