Note: This is an update to a post that was originally called “Break Even Turns”. After comments from industry experts, I have updated the post to reflect the relationship between inventory turns and GMROII (Gross Margin Return on Inventory Investment). For most locations, a GMROII of between $2.50 and $3.20 is required to truly break even.
Managing cash flow is one of the greatest challenges of retailing. To compete, retailers need to focus on stocking shelves with the right amount of the right product. Too much product and inventory becomes bloated, tying up much needed cash. Too little product and valuable sales are lost.
Lots of retailers focus on turns, the number of times their inventory is bought and sold. Mathematically, a turn is the average inventory of a product divided sales. For example, if you keep 10 widgets on a shelf at all times and you sell 100 widgets, you have just turned that product 10 times. A product that turns frequently is sometimes referred to as a “fast-moving” product – it leaves the shelf faster than most.
Turns play an important role in product selection and product pricing. A higher markup on a product means you will need fewer turns to break even on your investment. Conversely, a lower markup means more turns are required to break even.
To break even, most locations require a GMROII of between $2.50 and $3.20. This depends on factors like rent, wages, utilities, etc. – expenses that are not typically included in cost of a product when analyzing margins.
I recently decided to spend some time researching the relationship between GMROII and turns for the purpose of optimizing the purchasing of a local retailer. I wanted to answer the question: “Given a certain mark up, how many turns will it take to for a product to reach a target GMROII”?
Surprisingly, it’s fairly simple. Mathematically, the target GMROII divided by the Cost Markup Percentage (Markup / Cost) equals the number of turns required. Consider a widget that you purchase for $1.00 and sell for $1.50. The cost markup percentage is 50% ($.50 / $1.00). With a target GMROII of $2.50, we can determine that the widget needs to turn 5 times to reach that goal.
Why is this even important? Because now you (or your buyers) can determine how many widgets to stock on your shelf to get your desired return on investment, especially if you have some sales history to base your decision on.
For example, assume you are selling a widget with a Cost Markup Percentage of 75% (purchased for $1, sold for $1.75). Based on the GMROII Turns formula, you know that you have to turn 3.33 times to post a $2.50 GMROII. Last year, you sold 20 of these widgets. If you expect demand to stay the same (if only it were that simple), then you know that your average inventory needs to be under 6 (20 units sold divided by 3.33 needed turns) to reach your GMROII goal.
The above example is overly simplified, but the message still holds. The GMROII Turns formula should be applied at an annual level to accommodate for seasonality. If a widget triples in sells during fourth quarter, then you should adjust what you stock to meet that demand.