The Monthly Metric: Gross Margin Return on Investment

The Monthly Metric typically aims to spotlight the most up-date applications of advanced procurement data, but this edition focuses on an analytic that evolved from a measurement that is older than Institute for Supply Management^® (ISM^®), which was founded in 1915.

Three years before ISM opened its doors, an electrical engineer at DuPont named Donaldson Brown developed a calculation to monitor the performance of the company’s investments. Brown became known as the father of return on investment (ROI), a barometer of how well an asset is performing for a business. ROI is a critical measure of a procurement department, and broken down, the concept can be applied to products and inventory.

Gross margin return on investment (GMROI) measures the profitability of products or product categories. GMROI is a popular metric in the retail world, but it can be useful for manufacturers and suppliers, says Tracey Smith, MBA, MAS, CPSM, president of Numerical Insights LLC, a boutique analytics firm in Charlotte, North Carolina. “With metrics like GMROI, I tend to take it down to the product-category level,” Smith says. “Retailers, however, are more likely to use it at the item level. If you're selling shirts, you want to know how popular a certain style or size of shirt is. But for a distributor or a manufacturer, product category is as deep as you need to go. If your GMROI of a category is profitable, then likely your individual items are profitable.”

GMROI — especially when used with other inventory metrics like turnover ratio, Smith says — can help measure a supply chain’s impact in ensuring a company has the right amounts of products at the right time for maximum sales, cash flow and profitability. Also, the metric can pinpoint breakdowns in ordering and inventory processes.

Meaning of the Metric

Dividing a product’s gross margin by its average inventory cost determines its GMROI. For example, if a widget’s gross margin is US$64,000 and its average inventory cost is $38,000, the GMROI is 1.68, meaning the company earns $1.68 for every inventory dollar. While a GMROI of 2 or better is considered good in retail, there are no consensus procurement benchmarks. An ideal benchmark varies by product mix, Smith says, adding that it’s best for manufacturers or distributors to strive for continuous improvement. “Obviously, if your GMROI is less than 1, you're in a world of hurt and need to take some action fast,” she says, chuckling.

GMROI is often measured annually, but Smith recommends tracking it monthly for some product categories, especially those with a shorter life cycle. “You want to be aware of trends in profitability of those categories,” she says.

For staple items sold year-round, GMROI is not the best metric, Smith says. Since inventory for those items tends to be steady, a slight demand dip can result in a misleadingly low GMROI, she explains — another reason to limit its use to product categories. Such products as nuts and bolts are always in demand, Smith says, but other products like gear pumps have a life cycle. “With an older product, if you (can gauge) demand and manage your inventory properly, then you can almost take your inventory down to zero,” she says. “As you phase out that product, it’s going to look better under a GMROI than the regular items you sell 365 days a year, like nuts, bolts and nails.

“So, you must be careful with GMROI. If you go deeper by measuring (individual products), you could misinterpret what it’s telling you.”

Case Study

Smith cites a family-owned beverage distributor that, thanks to tightening cash flow, struggled to pay for inventory each month. “(The owner) had been following the business-management methods his family used but realized that they were no longer working,” she says. “A look at the financial metrics made it apparent that good inventory management (was one of) the most urgent items to address to turn around the business.”

The GMROI revealed a monthly roller-coaster ride for the business, which fluctuated between an operating profit or loss. Other analyses found (1) dead inventory taking up warehouse space, (2) subjective application of customer discounts and (3) products unknowingly sold at a loss, resulting in a negative gross margin. Those problems were addressed in part through close attention to GMROI, Smith says.

Again, GMROI should not be confused with a typical ROI metric. It measures the profitability of inventory, not an entire business. But GMROI can be a valuable tool for inventory management — projecting returns on products or product categories, determining what and how much to stock, and taking actions if sales do not meet expectations. And such inventory decisions impact a company’s bottom line.

“In most cases, (GMROI) is not something that I would use alone," Smith says. “Depending on the product, I would pair it with the inventory turns, and I would look at how the gross margin is trending as well. And then do your inventory management from there.”

To suggest a metric to be covered in the future, leave a comment on this page or email me at dzeiger@instituteforsupplymanagement.org.