The effect of inventory decisions and parameters on the opportunity cost of capital

Inventory costs are typically calculated by adding the out‐of‐pocket cost of holding inventory and the opportunity cost of capital tied up in inventory. The concept of opportunity cost of capital is based on the business risk of the firm associated with particular decisions. Most firms use a fixed opportunity cost of capital; an assumption also made by most production and inventory models. In other words, it is assumed that the production and inventory decisions do not affect the business risk of the firm. But, this assumption may be inappropriate given that the competitive environment in most industries has altered significantly in the last decade. This is evidenced in the popularity of just‐in‐time manufacturing systems, concerns for justification of new manufacturing technologies such as flexible manufacturing systems and robotics, and efforts to reduce inventory and setup costs. All of these catalysts for becoming more competitive have one thing in common—they alter the business risk of the firm significantly. Hence, in adopting, implementing and sustaining any of these, it seems appropriate that the change in the business risk is reflected by varying the opportunity cost of capital. This paper uses a simple single product inventory model to present a conceptual framework to show how various inventory parameters and decisions affect the firm's business risk, and hence the firm's opportunity cost of capital. The inventory parameters considered are setup cost, out‐of‐pocket inventory holding cost, replenishment lead time, standard deviation of demand, and correlation of demand with the stock market. The decision parameters considered are lot size and safety stock decisions of the firm. The framework also discusses how this interdependency can be incorporated in the decision‐making process. This paper applies existing finance theory to inventory problems to develop some new insights and discuss possible applications of these insights. Our analysis has three main results. First, the business risk, and hence the opportunity cost of capital for inventory investments, is an increasing function of setup cost, replenishment lead time, out‐of‐pocket inventory holding cost, standard deviation of demand, and the correlation of demand with the stock market. Second, the opportunity cost of capital is a decreasing function of variable profit per unit (selling price minus variable costs). Third, lot size reductions can increase the business risk of the firm, and hence, the opportunity cost of capital, unless accompanied by a simultaneous decrease in the setup cost. The above mentioned results have a number of interesting implications in the current manufacturing environments where firms are changing their cost accounting systems, developing new ways to measure performance, and developing better ways to evaluate investments in new technologies. First, our results suggest that inventory of products with high lead times and high setup costs should be charged a higher opportunity cost of capital. This would not only lead to a more accurate estimate of the cost of producing different products but also provide managers with incentives to reduce lead times and setup costs. Second, lower inventory levels reduce the business risk of the firm, and hence the opportunity cost of capital. Thus, investments in new manufacturing technologies that help reduce inventories should be evaluated using a lower discount rate. Third, reducing lot size while ignoring the lot size economics, can actually increase the business risk of the firm. This suggests that firms should not unilaterally reduce lot sizes, but should simultaneously seek to decrease lot sizes and setup costs. This will reduce the business risk of the firm. Fourth, our analysis indicates that another benefit of just‐in‐time (JIT) manufacturing philosophy is that it lowers the business risk of the firm. This is an important implication for JIT because firms with low business risk are less likely to be adversely affected by recessions than firms with high business risk. Fifth, since lower lead time reduces the business risk of the firm, investments that reduce lead time, as well as evaluation of decisions on sourcing, should incorporate the benefits of reduced business risk. Similarly, a supplier's marketing strategy should emphasize the benefits of lower business risk for customers due to its lower lead time. Finally, many researchers claim that inventory holding cost is understated as the implicit costs of holding inventory are often difficult to assess. Our analysis shows why inventory holding costs may be mis‐estimated.