Financing Inventories with an Investment Efficiency Objective: ROI-Maximising Newsvendor, Bank Loans and Trade Credit Contracts

Abstract

The inventory and supply chain literature barely mentions any use of capital efficiency metrics, such as Return-on-Investment (ROI), and their impact on ordering decisions and inventory investments. Capital efficiency metrics offer a balanced view of profit margins and asset turns. Our work will offer an understanding of how such metrics, like ROI, affect orders at a stand-alone single stocking stage under demand uncertainty (newsvendor-like models) or within bilateral supply chains of a supplier and buyer interacting with the use of a trade-credit-contract. In both environments, the buyer is looking for financing its inventories either through a bank or through the supplier via extended payment terms. In the single stocking stage case, our buyer -- the newsvendor -- exhibits conservative behaviour and orders less than the traditional quantity. Our buyer is willing to trade-off profit margins for increased turns and end up with a shorter cash-to-cash (C2C) cycle and increased cash position. The analysis of the bilateral supply chain of our newsvendor buyer and a supplier, who is willing to finance the buyer’s inventories via extended payment terms (trade-credit contract), continues to support the low interest rate of such contracts. Interestingly now the buyer orders more than under profit optimisation. The ROI-driven buyer enjoys higher margins due to unusually low supplier financing rates even at slightly increased wholesale prices and is willing to reduce his inventory turns. The buyer ends up with improved working capital metrics (shorter C2C and increased cash position). The overall supply chain efficiency improves, and the supplier increases her percentage of the chain profit by offering higher wholesale prices but accepting some inventory financing risk. Using ROI to make ordering decisions better aligns these decisions with sound working capital management metrics while at the same time accounting in a balanced way for profit margins.

Keywords: Return on investment, trade credit, supplier financing, newsvendor