Gross Margin Return on Investment Definition
The GMROI is an inventory profitability ratio that analyzes a company's ability to convert inventories into cash above the cost of inventory. It is calculated by dividing the gross margin by the average cost of inventory. GMROI is used frequently in the retail industry.
GMROI is a useful measure as it helps an investor or manager see the average amount of inventory returned on its cost. A ratio higher than 1 means the company is selling more than it costs it to buy and shows the business has a good balance of revenue, yield, and cost of inventory.
The opposite is true for ratios below 1.
- GMROI shows how much profit inventory generates after covering inventory costs.
- A higher GMROI is usually better, as it means that each inventory unit is generating higher profits.
- The GMROI can show significant variance depending on the market segment, period, item type, and other factors.
The formula for calculating GMROI
GMROI = Gross profit / Average inventory cost
In order to calculate the gross profit-to-stock ratio, two numbers must be known: gross profit margin and average inventory. Gross profit is calculated by subtracting COGS from the company from sales. The difference is then divided by its revenue. The average inventory is calculated by taking the total ending inventory for a specified period and dividing the total by the number of periods.
How to use GMROI
For example, let's say the luxury goods retailer ABC has a total revenue of $ 100 million and a cost of goods sold of $ 35 million at the end of the current financial year. As a result, the company has a gross margin of 65%, which means it retains 65 cents for every dollar of revenue it generates.
Gross margin can also be expressed in dollars, not percentages. At the end of the fiscal year, the company has an average inventory cost of $ 20 million. This company's GMROI is 3.25, or $ 65 million / $ 20 million, which means it makes a revenue of 325% of the cost. Therefore, ABC Company is selling the goods at a price higher than the cost of buying it.
Assume luxury retailer XYZ is a competitor to company ABC and has a total revenue of 80 million dollars and the cost of goods sold of 65 million dollars. As a result, the company has a gross profit margin of $ 15 million, or 18.75 cents, for every dollar of revenue the company generates.
The company has an average inventory cost $20M. Company XYZ has a GMROI of $15 million / $20 million (0.75). As a result, it earns 75% of its revenue and gets $ 0.75 of gross profit for every dollar invested in inventory. This means company XYZ is selling the goods at a price lower than the cost of the acquisition. Compared to company XYZ, Company ABC could be a more ideal investment based on GMROI.
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