In our previous article, we shared some basic such as to the what of Vendor Managed Inventory.
In this post we’d like to dive into the real benefits. Often the benefits are not clear to either side, and thus these programs are ignored. Even worse, they are implemented without understanding the cost savings that can be enabled, and thus they are never achieved.
However, there are real cost and time benefits to implementing a VMI… even if the piece price is higher!
In our experience, the move to a VMI has lowered total cost of ownership from 20% to 50%.
Implementation Of The VMI Program
VMI is a type of supply solution, it does not in itself describe the entire system. Once it is agreed that the customer wishes the vendor to supply parts based on a push system, there are a few details still to be hashed out.
The major areas that need to be agreed on are:
- Agreement Type
- Inventory Ownership
- Part Characteristics
- Supply Settings
- Purchase Mechanism
- Payment Terms
These decisions are largely based on the risk tolerances of the customer and vendor, and the strength (or trust) in the relationship.
They seek to answer basic questions such as:
- Where is the material stored?
- When does the customer take ownership of the material?
- Are are purchase order’s aligned?
- When is the customer invoiced?
- What are they payment terms?
- What happens on a sudden dissolution of the production line?
Benefits To The Customer
There are two main benefits for a customer to implement a VMI program.
The first relates to administrative burden. The more time involved in maintaining all parts in the facility to keep a production line moving, the higher the administrative burden. These activities include:
- Counting Inventory
- Planning Demand
- Placing Orders
- Receiving Goods
- Inspecting Items
- Moving between Processes
- Managing Vendors
Going back to our previous example, we can see that the number of items can add up fast when looking at low price, high volume goods such as fasteners. Repeating all of these activities across 120 parts, multiple times a year places a huge administrative burden on the customer. With a VMI, much of this can be reduced.
Moving to a VMI has the following outcomes
- The following activities are moved to the vendor
- Inventory control
- Demand Planning
- Supplier Management
- The following activities are greatly reduced
- Quality Inspection
- Receiving goods
- Placing Orders
In our experience, the move to a VMI has lowered total cost of ownership from 20% to 50%. Labor is expensive, and by drastically lowering the amount of labor needed by the customer in order to have parts at the production line, costs drop significantly. This why you may see companies pay 10% - 20% for parts on a VMI, they are still netting huge savings considering the overhead involved.
Let’s look at one example, the placing of orders.
Imagine a buyer who is the lead on fasteners for a few production lines. He may have to keep inventory lean, and therefore analyzes demand and places orders once per month. If there are 120 parts from 10 different vendors, that is 10 purchase orders per month or 120 purchase orders per year.
Here are a few stats on purchase orders:
- The average purchase order from inception, to being vendor confirmed takes about 30 minutes of labor, but can be as high as 45 minutes for more complex buys.
- The average purchase order costs about $90, but can go as high as $320 in some industries
This translates to 5 hours and approximately $1000 per month on orders for this one aspect of the production line.
The costs of administrative burden increase the more you consider the work, analysis, and time needed to go from identifying the need for a part, to that part being available on the floor.
ROA & Inventory Reduction
Another main reason for moving to a VMI is to lower inventory on hand.
Under a properly setup system, the supplier will make frequent trips to “top off” the the supply of parts. Frequent visits mean that the inventory on hand for the customer does not need to be very high.
Inventory is only needed in production, not for storage. The reason to store inventory is so that you don’t run out of parts and stop production. This leads to the amount of inventory on hand being a risk to reward question.
- Storing inventory is relatively cheap ; but increases asset levels and thus lowers Return on Assets
- Running out of inventory is extremely expensive, but lean inventory allows for greater cash for investments and a more nimble production facility.
A VMI program solves these issues and gives you the best of both worlds. The ability to have zero, or near zero, inventory on hand while also preventing expensive stock outs.
The supplier should have 3-24 months of inventory on hand moving the inventory risk and cash investment to them. They in turn will drop off daily or weekly, depending on the agreed upon terms, just the parts needed for production.
In this case, a successful program relies on
- concrete terms agreed upon by both parties
- free sharing of information on production and supply metrics
- a good relationship for forecasting and sharing risk.
Return on Assets
Return on Assets is a major metric for industrial companies and manufacturing firms. These companies tend to be asset heavy with production machines, equipment for moving, storing, and measuring material, and of course buildings, and facilities. With these types of firms, it important to make sure you are getting the most from your equipment. Return on Assets or ROA is one way of doing this.
ROA is defined as
It tells you how much income you are getting per unit of asset that you have. Said another way, it shows you the productivity of your assets in terms of the income they bring in to you.
Maximizing this metric entails both raising income and lower assets. Therefore, lowering inventory as much as possible, is one lever that can be used to maximize ROA, or the amount of income you get per dollar of assets your firm has.
The benefits become even more clear when we think of inventory as investment.
We can think of inventory as investment that ties up our cash. We are hoping for a return, but in the meantime we don’t have cash for other opportunities.
… becomes …
So getting the same income or return using less cash (or inventory) can really benefit customers by giving them more cash for growth and investment without reducing return or income.
Time is truly money in production. Processes that take time without producing a sellable widget eat into a customer’s profits. Example activities include:
- Machine down
- Switch overs
- Stock out
- and Lead-Time
Lead-times can reduce the agility of firm. If parts takes 8 weeks to order, produce and receive into the production facility, the quickest that the facility can react to engineering changes or production volume variations is 8 weeks or more.
With a VMI program in place, and a supplier who is close or within a day’s shipping distance, parts can be in place within a day.
It works like this
- Vendor orders all the necessary parts and stocks them with 6-24 months in the warehouse ready to ship
- Vendor delivers daily/weekly to the customer just what is needed
- Customer receives parts and used based on forecast build
Situation: High Production
In the case where production ramps up, the customer would normally be at risk of running out of parts earlier and then having the line down for 8 weeks waiting for replacement shipment.
The VMI would allow parts to be supplied from the vendor buffer stock with in a few hours to a day depending on the terms of the VMI.
The key is the buffer stock at the vendor’s facility allowing for both lean customer inventory, with low risk of stock outs.
Situation: Low Production
In the case where production slows down, the customer would normally then have high levels of stock in which cash was tied up and the cash cycle time would be extended.
The VMI usually has some max fill level for each part in the program. So if no parts were used, no parts would be supplied by the vendor. This allows for the inventory to quickly react to production levels without prior knowledge of the variations. The program itself adjusts based on the frequent vendor visits.
There are various other benefits that accrue to the customer as well.
Per Shipment Activities
Any task that must be repeated with each order can be greatly reduced (along with its costs) through a VMI.
An example of this would be quality lot inspections. Many firms require all incoming material to pass through an inspection before being officially received into inventory. This ensures the parts are correct and a production slow down will not occur.
Each time a company orders a part, it is called a lot. This is a unique production run or delivery. It is used to keep parts from different vendors, production runs, or deliveries separate. The thought is that individual lots will share the same characteristics and flaws since they were run or made at the same time.
As companies tend to keep inventory as lean as possible, this can lead to 12 - 48 orders and lots, and thus quality inspections per part per year. If we go back to our example of 120 parts, we are looking at 1440 to 5760 inspections per year. At a cost of $15 per inspection on the conservative side, the cost for inspecting these shipments would sit between $20,000 and $80,000 per year.
When moving to a VMI, all such activities are greatly reduced. The vendor will buy in larger quantities to fulfill demand for 6-24 months. This means their lots will be larger in quantity and smaller in frequency. Quality inspections are thus reduced from once a month or week, to once a quarter or even once a year. As long as the vendor properly labels parts and which lot they are associated with, the customer can pass the first parts from a new lot through inspection. Then all subsequent deliveries from that lot are already passed based on the previous inspections.
Shorter Cash Cycle
Under normal circumstances a PO is placed, and then parts are shipped and invoiced by the supplier. The parts must then be
- Moved to customer facility by logistics provider
- Moved to inventory
- Moved to production facility
With a VMI, parts are not billed until either they are delivered straight to inventory, or until use. Either way, the cash cycle is shortened by a few days to a few weeks.
Some programs do what is called purchase grouping where all deliveries over the past month are grouped into one purchase order. This lowers the administrative burden for both the vendor and customer since only one PO is cut each month (or whatever the grouping period is).
Under a purchase grouping arrangement, parts may be delivered for up to a month before they are even written into a PO and then invoiced against. This extends terms another 2 weeks on average (or half of the grouping period).
VMI programs are a soft way to extend payment terms for a customer without negotiating explicit term changes on the PO.