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This report examines the GMROI issue from
two perspectives.
The Computational Bias—An examination of why GMROI results may
lead to incorrect decisions.
Suggestions for Action—An
identification of some very difficult, but necessary, steps to drive
higher profits from the inventory investment.
The Computational Bias
The theory behind GMROI is unassailable. The ratio attempts to measure
the return (gross margin) produced from every dollar of investment
(inventory). In this way, individual items, departments and suppliers
can be evaluated from an ROI perspective.
Computationally, GMROI is the gross margin dollars generated by a
specific item (or department or supplier) during the course of the year
divided by its average inventory investment over the year. In practice,
very few firms calculate GMROI directly. Instead, most firms actually
calculate an approximation of GMROI, more correctly called the Turn &
Earn Ratio. The two ratios share basic DNA, so the exact form of the
computation is not a problem as long as the firm uses the same method
consistently.
GMROI (via the Turn & Earn formula) is the Gross Margin Percentage times
the Inventory Turnover Ratio. The typical AVDA member has sales of
$400,000,000, and cost of goods sold of $320,000,000 resulting in
$80,000,000 of gross margin. It also has inventory of $45,000,000. The
firm thus has a gross margin of 20.0% ($80,000,000/$400,000,000) and an
inventory turnover of 7.1 times ($320,000,000/$45,000,000). Combining
the two produces a GMROI of 142.2% for the firm.
For managers with experience using GMROI, the value of this form of the
calculation is obvious immediately. If the firm wants to increase GMROI,
it has two financial levers to work with—it can try to increase the
gross margin percentage or increase the inventory turnover. Either
choice should lead the firm to a greater return on the inventory
investment.
To get a feel for how GMROI is biased, it is necessary to examine
Exhibit 1 which reviews three items, cleverly labeled Items A, B and C.
As the exhibit indicates, these three items all have identical sales
levels. However, they are very different in terms of both their gross
margin and inventory investment.
Item B in the middle has been designated
as typical. It has a gross margin of 20.0% and an inventory turnover of
7.1 times. To understand what is happening in the firm, it is necessary
to know that Item B really is exactly typical. Since the typical AVDA
member has a total firm gross margin of 20.0% and turned its inventory
7.1 times per year, Item B is a microcosm of the total firm.
Item B is flanked by two items with somewhat unique characteristics.
Item A generates 20.0% more gross margin dollars than Item B on the same
sales, but requires a 20.0% larger investment in inventory. It is a
classic high margin/low turnover SKU.
In contrast, Item C is the mirror image of Item A with 20.0% fewer gross
margin dollars than Item B, combined with a 20.0% smaller investment in
inventory. It is in the low margin/high turnover camp. Clearly, these
three items are not equal.
GMROI is almost always used as to identify problem items. It is a “what
should we worry about” sort of ratio. The answer, based upon GMROI, is
to worry about the items with the lowest return. In Exhibit 1 this turns
out to be Item A, with a GMROI of only 135.1%. At the extreme, Item A
might even be considered a candidate for elimination given its low GMROI.
If not a candidate for elimination, at least a candidate for corrective
surgery. However, Item A actually produces the most gross margin dollars
of the three items shown.
At the other extreme, Item C with the highest GMROI would be designated
as a superstar item. It is the sort of item that management might want
to emphasize in its marketing programs. The firm would try to sell all
it can to enjoy the benefits of the item’s great GMROI of 149.3%.
It should be remembered that the typical AVDA member has an overall
gross margin of 20.0%. It also has operating expenses that equal 18.0%
of sales. Assuming that all three items have about the same cost
structure (they are all in the same merchandise category), then Item C
could be well under water as operating expenses actually exceed gross
margin. Probably not an item to push.
GMROI will always make low gross margin items look better than they are
and make high gross margin items look worse than they are. It is a bias
that leads the firm down the wrong profit path. GMROI continues to be a
ratio that is based upon a brilliant concept, but is flawed beyond
repair in operation.
Suggestions for Action
The real advantages of GMROI are that it is quick to calculate and easy
to understand. However, quick and easy but inaccurate is not necessarily
a formula for success. Something else is needed, but that something else
is almost always a lot more effort.
The real solution is to move to measuring direct product profit (DPP).
Such an approach involves measuring the actual dollar profit generated
on every individual product, department and supplier. This requires
determining not only the gross margin produced on each item, but the
expenses associated with buying, stocking, selling and distributing that
item.
The real advantage of DPP is that it opens up a wide array of different
ways to improve the profitability of individual items. The answer may
not be just more gross margin or less inventory, but rather lowering
handling costs, selling in different quantities or any of a myriad of
different actions. If there are lots of things that drive profit, there
is no real reason to focus on only two of them.
GMROI was invented before computers of any sort existed. This made the
ease of calculation always more important than the level of
sophistication of those calculations. With today’s incredibly low cost
of computing power, the trade off should now favor sophistication.
Beyond information systems, there is also the need for education of the
management team. GMROI is ingrained into the collective thinking of
virtually every distribution organization. Replacing GMROI with
something more difficult to understand will not be easy. If done
correctly, though, the something new will lead to much better decision
making.
About the Author
Dr. Albert D. Bates is founder and president of Profit Planning Group, a
distribution research firm headquartered in Boulder, Colorado.
©2007 Profit Planning Group. AVDA has unlimited duplication rights for
this manuscript. Further, members may duplicate this report for their
internal use in any way desired. Duplication by any other organization
in any manner is strictly prohibited.
A
Managerial Sidebar:
GMROI Versus Turn & Earn
True GMROI and the Turn & Earn Ratio both attempt to measure the return
on the firm’s investment in inventory. However, they do involve two
somewhat different ratios. When comparisons are being made across
industries, it is essential to ensure that the same calculation is being
employed in all cases.
The basic difference between the two ratios is as follows. All figures
are for a typical AVDA member.
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