Save Costs by Differing Inventory Ownership!

It is extremely easy to convert cash into Inventory, but it is immensely hard to convert inventory into cash.  The success of Inventory management lies in balancing the cost of carrying inventory with benefits of carrying inventory.  Under these circumstances, if someone can suggest a solution that could help the company to differ the ownership temporarily, it would be an ideal solution for any business.  Is it feasible?  The answer to the question is yes and no.  Yes, because it is possible using a concept called Vendor Managed Inventory (VMI) and no because, in order to implement the concept, we need to make sure that some factors within the supply chain are optimized.  This concept is hugely common under Pull supply chain and heavily used in IT-High Tech industry and also in automotive and retail industry.  In order to make this concept work for business, the supply should be abundant and multiple suppliers and also supplier willingness to participate in the VMI program.

Let us understand how using VMI, one can differ Inventory Ownership for any organization.  This concept is also known as “Supplier Owned Inventory” but popular term is VMI.  The VMI was first introduced by Kurt Solomon Associates in 1992 (http://www.kurtsalmon.com). VMI perhaps is the most widely known Inventory minimization solution which allows buyers to authorize the supplier to manage the level of inventory at the buyer’s site or in a 3PL site close to the buyer’s location under agreed upon parameters.

VMI can be used for components management as well as Finished Goods.  In a normal practice, in any manufacturing environment, organizations carry inventory in anticipation of orders and the title rests with manufacturing organization. In this conventional setup, the chances of carrying appropriate inventory hinges on demand forecast accuracy.  As current markets are defined as hyper markets and conditions are dynamic, the forecasting accuracy is anywhere between 70% to 85% at the finished goods level and at the component level the forecast accuracy could be much lower if the product has many variations.

Based on the survey data collected during Institute of Business Forecasting conference held in 2004, the forecasting errors at SKU levels by Industry are given below:

Source: “Benchmarking Forecasting Practices”(2006) by Chaman L Jain and Jack Malehorn.

A Practical Model:

Parties Involved:

1. Buyer;
2. Suppliers;
3. 3rd Party Service Provider.

Process:

Step 1: The buyer places the blanket purchase order based on annual or quarterly demand for an SKU.

Step 2: Buyer appoints a common 3PL service provider who will handle products from all suppliers.  The cost of warehousing will be negotiated by the Buyer and advices all suppliers accordingly.  The suppliers are responsible for the 3PL cost.

Step 3: Based on the recent demand trends and actual consumption pattern, the buyer and seller collectively work out three inventory levels to be managed in a 3PL Warehouse.  They are, Maximum Inventory Level, Replenishment Level and Minimum Inventory Level.  The same information will be shared with 3PL also.

Step 4: Based on the defined inventory levels, the supplier will supply the material to the warehouse managed by the 3rd Party.  The inventory title at this point of time will remain with the supplier.

Step 5: Based on daily demand in the trading environment or based on daily manufacturing plan, the buyer would pull the inventory into the production line or the warehouse.

Step 6: 3PL will arrange to deliver the pulled material to the buyer.  At this point of time, the inventory ownership is transferred to the buyer from supplier.  The SKU that was pulled that particular day could be sitting in the 3PL warehouse for any amount of time.  However, the ownership will be transferred to the buyer only when the SKU was pulled into buyer’s premises and the payment terms kick-in from that time onwards.

Step 7: Daily use (pulls information) will be shared by the 3PL with all respective suppliers either by EDI or as an email attachment.  At the same time, the suppliers should be in a position to monitor their inventory levels periodically using 3PL web based Warehouse Management System (WMS).

Step 8: Based on the inventory levels, the supplier may use EOQ or any other technique to determine the economic lot to be despatched and will replenish the inventory at the third-party warehouse.

Step 9: Based on the agreed payment terms, the buyer will organize the payment for the SKUs consumed/pulled.

In simple VMI helps organizations to manage uncertain demand with reliable product supply and also allow the buyers to differ the inventory ownership till the actual point of consumption.

Benefits of VMI: According to Fernando del Cid, Roger Gordon Brian Kearns, Paul Lennick, and Andreas Sattleberger, the following companies are wonderful case studies for VMI success.

• At K-mart: Inventory turns on seasonal items have gone up from 3 to between 10 and 11; and for the non-seasonal items form 12-15 to 17-20. (Retail)
• ACE Hardware, Fill rates rise 4% to 96% in the past few years.(IT/High Tech)
• Fred Meyer, Inventory carrying reduced up to 40%. (Retail)
• Grand Union, Inventory Turns up by 80%. (Grocery Retailer)
• Oshawa Foods, Inventory turns improving from 3 to 9 times, while achieving customer service levels of 99%.  (FMCG)
• Panduit, Able to reduce replenishment costs which were squeezing profitability out of the entire supply chain using VMI model. (Electronics)

Source: vmi.doc. (n.d.). Retrieved from http://www.prenhall.com/divisions/bp/app/chopra/word/vmi.doc

There is no doubt that VMI would eliminate inventory carrying to a large extent.  However, in an integrated supply chain world, if the supplier is carrying inventory on behalf of the buyer, the cost of carrying inventory is always passed on to the ultimate customer.  Having said that, the overall inventory management efficiencies could improve because of the supply chain transparency and the collaborative approach adopted by the buyers which allows the suppliers to access the real-time data + forecast in advance in order to manage the supplies to VMI hub.  There is also a hidden danger because of the transparency.  The suppliers could modify the forecast based on past performance without considering the market dynamics, which could lead to material shortage.  As mentioned earlier trust is the foundation for the relationship.  As long as there is trust and mutual cooperation between the buyer and supplier, a healthy supply chain is a certainty!