How do we decide which products to keep and which products to discard?
In a world with unlimited capital, you may decide to sell any product that is profitable, period.
But unlimited capital is never the case. So, by choosing to carry one product, this may mean no longer carrying another.
In order to compare profitability, we often look at Profit Margin and Internal Rate of Return (IRR).
While many people already know what Profit Margin is, they are often unfamiliar with IRR and how it can help them make profitable decisions.
What is the Internal Rate of Return?
Internal rate of return (IRR) is a method of calculating an investment’s rate of return. It shows the annual rate of growth an investment is expected to generate.
As the name suggests, it excludes external factors, such as the risk-free rate, inflation, the cost of capital, or financial risk.
Example to Understand the Internal Rate of Return
iPhone Case 10a
Profit Margin: 35% ($3.50 profit on 10.00 sale)
iPhone Case 11a
Profit Margin: 10% ($1.00 profit on 10.00 sale)
When faced with limited capital, you would choose the iPhone Case 10a because it has a better profit margin.
However, the margins for an individual sale do not take into consideration sales velocity. The true comparison between two products in terms of investment decision would be looking at the IRR.
As mentioned, IRR calculates an effective annual return based on a series of cash flows. Excel has a built in XIRR Calculation that we can use to calculate this.
Going back to the first example, imagine the cash flows look like this:
iPhone Case 10a
|1/1/2020||-65.00||Purchase Order 10 units|
|4/1/2020||10.00||Sale x 1|
|4/20/2020||10.00||Sale x 1|
|6/3/2020||20.00||Sale x 2|
|7/3/2020||10.00||Sale x 1|
|8/15/2020||10.00||Sale x 1|
|8/23/2020||30.00||Sale x 3|
|9/15/2020||10.00||Sale x 1|
You can see from our Google Sheet example here that the IRR for iPhone Case 10a is 134.34%. Not bad, right? Looks like an amazing return!
Now let’s look at the iPhone Case 11a.
iPhone Case 11a
|1/1/20||-90.00||Purchase Order of 10 units|
|2/1/20||10.00||Sale x 1|
|2/2/20||30.00||Sale x 3|
|2/3/20||40.00||Sale x 4|
|2/4/20||10.00||Sale x 1|
|2/5/20||10.00||Sale x 1|
The IRR on the iPhone Case 11a is a whopping 223.01%!
But how could this be?
The answer is the time value of money. While the profit on 11a was only $10.00 compared to $35.00, it was generated much quicker, which would allow you – the seller – to reinvest the capital that faster.
You can also see how factors such as Supplier Lead Time have a big impact on IRR. Case 10a took about 3 months to arrive from the date of payment, whereas Case 11a took only a single month.
That extra 2 months made a big difference in terms of opportunity cost. Imagine what you could have alternatively done with that money during the waiting period!
IRR and Borrowing Money
Another great thing about IRR is it tells you the maximum annualized interest rate that you can afford to pay to break even. If you can borrow at any rate below the IRR of an investment, that is a profitable decision.
Obviously, this is an oversimplified example that I used to illustrate the impact of IRR. Careful consideration must be made to ensure all cash flows related to the product are considered.
Also, if you are using historical data to look at past IRR, you are making the assumption that the future demand for the product would result in a similar future cash flow.
At the very least, when making any borrowing decisions based on IRR, be sure to use extra conservative assumptions so that you don’t end up losing money after financing costs.