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Making Consignment and Vendor-Managed Inventory Work for You

By Mark K. Williams, CFPIM  mark.williams@att.net

Introduction

As manager of a manufacturing or distribution operation, you’ve just been notified by two of your largest customers that they want to purchase goods on consignment.  A third very large customer wants to emulate Wal-Mart and begin a Vendor-Managed Inventory (VMI) program - with you as the chosen vendor. 

You’re beginning to see the pattern: your customers want to increase their profits at your expense. Instead of paying for product within 30 days of delivery, the two who want a consignment program want to delay payment until after using or selling your product. The third wants to go one step further - they want you to plan their inventory!  

It’s obvious how these moves will benefit your customers, but is there any benefit for you? We’ll examine these issues in a moment, but first, let’s define terms.

Consignment & VMI Defined

The APICS Dictionary1 defines consignment as “The process of a supplier placing goods at a customer location without receiving payment until after the goods are used or sold” (author’s emphasis). This is very different from traditional practice whereby a customer pays for goods within a set time period after receiving them (often 30 days). Under consignment, it makes no difference whether product sits in the customer’s warehouse or shelves for two days or two years; the supplier receives nothing until it is used or sold. This could result in a serious cash flow problem for the supplier if goods continue to be produced but money is not collected. 

Vendor-Managed Inventory (VMI) is a planning and management system that is not directly tied to inventory ownership. Under VMI, instead of the customer monitoring its sales and inventory for the purpose of triggering replenishment orders, the vendor assumes responsibility for these activities. In the past, many suppliers operated vendor-stocking programs where a representative visited a customer a few times a month and restocked their supplies to an agreed-upon level. Popularized by Wal-Mart, VMI replaces these visits with information gathered from cash registers and transmitted directly to a supplier’s computer system via Electronic Data Interchange (EDI). Now, suppliers can monitor sales of their products and decide when to initiate the resupply procedure. This is not an inexpensive proposition for suppliers.  Investments must be made in new systems, software, and employee training. Which brings us back to the question: Is there a payoff?

Benefits of VMI 

In the article “Integrating Vendor-Managed Inventory into Supply Chain Decision Making,” Mary Lou Fox 2 outlines four advantages of VMI: 

1.  Improved customer service. By receiving timely information directly from cash registers, suppliers can better respond to customers’ inventory needs in terms of both quantity and location.

2.  Reduced demand uncertainty. By constantly monitoring customers’ inventory and demand stream, the number of large, unexpected customer orders will dwindle, or disappear altogether.

3.  Reduced inventory requirements. By knowing exactly how much inventory the customer is carrying, a supplier’s own inventory requirements are reduced since the need for excess stock to buffer against uncertainty is reduced or eliminated.

4.  Reduced costs. To mitigate the up-front costs that VMI demands, Fox suggests that manufacturers reduce costs by reengineering and merging their order fulfillment and Distribution Center replenishment activities. 

While these are all potential benefits of VMI, the most important ones were not cited. 

        Improved customer retention. Once a VMI system is developed and installed, it becomes extremely difficult and costly for a customer to change suppliers.

        Reduced reliance on forecasting. With customers for whom a supplier runs VMI programs, the need to forecast their demand is eliminated. 

VMI - Binding Customers to Suppliers 

Once a VMI system is established, a customer has effectively outsourced its material management function to its supplier. After a period of time, the customer will no longer have the resources to perform this role in-house, making him more dependent upon the supplier. In addition, developing a VMI system entails major costs to the customer. His information services department has to spend time ensuring a smooth transfer of data to the supplier. And his materials management organization has to spend a significant amount of time making sure that the chosen supplier will perform, and beyond that, ironing out a myriad of details ranging from what will trigger a reorder to how returns will be handled. Once all this work is done, nothing short of a major breach in a supplier’s performance will prompt the customer to search for a new supplier. With VMI, customer/supplier partnerships are not only encouraged, they are cemented.

Sidestepping the shortcomings of forecasting

Traditionally, most manufacturing and distribution operations determine what to sell and how much to sell by way of forecast. Countless hours are spent developing, massaging, and tweaking forecasts – only to have them turn out to be dead wrong. Why? Because a forecast is nothing more than “an estimate of future demand” (APICS Dictionary). And, unlike Nostradamus, most of us cannot predict the future! Under VMI, instead of a supplier forecasting what customers will buy - which means guessing at 1) what customers are selling, 2) their inventory positions, and 3) their inventory strategies – a supplier works with real sales and inventory data first hand. Because the supplier is effectively handling their customers’ materials management function, customer inventory strategies are revealed.  Soon, the supplier finds that it can provide input on the timing of promotions and safety stock strategies such that it can easily accommodate changes in demand. This reduction in demand uncertainty enables suppliers to operate at higher service levels with lower inventories. Clearly, these are benefits coveted by any and all suppliers.

Benefits of Consignment

Such are the benefits of VMI - what about consignment? Isn’t that the same as giving a customer an interest-free loan? Maybe. Before passing judgement, let’s take a look at how most companies do business and examine the components of inventory carrying cost.

Most manufacturing and distribution companies, with the exception of make-to-order firms like Boeing, hold inventory for customers in the form of finished goods. This buffers manufacturers against fluctuations in demand. However, this stock of finished goods doesn’t come free. As Ross indicates below3, annual inventory carrying costs for most companies range from 20 to 36 percent. 

Cost of Capital

10 – 15%

Storage & Warehouse Space

2 – 5%

Obsolescence & Shrinkage

4 – 6%

Insurance

1 – 5%

Material Handling

1 – 2%

Taxes

2 – 3%

Total Annual Inventory Carrying Costs

20 – 36%

 Let’s examine the impact of consignment on two businesses that both have annual carrying costs of 36 percent. Company A holds finished goods inventory and Company B has just decided to provide it on consignment. Company A is responsible for capital, storage, handling, and all other costs listed above.  Company B is responsible for providing the capital, and as owner of the goods, is responsible for paying taxes on what isn’t sold. However, under consignment, Company B is no longer responsible for storage or material handling. In addition, as with most consignment agreements, Company B’s customers now have responsibility for any damage or disappearance of goods on their properties. Thus, Company B has transferred its cost of insurance and “shrinkage.” Finally, by closely tracking the use of product and acting swiftly on slow-moving items, Company B can minimize or completely eliminate product obsolescence.  

A quick review of cost components demonstrates that by implementing a consignment program, Company B can reduce its annual inventory carrying costs from 36 percent to 18 percent (cost of capital + taxes) in a consignment program, a reduction of 50 percent! However, if too many dollars are put into customers’ warehouses on consignment, the negative impact on cash flow could leave a supplier asset rich and cash poor, a condition that could lead to bankruptcy. The solution: a well-designed consignment agreement. 

Keys Points in Any Consignment Agreement

 When negotiating a consignment agreement, it is critical to consider the elements of cost, responsibility, and time. The key elements are as follows: 

v      Level of consigned inventory. A customer would prefer to hold a large amount of consigned inventory, viewing it as a cheap way of buffering against demand uncertainty. The supplier, however, must determine the level at which it can provide goods profitably. Negotiating a set number of weeks of supply will meet the needs of both parties. If the customer sells/uses $5.2 million dollars a year and the agreement calls for ten weeks of supply, both parties know that $520,000 is the consigned level. The supplier can now budget for the capital required and the potential taxes involved in supporting the inventory. Adjustments can also be made in its cash flow projections. This arrangement also provides the customer with an incentive for increasing sales of the suppliers’ products since an increase in sales translates into an increase in consigned inventory.

v      Responsibility for slow-moving inventory. Another key element in a successful consignment relationship is to keep the inventory moving. Developing inventory turn goals, by individual product or by product group, can uncover slow-moving items that are inappropriate for consignment. During negotiations, it is important to determine which party will monitor inventory turnover and how slow moving goods will be handled, whether they will be returned to the supplier or purchased by the customer and removed from the consigned inventory.

v      Responsibility for damaged or lost inventory. Another critical factor to address during negotiations is the disposition of stolen or damaged inventory. It is customary for the customer to assume complete responsibility for all consigned inventories - lost, stolen, or damaged - on its premises. A periodic physical inventory needs to be established to account for all consigned inventories.  

By following these guidelines, a successful – and profitable – consignment relationship can be established that benefits both parties.  

Conclusions

 We have examined some of the benefits of VMI and consignment from a supplier’s perspective. Indeed, there are benefits to both approaches, as well as costs and risks. By understanding and managing the costs, and controlling the risks through careful negotiations, one can make both consignment and VMI work not only for the customer, but for the supplier as well.

 References 

1. APICS Dictionary, 8th Edition

2. Fox, Mary Lou, Integrating Vendor-Managed Inventory into Supply Chain Decision Making, APICS 39th International Conference Proceedings, 1996

3. Ross, David Frederick, Distribution Planning and Control, Chapman & Hall, 1996 

About the Author

 Mark K. Williams, CFPIM, is currently Consulting Manager with The North Highland Company, an Atlanta, Ga. based firm specializing in Supply Chain Management Consulting. Prior to this Mark spent two years at Georgia-Pacific as Senior Manager of Materials and Manager of Logistics, and over twelve years in manufacturing and materials management in various positions for the Vermont American corporation including Operations Manager, Distribution Manager, Materials Manager, Production Control Manager and Corporate Internal Auditor. 

Mark received a BA in Political Science from the University of Louisville. He is an APICS Certified Fellow in Production and Inventory Management (CFPIM). He has taught many APICS certification review courses and spoken to both APICS Chapter and Region Meetings on a variety of topics. Mark has presented at three APICS International Conferences. 

Mark is Past-President of the Falls Cities Chapter (Louisville, Ky.) of APICS. Currently, Mark is a member of the Inventory Management Committee of the Curricula and Certification Council. In addition, he is also Director of Education of APICS Region IV that includes Georgia, Florida, Alabama, Mississippi and Puerto Rico.

 


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