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Supply Chain Management With Vendor Managed Inventories

Author(s):

Bill Poole (CPIM)
Bill Poole (CPIM), Purchasing and Planning Solutions.

83rd Annual International Conference Proceedings - 1998 

For years companies thought low unit manufacturing costs were the only secret to a successful business. It is only recently that manufacturers have become aware of the total cost of doing business and that just low unit costs are not the only answer. This recognition has spurred supply chain management as a key function to improving corporate profitability. So key is supply chain management that many companies have reengineered their business around this strategy. Many of the costs of doing business that had previously been accepted as fixed are now being challenged and changes are occurring that result in activities being more cost efficient. These new practices start with the customer where much emphasis is placed on getting all materials delivered on time, in the exact quantity ordered, defect free and billings done error free. It is now understood that these areas add cost to doing business without adding value and the result is customers that are placed in a less competitive situation.

While extremely important, customer service is only one area that supply chain management is focused on. Back in manufacturing it is now recognized that lowering unit cost by just producing unneeded product is quite costly to a company. Thus for the first time manufacturing is no longer producing product just because they have labor available. Instead many companies now shut down their equipment and spend time training and working on other cost saving and process improvement techniques to allow better optimization of the supply chain. In many cases management has recognized the ills of looking solely at unit costs and has changed the measurement system for manufacturing managers. In addition to unit costs other measures such as inventory turns and customer service receive equal if not more than equal weighting when these managers performance is reviewed. Even Wall Street have changed their perspective on measuring the success of a company. For years earnings per share was the only measure. Now cash flow is looked at equally as an indicator of how well a company is performing. One of the key areas that shows up in cash flow is inventory. This paper will focus on how using vendor managed inventory (VMI) techniques can enhance cash flow and weigh heavily in the selection of suppliers.

The value of vendor managed inventories requires a good understanding of the total cost of doing business. For those companies to see the value of VMI requires they need to understand the total cost of the raw materials they purchase. This means that focus on unit cost of the materials purchased must take a back seat to the total cost of the materials procured. This means that supplier selection will take into account many additional criteria including:

  • Inventory
  • Material quality
  • On time delivery
  • Value added services
  • Non-value added cost
  • Integration of material

Interestingly enough these are all key measures when looking at VMI and how it can reduce the total cost to manufacturing.

On time delivery to the day or hour specified with zero tolerance for either being early or late is likewise a key to reducing safety stock. Also when working with suppliers that deliver as promised the amount of expediting is drastically reduced as the planner/buyer knows the delivery will be on time.

VENDOR MANAGED INVENTORY METHODOLOGIES
One of the most effective ways of dealing with improving the total cost picture is by initiating a vendor managed inventory program (VMI). In the simplest terminology VMI places the responsibility for planning and maintaining inventory with the supplier with the ownership of the material typically changing at the time the material is consumed or when the finished product is transferred to finished goods. Three ways we have seen VMI effectively utilized are outlined in the following:

1. Having an employee from the supplier's plant located at the customer site and actually doing the planning and material replenishment for the customer. This includes having access to the customers computer system as well as the authority to place replenishment orders. The benefits from this relationship are the supplier has information as to how much and when material will be consumed. This allows them to schedule their plant's production in a more effective manner. In some cases the vendor on site planners are able to drive the replenishment orders right into their plant's master production schedule. By having visibility into future planned usage the vendor planner can also make strategic decisions as to how much to make. Depending on orders from other customers this inside knowledge will allow the planner to decide to make additional quantities or such key decisions on working overtime versus delaying production a day or so. In the past most suppliers had little insight into when their material was actually going to be consumed unless they had a KANBAN or JIT relationship. This often resulted in suppliers doing ineffective things in their plant to meet their customer's order dates, often not the true the material was to be consumed. Such disconnected planning resulted in bloated inventories and higher than necessary costs.

2. Another method of providing VMI is he suppliers plant hooking into the customers computer system mrp output. The advantages of this methodology over on-site location is the personnel cost savings on the suppliers side by not providing on site personnel. The shortcoming of this methodology is the risk of missing out on new product at time of conception and the difficulty in staying as close to the customers short term manufacturing plans. This type of relationship for VMI is only recommended when the supplier is providing a very narrow line of products and is located a significant distance from the customer.

3. The third style of VMI relates to the replenishment of materials used on a consistent basis with minimal volume swings. They typically are materials that are stored in silos or storage tanks. By equipping these storage facilities with level indicators the supplier has a trigger to know when the next "load" needs to be delivered with no additional information from the customer. In a sense this is a KANBAN style approach except a KANBAN square per se is not used.

The reason for doing VMI is to extend the supply chain and drive additional savings. The savings will come from:

  • Reduction of inventory
  • Reduction of transactions
  • Reduction of personnel
  • Optimizing the suppliers plant by producing to the true usage rate of the customer

INVENTORY SAVINGS
The reduction of inventory comes from having the supplier deliver the materials directly to the plant location where they are to be consumed. This sharply reduces warehousing, handling, damage, obsolescence as well as the total overall inventory. For years inventory has been a key measure of the success of a planner. Unfortunately the measure has been grossly misused as most companies have inadequately calculated the cost of carrying inventory. We have done numerous samples of the cost used by many large companies and have found they use the cost of borrowing money to twice the cost of borrowing money. This means typically a figure of 8%-15% is used. In reality the cost is much higher than this as in most cases the total cost of carrying inventory is not understood. This cost should include:

  • Cost of the storage space used
  • Cost of the personnel to manage the warehouse space
  • Taxes paid on the warehouse space
  • Material damaged and written off in the warehouse
  • Material that becomes obsolete and is written off
  • Cost of moving material from the warehouse to manufacturing line(s)
  • Rework cost of damaged material
  • Retesting of out dated material
  • Replanning cost
  • The cost of borrowing money

When these are properly calculated the true cost of carrying inventory is frequently found to be 30%-50% or a tremendous opportunity for cost reduction. Benchmarking has shown that most companies only use 8-15% as the cost of carrying inventory.

TRANSACTION REDUCTION
The second major area of savings will come by sharply decreasing the amount of transactions associated with purchasing materials. These reductions will come from fewer:

  • Purchase orders, we have seen reduction from 500 hundred per year to one for only one commodity, think of the possibilities for all of your major items
  • Receipts, by using backflushing receipts are no longer needed, suppliers are paid based on the amount of product that goes to your customers plus standard waste and any special waste that occurred.
  • Invoices are now a thing of the past by the use of backflushing. At as little as $10 per PO, receipt or invoice I have seen savings of $100,000's annually be eliminating the non value added paperwork. Many companies place a value of originating a PO at $50 to $100 and for them the savings potential is much larger.

NEW PRODUCT DESIGN
Another key reason for providing on-site service is the access to future projects and the opportunity to assist in the design stage of the project. Having early supplier involvement is key to achieving effective products. A key item to remember is once the design is set 80% of the cost is designed in and there is little opportunity for achieving savings without going through another design phase. Also by having knowledgeable on-site personnel the supplier can provide direction so the design takes into account their plant(s) manufacturing expertise/capability. There is something to be said for designing a product that a supplier can manufacture in an efficient manner when they submit a cost estimate.

EXTENSION OF THE SUPPLY CHAIN INTO THE SUPPLIERS PLANT
In some cases these vendor on site planners are able to drive the replenishment orders right into their plants master production schedule. By having visibility into future planned usage the vendor planner can also make strategic decisions as to how much to make. Depending on orders from other customers this inside knowledge will allow the planner to decide to make additional quantities or such key decisions on working overtime versus delaying production a day or so. In the past most suppliers had little insight into when their material was actually going to be consumed unless they had a KANBAN or JIT relationship and they often did ineffective things in their plant to meet their customers order dates, often not the true material was to be consumed. Such disconnected planning resulted in bloated inventories and higher than necessary costs.

SUMMARY
The supply chain has proven to be the key way to most effectively manage the total cost of doing business. All measures of the business should be at the supply chain level. These include measuring:

  • Total delivered cost, not just manufacturing unit cost or raw material purchase price
  • Supply chain inventory turns and dollars, not just finished goods or work in process
  • Delivery to the customer, not just delivery point within the supply chain
  • Elimination of non value added paper work

One of the key ways of optimizing the supply chain is to involve your suppliers and VMI is an effective way of achieving major savings and improving material flow as well as building key business relationships.


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