What are the pros and cons of using internal rate of return to evaluate inventory investments?

1 What is inventory investment?

Inventory investment is the amount of money that a business spends on buying, storing, and managing its inventory. Inventory is the stock of goods that a business has on hand or in transit to sell to customers or use in production. Inventory investment can be positive or negative, depending on whether the business increases or decreases its inventory level over a period of time. Inventory investment is part of the working capital of a business, which is the difference between its current assets and current liabilities.

4 What are the disadvantages of using IRR for inventory investments?

One disadvantage of using IRR for inventory investments is that it may not reflect the true cost of capital. The IRR assumes that the cash flows from the inventory investment can be reinvested at the same rate as the IRR. However, this may not be realistic, especially if the IRR is very high or very low. A more realistic approach would be to use a discount rate that reflects the actual cost of capital for the business, which may include the cost of debt, equity, and taxes. Another disadvantage of using IRR for inventory investments is that it may not be unique or consistent. Sometimes, an inventory investment may have more than one IRR, or no IRR at all, depending on the pattern of cash flows. This can make it difficult to compare and choose between different inventory investments. Moreover, the IRR may not agree with other criteria, such as the net present value or the payback period, when evaluating mutually exclusive projects or investments.

5 How to use IRR with other inventory analysis tools?

IRR is not the only tool that you can use to analyze inventory investments. You can also use other methods, such as the economic order quantity (EOQ) model, the inventory turnover ratio, and the ABC analysis. The EOQ model helps you determine the optimal order quantity and frequency that minimizes the total inventory costs, such as ordering costs, holding costs, and shortage costs. The inventory turnover ratio measures how efficiently you use your inventory to generate sales. It is calculated by dividing the cost of goods sold by the average inventory value. The ABC analysis helps you classify your inventory items into three categories, based on their importance, value, and frequency. The A items are the most important and valuable, and require the most attention and control. The B items are moderately important and valuable, and require less attention and control. The C items are the least important and valuable, and require the least attention and control.

You can use IRR together with these other tools to optimize your inventory investment decisions. For example, you can use EOQ to find the optimal order quantity that maximizes your IRR. You can use the inventory turnover ratio to monitor your inventory performance and adjust your IRR expectations accordingly. You can use the ABC analysis to prioritize your inventory investments based on their IRR and their impact on your business goals.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?