Retail Inventory Optimization – How Standard Measures Of Inventory Profitability Can Mislead You

If you are the owner of a small to medium-sized retail store (or stores), typically 75% of your investment is in inventory. In addition, except for add-on services and custom orders, nearly all sales revenue and profits are generated by your inventory. Most importantly, excess inventory can suck up all your cash, and force you to insolvency and closure.

Therefore, one of your primary goals is to maximize the return on your inventory.

The standard industry measure of how well you are accomplishing that is called “gross margin return on inventory investment,” or GMROI. GMROI is defined as:

(Sales – Cost of Goods Sold) / Average Inventory Value (at cost)

GMROI can be calculated for the whole store, for individual items, for departments, and for any arbitrary group of items.

The higher the GMROI, the more money you make for every dollar you have invested in inventory.

Retail consultants typically give the following advice:

  • Calculate the GMROI of your inventory items
  • Identify the items with the lowest GMROI, and those with the highest GMROI
  • Look to replace the items with the lowest GMROI, with items more like those that have the highest GMROI

In principle, the above is very good advice. By focusing on the types of merchandise that yield the greatest profit, a retailer will be able to improve his cash flow and profits.

It therefore seems that all you have to do is to install a POS and inventory-management system that provides that type of information (a caveat – except for the very high end, most POS systems do NOT track average inventory, and therefore cannot compute GMROI or inventory turns at the item level).

In practice, however, the solution is not as easy as the above suggests. This is because an item’s GMROI is greatly affected by the retailer’s own actions. In many cases, to improve GMROI, what the retailer has to do is change his processes, not his merchandise!

Put it another way – no matter what you replace an item with, GMROI will remain low, if the underlying cause of the low GMROI is one of these:

  • Excessive stocking of slower-moving items
  • If you carry the same average inventory of a slow-moving item as a fast-moving one, it will naturally have a lower GMROI. For example, we had a customer that would always purchase more of any item in one department, if his stock was down to 3 dozen of the item. For his top sellers, that represented only 1 week’s sales. But for the slower-moving ones, it would take more than a month to sell 3 dozen. Naturally, the GMROI of the slower-moving items were much less than the GMROI of the faster-selling ones.

    If you can reduce your stocking level of a slow-moving item, you will increase its GMROI. That’s because your average investment will be lower. In general, you don’t have to replace merchandise with a low GMROI, if you can reduce its average inventory without reducing its sales.

  • Buying overly large lots at a time
  • You may be buying large quantities of an item because you get a volume discount, or because the vendor convinced you to stock up on it. For example, one of our retailers was tempted by a vendor’s volume discounts. He would purchase quantities large enough to get to the discount level of much larger stores than his. Unfortunately, those orders were so large they would take over 6 months to sell. As a result, his cash flow suffered greatly, and the GMROI of those items was very low.

    The good news is that you don’t have to look for replacements for items with this problem. All you need to do is exercise cash-flow discipline, and order smaller quantities more frequently. GMROI will rise proportionately, and you will find yourself with more cash.

  • Extreme markdowns
  • You may be using an item as a “loss-leader” by pricing it at cost, or even lower. Or, the selling season may have been shorter or less pronounced than normal, and you ended up having to offer a drastic clearance sale on the seasonal items. Either one of those will cause the items to have a low measured GMROI.

    Again, the good news is that you don’t have to replace the merchandise. Just ignore the apparently low GMROI – the profitability is actually higher than your calculations indicate. If you are using the item as a loss-leader, you should charge the losses to marketing. If you had offered a clearance sale on seasonal items, resolve to be more conservative next time. The point is: if you manage the item’s pricing the same way you do your other items, its GMROI will be higher, and you may not have to replace it, after all.

  • Moving items to slow-moving display locations
  • In any store, the merchandise in some parts of the store move faster simply because of their location. Island displays, eye-level shelves, the front of the store – merchandise in those areas will sell more than the merchandise in other areas. If an item is not in those high-traffic areas, expect its sales to be lower than if the item were displayed in the high-traffic areas. That will bring GMROI lower.

    Replacing those items won’t be likely to raise your sales, profits, or GMROI. Any replacement item you place in a low-traffic area will still have lower sales than if it were in the high-traffic areas.

    Unfortunately, the high-traffic area of any store is limited. So, you can’t put all of your merchandise in high-traffic areas.

    The solution is to keep less stock of the items you place in the low-traffic areas. By lowering average inventory in proportion to the lower sales volume, you will be able to free up cash and raise the GMROI.

As you can see, there are a lot of reasons why GMROI can be lower for some items than others. You should first try to pinpoint why the GMROI is lower, and to try ways to bring it up. Ask how to have your system calculate the “potential GMROI” of an item, which is what it will be after you make all the adjustments suggested above. You should only replace items if their “potential GMROI” is still low.