If you use the Amazon FBA Restock tool, you may have noticed that excess inventory management requires you to specify a cost of capital. In that context, Amazon uses it to help determine discount levels for excess stock.
But in practice, this metric has a much more important purpose — one that goes far beyond clearing excess inventory.
Consider a situation where you have borrowed money to accelerate the growth of your business.
The interest you pay is the cost of your borrowed capital.
But even your own funds have a cost, for a simple reason: you almost always have alternative ways to use that money.
If you choose to invest in working capital instead of another opportunity, you give up the return that alternative could have generated. That forgone return is also a cost — the cost of your own capital.
It is reasonable to expect at least the same return from investing in working capital as from the best alternative uses of your money, adjusted for risk. (Higher risk assumingly should correspond to higher expected return on investment.)
Taken together:
- •the cost of borrowed funds, and
- •the cost of your own funds (your opportunity cost)
form what is effectively your cost of capital.
Compare Values Expressed Over the Same Time Period
When comparing the return of a product with your cost of capital, it is important to compare values expressed over the same time period.
Since interest rates on loans are usually presented as annual rates, the expected return on investment on the product should also be evaluated on an annual basis.
A product may look attractive in absolute terms per cycle, but if the cycle is long, its annualized return may be lower than your cost of capital.
Similarly, a shorter cycle with modest profit may outperform once both alternatives are brought to the same timeframe.
The Bottom Line
It does not make sense to allocate your limited capital in a product if it generates a lower return than your cost of capital — even if the product sells very well.
In that case, someone else benefits from your effort, while you effectively lose money by not earning the return you could have earned elsewhere.
Therefore, when making working capital investment decisions, compare the expected return on investment of the product with your cost of capital.
- •If the expected return on investment is higher, you are creating value.
- •If the expected return on investment is lower, you are losing money — not through a negative margin, but through the opportunity cost of capital that could have been deployed more effectively elsewhere.
In the previous article, Lead Time as a Financial Variable: Why Buying "Cheaper" Can Cost You More, we looked at how lead time affects capital efficiency by changing how long money is locked.
In the next article, Making Better Restocking Decisions When Capital Is Limited, we'll explore how capital constraints change restocking decisions from independent choices into comparative ones.