Last month we looked at how to calculate inventory turnover. Many companies view inventory turnover as their primary measurement of inventory performance. But should turnover be the only inventory metric analyzed on a regular basis?
If a company enjoys high gross margins, it can be successful with lower inventory turns. Many surplus houses justify keeping items in their warehouse for years because they bought the material for pennies on the dollar and will eventually sell some of it for a premium. The Turn/Earn Index will help you balance turnover and profits. It is calculated by multiplying inventory turns by the gross margin percentage. It highlights situations where high margins can compensate for low inventory turns.
Say, for example, you turn over inventory of an item four times a year and earn an average 30% gross margin on each sale of the product. That’s a T/E Index of 120. We get the same return on investment value if we turn the inventory of an item only twice but make an average gross margin of 60% on every sale:
2 turns * 60% average margin = 120
On the other hand, the stock of a product with an average margin of 20% has to turnover six times in order to achieve the same 120 T/E Index. Your T/E target should normally be at least 120 (e.g. a vendor line turning six times annually and earning an average 20% margin). But the higher the T/E Index, the better!
A similar measurement to the Turn/Earn Index is Gross Margin Return on Investment (GMROI). GMROI is calculated by dividing gross profit dollars from sales in the past 12 months by the average inventory investment over the same time period:
Gross Profit Dollars from Past 12 Months ÷ Average Inventory Value
For example, if you earned $20,000 in gross profits from an average inventory investment of $10,000, your GMROI would be 200 ($20,000 ÷ $10,000 = 2.00). In other words you are earning $2.00 for every dollar invested in inventory.
Please note that while the Turn/Earn Index and GMROI both measure profitability, they do so based on two different scales (sort of like Fahrenheit and Centigrade temperatures). Compare the calculated T/E Index and GMROI using the following data:
|12 Month Sales Dollars||$8,000|
|12 Month Cost of Goods Sold Dollars||$6,000|
|12 Month Gross Profit Dollars||$2,000|
|Gross Margin ($2,000 ÷ $8,000)||25%|
|Average Inventory Value||$2,500|
|Turnover = ($6,000 ÷ $2,500)||2.4 Turns per Year|
T/E Index = 2.4 * 25% = 60
GMROI = 2,000 ÷ $2,500 = 80
Because they utilize different scales the GMROI will always be greater than the corresponding T/E Index. It doesn’t matter whether you calculate a T/E Index or GMROI. Either is a wonderful gauge of the profitability performance of your investment in stock inventory.