Inventory holding cost

Many vendors offer to pay freight charges if an order exceeds a certain minimum requirement. Many buyers are "brainwashed" into thinking that they must always place an order that meets the free-freight minimum, even if it means bringing more inventory than can be used or sold in a reasonable amount of time. But is placing a free-freight order always a good idea?

In this article, we're going to examine a process that will let you determine whether or not placing a free-freight order is a good buy. As you will see, sometimes you can maximize your profitability by paying the freight.

How much is free freight worth? That's easy. It's the dollar amount on the freight bill. This amount is an additional discount offered by the vendor. Using the process described below, you can determine whether this discount exceeds the cost of carrying the additional inventory necessary to meet the freight prepaid requirement.
Calculate the inventory holding cost that would be experienced at each discount level. The holding cost is the amount of money necessary to maintain the balance of a vendor shipment in your warehouse during the time it takes to sell the entire shipment. It is calculated using the inventory carrying cost percentage, a measurement that reflects who much it costs to maintain a dollar's worth of stock inventory in your warehouse for an entire year. How to determine the inventory carrying cost percentage is discussed in some of our other articles. The company in this example has an annual inventory carrying cost of 30%. That is, it costs 30 cents to maintain a dollar's worth of inventory in the warehouse for an entire year.
Your total cost of inventory (including all of the costs you will incur) is the net investment plus the holding cost dollar.
Finally, calculate the cost per dollar of inventory. The cost per dollar of inventory relates the total cost of inventory at each purchase level to the amount of inventory you will receive.
Even considering the cost of carrying the additional inventory, the freight savings realized with a $2,500 order make the larger purchase worthwhile.
So, if you plan to take advantage of free-freight offers, perform the analysis described above. And only purchase these quantities when it's time to place a normal target with the vendor. You'll always know when your vendor is offering you a good deal!