Acceptable ROI on inventory: How much is enough?

Last week, I started talking about the cash flow problems caused by inventory in growing businesses. I mentioned that I would return to the subject today and talk about inventory ROI (return on investment).

If you invest in assets in your business, ROI should be one of the main factors you consider. Let’s look at a few examples.

First, let’s assume that you have calculated that buying a $30,000 forklift will improve productivity by 10% and you have figured out that after paying all running costs, it will save you $10,000/year. Roughly speaking (accountants might quibble with me about depreciation and such things), the ROI in the first year is 33%. You get this simply by dividing the increase in profit you expect to gain ($10,000) by the cost of the investment ($30,000).

Now, if you were in real estate, you would salivate over a 33% ROI. Real estate investors have to be happy with 8-12% ROI though there is a big difference: their investments are much less risky than your forklift purchase. Regardless, this is a reason why business can be a lot of fun. Very often, the ROI on your inventory/investments can be quite high.

Now, let’s consider a second example: inventory. Let’s say that your business is doing $400,000/month with a 50% gross margin and you keep one month of inventory on the shelf. What that means is you have $200,000 invested in inventory.

Let’s say that your vendor comes to you with a proposal. She tells you that if you will purchase $400,000 in inventory, you will get a 10% discount. In other words, you will have to boost your inventory from 1 month to 3 months.

Again, I am going to simplify this in a way that your accountant may not like, but let’s calculate a rough ROI to decide whether the deal is attractive. First, the discount translates to a savings of $40,000. That $40K is yours for the taking if you decide to take it. You have to put up $400,000 to make $40,000 but you only have to put it up for 2 months.

The ROI on the additional purchase is a whopping 60%. The ROI would be 10% if it would take you a full year to get your money back but you are going to sell it in two months (1/6th of a year). Therefore, you multiply 10% by six.

There simply are not many people in any business that would walk away from a 60% ROI. I can tell you that very often, a 60% ROI is low end. We have seen ROIs on inventory in the range of 200%.

With those salivating ROIs comes risk. The product could be defective or the market for it may collapse. Some prudence is in order. But if you are in the business and believe in what you are doing, it is going to be very hard to pass up those kinds of opportunities.

This is also why fast-growing companies often do not have any money (read more about this here). They have growing inventory needs but they are also using excess cash to take advantage of volume discounts. In some cases, they are also using leverage (debt).

All this is fine and good as long as the risk is figured into the calculation and that brings me back to my original question: what is an acceptable ROI on inventory.

The right answer is it depends on the risk. The higher the risk, the bigger the ROI needs to be. However, it is hard to imagine a situation where you want that ROI down at the typical level of real estate. Only very large companies that are very stable can consider such things.

I should also mention that using debt increases the ROI but also increases the risk. In the example above, if you borrowed half of the $400,000, your ROI doubles. In general, that is additional ROI we choose to pass on. We very rarely use debt to fund inventory. The reason why may surprise you. We choose to avoid debt because of how it impacts intangible things like our decision making and the way we want to live outside of work.

I actually want to discuss that last sentence in more detail next week. There is a significant emotional impact that comes from cash management in an inventory business. That impact is very important even though you will not find many business blogs talking about it.