Estimating the opportunity cost of capital for inventory investments

Accurately estimating inventory holding cost is important for several reasons. It would lead to an improved analysis of the benefits of Just-In-Time philosophy, a more accurate specification of cost savings associated with investments in new technologies, and improved accuracy of production-inventory decisions. The inventory holding cost of a firm is typically calculated as the sum of the out-of-pocket cash flows associated with storage, and the opportunity cost of capital tied in inventories. Recently many writers have suggested that inventory holding cost may be misestimated in many firms. This paper presents an approach for estimating the opportunity cost of capital for inventory investments. The approach uses the capital asset pricing model CAPM to evaluate the risk of the cash flows associated with inventory decisions. Using the periodic review inventory model as an example, the paper shows how the opportunity cost of capital varies with lead time, ordering costs, and the time between reviews.