I would expect blank stares if I asked a brand finance person what their Inventory IRR is, but it’s my favorite pet metric because it distills into a single number the potential of the brand’s core engine and provides a quick diagnostic check on what’s happening under the hood and how to make the engine run better.
The core engine of a brand is acquiring inventory at a low price and selling it at a higher price. Doing this repeatedly creates a cycle and the two components of the cycle that matter are
- how much money is left after the cycle and
- how quickly the cycle happens.
Margin metrics such as Product Margin, Gross Profit Margin, Contribution Margin 1 Pre-Marketing, Contribution Margin 2 Post Marketing etc describe the how much is left part. And Inventory Turnover, Days Inventory and CCC (Cash Conversion Cycle) describe how quick the cycle is.
Inventory IRR combines the how much and how quickly into a single number. What it’s telling you is the annualized return you could achieve if you fed that engine continuously. But Inventory IRR lets you go deeper than the company level and understand the strength of the engine at the product level.
Your financials are a composite of all your activity. They are the sum of all the sales, expenses and uses of capital over a month or quarter or year. If you are not making enough profit or you are using capital inefficiently, how do you fix that? This is where the Inventory IRR gets really useful because you can quickly calculate it by product and then tease out the winners and losers from your product mix.
But before we dive into how to use this metric, let’s quickly understand how I am calculating it. Below is a simple worksheet you can copy, load in your own numbers and play with.
How I Calculate Inventory IRR
You can calculate Inventory IRR’s for the company as a whole (the composite) but you can easily calculate the IRR’s for individual products. An important note here is that I am not spending time trying to be super precise. Some things we will know quickly like the average time it takes between paying for a certain product and when it shows up in the warehouse and the product margin. For other items, I take averages or company averages. I start with a company wide Inventory IRR. But doing this on a product or category level reveals real insights as it quickly reveals unknown strengths or weaknesses of certain products.
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You can make a copy of the worksheet below to get started.
What Inventory IRR Tells Me
#1 Product Margin is critical
The IRR is most sensitive to this variable. Single percentage point increases make huge differences in the IRR. Turning a dollar of inventory into five instead of 4 makes a massive difference in the quality of your engine.
I am surprised at how often when you look at an underperforming brand the core issue is product margin. Sometimes the brand has not found Product Margin Market Fit, but sometimes all the other aspects of the business, especially advertising performance, have swamped the mindspace of the team so product margin is underweighted.
Inventory IRR is unforgiving. Low IRR’s are almost always a result of insufficient product margin.
#2 Product level IRR’s quickly reveal winners and losers
Product margins, the time between paying invoices and receiving the inventory, sales velocity, CAC’s and repeat/new sales will vary by products and categories. Is a product dragging down your overall IRR’s? Is a product unexpectedly subsidizing other products? Does a product have much higher repeat purchasing than other products? Does a product require much higher CAC’s?
One of my favorite examples of this is the backpack story from Michael Preysman at Everlane. For years the company focused on backpacks because they sold so well. But when someone finally looked at the data, it was clear that backpack buyers were one and done. They didn’t come back to buy other clothing. Product level IRR’s will reveal your product losers.
Another example is the hero product or introductory product with low margins that suck up disproportionate amounts of the ad budget. These products are justified internally because ‘they bring people in the door’ and ‘introduce people to the brand.’ The product IRR will reveal the real cost of these justifications.
#3 Are your IRR’s high enough to support outside capital?
You don’t borrow money at 25% to invest it at 10%. You wouldn’t do this with your personal money, so why would you do this in your business?
In a previous post I explain why you should use the IRR of outside capital to determine the true price as opposed to the capital providers’ stated APR. One of the main reasons for using IRR is so you compare your ability to use the capital to the price of the capital.
If your Operating Profit IRR isn’t well above the IRR on outside capital, you are going to create problems. Also, your company wide Operating Profit IRR may be OK, but when broken down at the product level you may find you are borrowing money at 30% in order to invest it in inventory that returns single digits IRR or even negative IRR’s. This will obviously create working capital and cash problems.
#4 Negative IRR’s are bad, very bad
If your Contribution Profit Post Marketing IRR is negative, you have a real problem. On the company level, you need to immediately start generating contribution margin before you do anything else and your biggest lever is product margin.
If your Operating Profit IRR is negative and you are early stage, then you need to focus on keeping OpEx as low as possible while you scale contribution profit past your OpEx threshold and get to profitability. If you are not early stage, you have a potentially serious capital problem. Think about it like this: your negative Operating Profit IRR is telling capital providers that you are good at turning dollars into eighty cents. Maybe that engine is fundable because you are on the cusp of scaling past OpEx. But more likely your product margin is too low and a lot of the other levers in the engine are not where they need to be.
#5 Repeat Sales and CAC are big levers
Playing with the assumptions for the percentage of sales coming from repeat customers and CAC reveal how impactful these two metrics are. Play around with your copy of the worksheet and see how much these assumptions alter the IRR’s. Obviously these numbers are approximations, but they directionally are accurate estimations of the size of these levers.
I would not set my CAC targets based solely on the IRR’s but they provide a useful second set of guardrails for what your maximum CAC’s can be.
#6 The trend of IRR’s over time is a signal of management quality
Strong management teams will make continuous improvements that compound over time. If we think of the IRR’s as the strength of the product’s and brand’s core engines, then the improvements by management will show up in improving IRR’s.
Composite financials i.e. the company wide financials can make discovering these improvements harder. It’s easy to get bogged down in the individual metrics, but looking at the IRR trend will quickly tell me that things are getting better (or worse) and the scale of the change gives me clues as to why i.e. big changes are likely from product margin improvements and/or better efficiency on repeat sales and CAC’s.
#7 The IRR’s describe current potential of the products and company
What does a Contribution Margin Post Marketing IRR of 1500% even mean? What is an Operating Profit IRR of 285%. On the surface, it’s hard to put these IRR’s in context. We know that 50% return from an investment is great, but how do we put 1500% in context? If I can make 16X my investment over a year, why am I not staggeringly rich?
First, the IRR’s don’t take into account all the costs of the business. For example the Operating Profit IRR doesn’t account for interest and taxes. Second, the IRR’s assume constant daily compounding which is not realistic because a brand doesn’t place PO’s for all products every day.
Determining IRR’s on a monthly basis reduces this compounding effect.
#8 The IRR’s help us understand the impacts of small improvements over time
People are very good at intuitively identifying patterns and extrapolating linear trends. We are terrible at intuiting compounding or exponential trends. We know that brand success requires continual small improvements and thus relies on the compounding effects of those improvements. We also know we don’t have infinite time, money and resources to make improvements so we have to prioritize the improvement projects. It can be hard for brand leaders to understand and articulate the compounding impact of each improvement. The IRR’s give a clear score on which improvements have the greatest impacts over time.
Let me know your questions, what I can make clearer and your suggestions for improving this framework.