Answer to Question 1
Sometimes called the interest or opportunity cost, capital cost focuses on the cost of capital tied up in inventory and the resulting lost opportunity from not investing that capital elsewhere. For example, all organizations borrow money from external sources to fund operations. This money might be in the form of equity (from stock issues) or debt (borrowing from banks). In either case, borrowed money has a cost associated with it. For equity, it is dividends; for debt, it is interest payments. In either case, an organization incurs a cost for borrowing money. If an organization decides to use this money to buy raw materials, build manufacturing plants, and hire labor to produce finished products for storage, then this inventory carries this borrowed money cost while sitting waiting to be sold. As such, capital tied up in inventory still requires dividend or interest payments to the funding source. The opportunity cost of this inventory is the return on capital the organization might have realized if it had invested in another opportunity rather than in raw materials, plants, and labor.
The capital cost is frequently the largest component of inventory carrying cost. An organization usually expresses it as a percentage of the dollar value of the inventory held.
In practice, determining an acceptable number to use for capital cost is not an easy task. One way of calculating capital cost for inventory decision making might use an organization's hurdle rate, the minimum rate of return on new investments. In this way, the organization makes inventory decisions in the same way that it does for investing in new facilities, advertising, and so on.
Another way of calculating capital cost is for an organization to use its weighted average cost of capital (WACC). WACC is the weighted average percent of debt service of all external sources of funding, including both equity and debt. This method reflects the direct debt service costs of having capital tied up in inventory.
Answer to Question 2
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