GMROI - The sacrificial lamb of retail
As a consultant and ex-Merchandise Planning Manager, I've spent quite a lot of time studying retail KPI's and it is without doubt in my view that GMROI (Gross Margin Return on Inventory Investment) is the most powerful KPI to help point the retailer in the right direction. It's a powerful KPI because it takes into consideration so many other "mini-KPIs" and rolls them into one. Sales, First Margin %, Markdowns, Stock Turn and Inventory management.
The funny thing is that despite many retailers knowing what GMROI stands for, its calculation and more importantly its interpretation are not well known at all.
Firstly, let's look at the calculation. If you search the web for the calculation you'll find example after example of how it is calculated. Here is one example, "if you purchase $2,000 of inventory and sold it in the same year for $6,000 your profit would be $4,000. The return on your investment of $2,000 was $4,000. Therefore the GMROI is $4,000/$2,000 = 2."
Spot anything wrong? Well there are are a couple of things, firstly the denominator of the equation should be average inventory. In the example we aren't told if the investment was all upfront, but given it is a naive example, lets go with that assumption. The average inventory is the average of starting ($2,000) and ending inventory ($0, given that it was all sold in the year), which is $1,000 and not $2,000. Using $1,000 the GMROI is 4 not 2.
The second aspect in the calculation that is almost universally overlooked on the web is the impact of time. GMROI would quickly become a useless tool for comparing stock performance if we wanted to compare product A that arrived in January with product B that arrived in March and we had to wait a whole year to make the comparison. As retailers, we want to know quickly what's working so we have to annualise the result in a shorter time frame. If we were analysing the data in April, we have four months data for product A, so multiply the GM x 12/4 to annualise it. On the other hand, product B which is 2 months old, is annualised by GM x 12/2. (You can use weeks also). Note that the denominator (average inventory) is not annualised.
Secondly, let's look at the interpretation of GMROI. As the KPI tells you how much you made for a $1 invested, it's obvious that a higher GMROI is better than a lower GMROI. If product A is making me $10 a year for every $1 invested that's better than product B that is only making $5. But the story doesn't end there. Many people think that the aim is get a higher GMROI, which unfortunately is too simplistic. The quickest way to get a higher GMROI is to reduce the average inventory (smaller denominators lead to larger quotients). The logical thing to do is actually invest more in product A, which is increasing the denominator (with the hope that more stock will lead to more sales overall) but of course the GMROI will quite likely go down as the GM goes up. The correct interpretation is to see GMROI as an indicator of opportunity not an end in itself. Another way to look at it is GMROI is a number and GM is real dollars. Which do you want, higher numbers or more real dollars?
The correct purchasing action for high GMROI product is to sacrifice the GMROI as long as total GM$ keeps going up.
