Gross margin return on investment is a useful metric for evaluating profitability. Managers and investors can use this ratio to determine the return generated by the inventory. It is especially useful for retailers carrying large amounts of inventory.
Defining Gross Margin
Gross margin is the percent of sales earned after accounting for the cost of products sold. The higher this percentage, the greater the earnings for each item sold. The actual gross margin percent a company earns depends on its industry. For example, manufacturing is a relatively low-margin business while software developers and high-end retailers have high gross margins. When calculating gross margin return on investment, however, gross margin is computed as a dollar amount rather than a percentage. Therefore, gross margin is simply the dollar difference between total sales revenue and the cost of goods sold.
Gross margin ($) = sales revenue - cost of goods sold
So, if a retailer had $750,000 in sales revenue for products that cost $500,000, the gross margin in dollars would be $250,000.
Calculating Average Inventory Cost
Average inventory cost measures the average amount spent on inventory over a certain period of time. Find the inventory cost at the beginning of every month in the period as well as the inventory cost at the end of the final period. Then find the average of those numbers.
Consider a retailer that wants to calculate average inventory cost over the first quarter. Inventory is $190,000 at the beginning of month 1, $195,000 at the beginning of month 2, $200,000 at the beginning of month 3 and $175,000 at the end of month 3. The average inventory cost would equal $190,000.
Calculating Gross Margin Return on Investment
Divide gross margin by average inventory cost to compute gross margin return on investment.
Gross margin return on investment = gross margin / average inventory cost
For example, a retailer has a gross margin of $250,000 and an average inventory cost of $190,000. The gross margin return on investment would be 1.32.
Analyzing the Ratio
A gross margin return on investment equal to 1 indicates the company’s revenue matches its inventory costs. There is no value being created for shareholders. A gross margin return on investment below 1 means the company is earning less than the cost of its inventory. A gross margin return on investment above 1 indicates a healthy company utilizing its inventory to create value for shareholders. The higher this ratio above 1, the better for the company. The company should compare its ratio to that of its competitors since the market average will differ across market segments.
Kimberly Goodwin has a Ph.D. in finance from the University of Alabama and is an associate professor of finance and the Parham Bridges Chair of Real Estate at the University of Southern Mississippi. She publishes in top real estate journals as well as on her blog, Your Finance Professor. Goodwin is also the managing editor of the Journal of Housing Research.