A few weeks ago a Canadian distributor emailed me with a very interesting situation:

"The vendor of one of our seasonal product lines has an interesting program to encourage us to stock a lot of their products. At the end of the popular season, they give us a full credit for all of our remaining stock on hand. They then re-bill us for this material next year, at the start of the popular season. Any obsolete material can be returned to the vendor and will be credited at full cost. Our salespeople are telling our buyers to stock tons of the material as unsold stock really doesn't cost us anything. How much should we buy?"

There is an old expression that there is no such thing as a free lunch, and I firmly believe that there is no such thing as free inventory. Just because the vendor issues a credit for any unsold material at the end of a season doesn't mean that the distributor doesn't incur costs in carrying the stock in their warehouse for the remainder of the year. These are the costs the distributor will experience in carrying this stock:

• Moving material from the receiving dock to the proper bin location and shifting it to other warehouse locations as necessary (such as to bulk storage at the end of the season and back to the picking area at the start of the next season).

• Insurance on the inventory. If it is in your warehouse, you are probably responsible for it.

• Rent and utilities for the portion of your warehouse used to store material. The material takes up space that could be used to store other products, sublet to another business, or not rented in the first place.

• The cost of physical inventory and cycle counting. If you don't buy it, you don't have to count it.

• The cost of inventory shrinkage. If it is in your warehouse, someone may steal it or it may be broken.

• Opportunity cost of the money invested in inventory – that is, how much could you make if the money tied up in inventory was invested in a relatively safe, income-producing investment. Or, if you finance your inventory purchases, the amount of interest that you pay the bank. Note that the distributor will only experience the opportunity cost during the popular season, as they will get their money back for any unsold material when the season ends.

The one typical cost of carrying inventory that this firm won't experience is product obsolescence. They won't have to sell some of the material below cost, or throw it out, because it has exceeded its expiration date or fallen out of fashion.

Because the company will only experience the opportunity cost for a few months, and they will have no cost of obsolescence, they will have a lower than normal cost of carrying inventory. How low? Well let's look at an example:

Say the firm normally writes off two percent of the average inventory value each year because of obsolescence. If the normal annual carrying cost for the company is 28%, the annual carrying cost for this obsolescence-free inventory will be 26%. But this figure must be further reduced because the company's money is only invested during the popular season. Assume that the popular season is four months long, the annual opportunity cost is eight per cent, and $10,000 worth of inventory is purchased for the entire season. If the annual opportunity cost is 8%, the monthly opportunity cost is 0.67% (8% ÷ 12). If we multiply this amount by four months, the result is a carrying cost of 2.68% – that is, a further reduction of 5.32% (8.00% - 2.68%) off of the annual carrying cost for the inventory of this product line. The result is a further reduction of the carrying cost to 20.68%. In fact, the actual carrying cost will be lower than this amount as the cost of any material sold during the four-month period will be immediately available for re-investment by the company, providing an opportunity for additional profit.

The economic order quantity formula (EOQ) is often used to determine how much of each product to order from the vendor. This formula is discussed in several of our articles and books, as well as most purchasing and inventory textbooks. A common version of the EOQ formula is:

If we order products using this formula, the lower carrying cost will suggest that we order more of each of the products in the line. Here is the EOQ for an item with monthly demand of 100 pieces, a cost of ordering of $5 per purchase order line item, and a replacement cost per unit of $25.

Here is the EOQ at the company's normal 28% carrying cost:

And here is the EOQ at the lower 20.68% carrying cost:

We will purchase 17% [(48 - 41)/41] more inventory at the lower carrying cost.

Yes, because of the vendor's special credit policies, the distributor should purchase more inventory. But, they should be careful not to get carried away and fill up their warehouse with material that won't contribute to the company's bottom line. There is, after all, no such thing as free inventory.