Retailers and business-to-business sellers use gross margin return on investment as a key gauge to determine questions of inventory management and profitability. GMROI puts the cost of obtaining inventory next to how much it yields in profit, taking into account total sales and variances in inventory cost. Gross margin return influences stocking and pricing decisions, as well as the frequency and extent of discounts.
Because many factors can influence the cost of inventory, prudent sellers use their average cost in determining whether to increase or decrease product supply as well as how much to charge for it. The actual cost of goods sold is only part of the equation, as shipping, taxes and other costs necessary to obtain the inventory must be included. The average cost is found by adding that figure to the month's or quarter's closing inventory and dividing in half.
Operational efficiencies often accompany higher sales, so well-managed inventory with an increasing sales profile can return higher gross margins. For example, if the Busoni Corporation orders 1000 of its Faust dolls, the shipping cost is only marginally more expensive than ordering 500, so its gross margin return is higher if it sells all 1000 items. Knowledge of the marketplace and buyer behavior are essential in guarding against purchasing too much inventory with the hope of increasing gross margins.
Inventory that sits on shelves not only produces no immediate profit, but it takes up valuable shelf or catalog space that would be better devoted to faster-selling items. The speed with which products move often determines the retail price, as sellers can afford to sell popular items for less gross margin than slow-moving inventory and still come out ahead. If, for example, the gross margin of Publisher A's book is $5 and it sells 5,000 copies annually, its return on investment is $25,000. Publisher B's book may earn a $10 gross margin but with only 1,000 sales, it earns 40 percent less.
Raw Materials Prices
The prices of metals and energy, for example, can vary widely from day to day as they are often traded on public exchanges. If the retail price of a product remains constant over a fixed period of time, yet the input costs decline, gross margins will rise. The converse is also true, and larger companies often have their own trading operations to ensure a continuous supply of materials at advantageous prices.
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