Using a term like Vendor Managed Inventory speaks more to a concept than an actual defined system. VMI refers to a supply system in which the vendor is responsible for pushing items to the customer rather than the customer pulling them through devices such as purchase orders or releases.
Because of the general nature of the term, there are a number of decisions which must be agreed upon between the vendor and customer prior to implementation.
In the coming weeks, I am going to highlight the 5 most critical decisions that must be made. These decisions are crucial for both customer and vendor given their impact on important variables such as:
- Cash Flow
- Return on Assets
- Inventory Levels
- Cash Cycle
- Payment details
- Inventory Risk
Understanding the risks ahead of time and properly implementing a VMI can save $1,000s for both suppliers and customers.
In a VMI, [the vendor is agreeing to supply parts by delivering before being needed by the customer]. Because of the nature of this setup, the customer is making some type of commitment or contractual agreement before receiving parts or even knowing quantities to be supplied. This creates risk on both sides of the agreement.
The customer is agreeing to something that will not occur at one point, but will instead be delivered over some time period. This allows for variations in quality of service or product as well as a number of exogenous variables that may enter as situations occur.
This also presents a risk to the vendor. In order to supply properly the vendor is required to stock parts to by supplied later. This indicates that they may order thousands of dollars of inventory, which the customer may never take.
There are various ways to help the the vendor and customer feel comfortable with these risks. The main ones are below:
Blanket Purchase Order
With a blanket purchase order, the customer issues a large order covering 6 - 24 months of usage for all parts in the program. The hesitance with customer’s to place large orders is the payment on these being due within payment terms. However, under with VMI programs, they orders are fulfilled over time, and thus invoicing will not occur all at once, but instead over time. So the order is basically just a cover for the supplier.
The result of a blanket po is an inventory level still at zero, therefore leaving ROA untouched. Instead the PO would be on accounts payable and affecting current liabilities and net working capital.
This gives the vendor the coverage they need in order to feel safe ordering the items, knowing that at some point the customer is committed to buying them.
Blanket Purchase Orders may or may not have release dates on them. Release dates are predefined dates and quantities for each item. So if you have a blanket order for 12000 widgets, you may state right in the purchase order that you will release 1000 on January 1, 1000 on February 1, etc.
When using blanket orders for A VMI program, it is actually better to leave release dates off. This gives the program flexibility to move with the usage of the customer rather than preset dates. The program works best when the vendor can truly push parts based on the usage of each part. This removes the administrative burden of planning demand from the customer (a key benefit of the VMI)
If release dates are added to the blanket, the burden of monitoring and updating those releases to jive with current production usage grows. Each time demand slows or speeds, all release dates on all parts under the VMI must be adjusted by moving them forward or back. This in turn generates updated purchase orders which are then sent to the vendors and entered into their systems. The administrative burden that grows to monitor all parts and move dates forward and backward can grow exponentially with the number of parts on the program. It also requires a high level of monitoring and adjusting on behalf of the customer.
The most successful programs are the ones that maintain the flexibility to auto adjust with demand, rather than manually controlled from either side.
Without release dates, vendors can monitor usage and keep facilities supplied based on the [supply settings] (talked about in part 3 of this series). This allows the customer to truly move the burden to the vendor.
With increased vendor flexibility to react and supply based on usage, we see corresponding increased service levels for the customer as well as improved customer financial metrics.
Let’s consider two extremes
- If there is no agreement in place (or blanket order), the vendor will order /build whenever the customer places an order. This results in a larger than needed lead-time for the customer. The customer’s lead time becomes the vendor’s lead-time + order processing time + build time.
- If there is a 24 month blanket agreement. The vendor can order all 24 months at once, get better pricing, and have a large supply of stock on hand in order to fulfill the customer demand no matter the run rate.
The more flexibility the vendor has in order to react to customer usage and demand requirements, the less intervention and paperwork needed by the customer to maintain production.
So the best way to move forward is to find an agreement and purchase method which balances
- Vendor Inventory Risk
- Customer Commitment Risk
- Vendor Flexibility
- Customer Control.
This is where Supply Agreements start to make sense.
A Supply Agreement is a document which lists the basic terms and workings of the VMI and includes clauses and appendices stating
- Items in the program
- Quantities of those items
- Prices of those items
- Term of the agreement
- Conditions under which the
- agreement can end
- customer can find alternative supply
Inventory Commitment Clause
An Inventory Commitment Clause states what happens should the VMI program, or specific parts on it, suddenly end. For each part on the program, the clause shows how much inventory the customer agrees to buyout. So if they vendor agrees to keep at least 6 months on hand at all times, this clause states that if the program should suddenly end, or the parts not be used anymore, the customer would buy up to 6 months of inventory from the supplier to close out that part on the VMI.
This can be in effect with supply agreements as well as blanket purchase order VMIs. One of the goals of the VMI is to eliminate chances of a line down for the customer. This requires what is commonly called buffer inventory at the vendor.
The vendor will hold more parts than needed in case parts are required above what is expected. What could cause this?
- quality issue with a current lot
- increase in production
Having a buffer stock, ideally in multiple lots, allows vendors to quickly supply parts to customer’s under varying conditions. If the vendor has 3-6 months of anticipated inventory on hand, and the customer doubles the production rate without notice, the vendor still has 1.5 to 3 months on hand. This does two things
- It allows the vendor to have 1 - 3 months to better equip their stock for the changed production rate
- It keeps the customer line moving without a shutdown.
The other side of buffer stock is that it increases inventory risk for the vendor should a line shutdown or a part revision change. So it is essential to give the supplier confidence in building proper buffer for the customer, to have some guarantee that parts will be purchased by the customer in the case of sudden shutdown.
The length of time depends on two main variables
- Lead time for the part
- Uniqueness of the part
If a part takes 3 months to get in (3 month lead-time) for the vendor, then holding a 3 months supply will require the vendor to make an order each month.
Should something go wrong such as delayed production or other unforeseen event, there is no actual buffer and there will be a part outage - only delayed 3 months.
A useful buffer must be calculated in terms of lead time, generally from 2x - 4x a part’s lead time. This allows ample supply to cover quality issues, reorders, production variation, delayed or lost shipments, or the myriad of other problems that occur.
However, this results in large inventory on-hand for a vendor. Thus it becomes essential that guaranteed up time from the supplier be accompanied with inventory commitments on behalf of the customer.
The other component that influences the specifics of this clause is that of uniqueness.
Some VMIs are simply a supply of standard fasteners. In this case, the inventory not used by one company, could be offloaded to another potential customer or marketplace requiring the same fastener.
Other VMIs contain unique items which that customer has designed and only they will buy. In this case, if a line shuts down, that inventory is truly dead and not able to be offloaded anywhere else.
Generally, the more unique an item, the higher the inventory commitment on the part of the customer.
Having the proper agreement in place is key to a successful VMI. VMI’s which are setup up, but not allotted the proper customer commitment on inventory or proper management by suppliers will ultimately fail.
We have a number of templates that are used by implemented VMIs both large and small. If you are interested, shoot me an email and I’ll get them right out to you.