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. Suppose you have a vendor who has a $500 minimum order, but offers free freight for a $2,500 order:
- Determine the how much it costs (per dollar) for the vendor to send you a shipment. This can be done by dividing the total freight charges on the last five vendor shipments by the dollar amount for the merchandise on those shipments. If you do not have this information:
- Determine the total weight and/or volume for each of the last five shipments from the vendor
- Contact a freight company to find what the freight charges would have been for each shipment
- Divide the total amount of the freight charges for these shipments by the total dollar amount for merchandise on those shipment
- A $2,500 pre-paid freight order offers a discount equal to 2500 times the average freight cost per dollar of material determined in step #1. For example, if the freight cost was $.20 per dollar of material, a freight-paid $2,500 order provides you with a discount of $500 ($2500 x $.20).
- Add the cost of the freight you must pay for a minimum order to the cost of the material on that order. For example, the minimum order the vendor will accept is $500. If freight costs $.20 per pound, you will have to pay an additional $100 in freight. So you will pay $600 for $500 in material. For a prepaid order, you will pay $2,500 for $2,500 worth of material. That is, you won’t pay freight on the larger order.
- Calculate the month’s supply of the vendor’s products that each purchase amount represents. Assume that total demand for all of the stocked products in the vendor line is $500 per month:
$500 ÷ $500/month = 1 month’s supply
$2,500 ÷ $500/month = 5 month’s supply - 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.
- Multiply the net value of material purchased at each discount level by one-half. This is the average amount of the inventory purchased that will be on-hand during the time it takes to sell the entire shipment. For example, if it takes 20 days to sell the entire shipment, the average amount you will have on-hand is a 10-day supply. Half the time you’ll have more than a 10-day supply, half the time you’ll have less than a 10-day supply. Note that freight charges, which are part of the net investment, are not considered in the average inventory investment!
Level Invty
InvestAvg. Invty 500 500 250.00 2,500 2,500 1,125.00 - Calculate the holding cost percentage for the time period you will have the shipment by dividing the annual holding cost by 12 (to determine the holding cost per month) and then multiplying it by the month’s supply determined in step #4. The annual carrying cost for this example is 30%. Thirty percent divided by 12 is 2.5%.
Level Month’s Supply CC% per Month Total Hold Cost % 500 1.00 2.5% 2.50% 2,500 5.00 2.5% 12.50% - Multiply the total holding cost percentage from step b by the average inventory investment that was calculated in step a. The result is your “holding cost dollars”:
Level Total Hold Cost % Avg Invty Holding Cost $ 500 2.50% 250.00 6.25 2,500 12.50% 1,125.00 140.63
- Multiply the net value of material purchased at each discount level by one-half. This is the average amount of the inventory purchased that will be on-hand during the time it takes to sell the entire shipment. For example, if it takes 20 days to sell the entire shipment, the average amount you will have on-hand is a 10-day supply. Half the time you’ll have more than a 10-day supply, half the time you’ll have less than a 10-day supply. Note that freight charges, which are part of the net investment, are not considered in the average inventory investment!
- Your total cost of inventory (including all of the costs you will incur) is the net investment plus the holding cost dollars:
Level Net Invest Holding Cost Total Cost 500 $600 6.25 606.25 2,500 $2,500 140.63 2,640.63 - 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. This is calculated by dividing the total cost of inventory determined in step #6 by the stock dollars required for each purchase amount.
Level Total Cost Cost per Dollar of Inventory 500 606.25 1.2125 2,500 2,640.63 1.0563
The cost per dollar for the $2,500 order is $1.0563, or 12.9% lower than the level at which you have to pay freight. Even considering the cost of carrying the additional inventory, the freight savings realized with a $2,500 order make the larger purchase worthwhile. But if the freight expense were less than $.20 per pound, it might not be a good idea to purchase a five month supply just to avoid freight costs. This analysis gives what was previously a very subjective decision a definitive dollars-and-cents answer.
And keep in mind that you cannot place a $2,500 order every week. In order to reap the savings of the free-freight offer, you must place larger purchase orders, less frequently. If you place a $2,500 whenever you need one or two items, you will increase the amount of inventory in your warehouse. It will take longer to sell this stock, resulting in much higher carrying costs. It won’t take long for these carrying costs to exceed the discount provided by the free-freight offer, no matter how costly the shipping charges.
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!