When You Keep Costs Low and Still Lose Money

Bear with us today, because we’re going to dive into the numbers of running a business… but our intentions are good: to help you profit.

Most general managers are focused on keeping cost of goods sold low, and prices as high as the market can accept. Buy low, sell high: if you do this consistently, you make healthy profits, right?

Not necessarily.

There’s a metric called gross margin return on investment (GMROI) and it dives a bit deeper. Scott Kreisberg, CEO of One Step Retail Solutions, GMROI asks, “For every dollar invested, how many dollars did I get back? How much did I pay for the merchandise and how much did I sell it for?”

GMROI = Gross Margin (divided by) Average Inventory Cost

According to Kreisberg, “GMROI calculates the return based on the gross margin from sales. For example, if you purchase $2,000 of inventory and sold it all in the same year for $6,000, your profit would be $4,000. The return on your investment of $2,000 was $4,000. The GMROI in this example is $4,000/$2,000 = 2.”

Still with us?

But in the example above, if you sold your inventory for $1,900, your GMROI would be .95 and you’d be losing money.

Why would you do that?

You might do that if…
● You had to order so far ahead of time that market conditions changed before you actually received the inventory
● Your customer needs product now, but you can’t get it. By the time your inventory comes in, they no longer need it.
● You order too much inventory, then interest rates start climbing and you need to sell at a loss

To use a close-to-home example, on orders we have a 72-hour turnaround time. Many of our competitors are two to six weeks out on fulfilling orders. Are we always the cheapest? No. But we’re almost always the fastest, which means you can fulfill your customer’s needs when they happen.

The more you study GMROI, the better you understand that cheap inventory is no bargain if it ends up arriving at the wrong time or being sold for even less than you paid for it.

Join the discussion 4 Comments

  • John Lambie says:

    What are the industry standards for GMROI? 2? 4? 12?

    • admin says:

      Hi there. Great question and bear with me as I delve into this topic a bit deeper.

      First let me say that GMROI is a standard metric that companies with physical inventory can use to measure profitability of the product for the seller. The outcome will vary based on a number of factors and so therefore there is no standard or target outcome like a GMROI of 2 for a company. Instead, GMROI along with other key performance indicators will be used by a company to inform and better execute their “product, pricing and sales” strategy. A GMROI of 0 would mean a company really needs to get their act together and make big changes to their strategy… a GMROI of 2 would mean their strategy is working well.

      That distinction being made, a GMROI is used to measure the productivity of your inventory. A GMROI greater than 1 means you are selling the merchandise for more than it cost you to acquire and that is a very good thing. Obviously, a GMROI below 1 is not. So I guess you could say as a general rule of thumb a GMROI above 1 would be preferred by this and any other industry.

      Each product may have a different GMROI since it is dependent on inventory turns, average inventory and gross profit. The GMROI can be higher for a low gross profit product that has high inventory turns vs a high gross profit product that turns infrequently. If you are measuring gross profit without average inventory & turns, you may think the product with the greater gross profit is more profitable but it may not be. Furthermore, a product that turns rarely will require a higher margin to be profitable.

      Additionally, carrying inventory due to longer lead times from your supplier(s) may have an impact on your profitability that you would not be aware of if you used gross profit as your key performance indicator.

      In today’s climate where customers want more value, more service for less price, paying attention to your inventory turns, investment AND your gross margin are the best way to increase profit.

      Thank you for interest and we appreciate you asking the question!

  • John Lambie says:

    I appreciate the detailed response. I find this to be a very interesting metric and have made it a part of my monthly evaluation.

    If you have other thoughts or hear back from other companies regarding their finding please don’t hesitate to e-mail me.

    Thank You

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