ESTIMATING THE FINANCIAL BENEFITS OF VENDOR MANAGED INVENTORY (VMI)

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1 ESTIMATING THE FINANCIAL BENEFITS OF VENDOR MANAGED INVENTORY (VMI) How to quantify the savings delivered by a vendor managed inventory programme. WHITE PAPER David Snelson / V4 / Jul 2012 Waer Systems Limited 2013 Copyright Waer Systems 2009

2 Introduction Vendor-managed inventory provides a streamlined approach to inventory management and order fulfilment based on collaboration between suppliers and their customers (e.g. distributor, OEM, or product end-user) linking the supplier directly to actual customer demand. Essentially, VMI is inventory that resides with the customer while still monitored and managed by the supplier. The customer consumes directly from stock held on-site while the supplier has full visibility of the actual inventory levels. VMI lets suppliers sense and respond to actual customer demand signals and gain continuous visibility to customer/market activity. VMI provides clear, unfiltered demand signals so that the right products are continually pulled into the right places at the right time with continuous replenishment at the point of consumption. This white paper presents guidance on how to quantify the cost savings and benefits that accrue from VMI. Copyright Waer Systems 2009

3 Estimating the Financial Benefits of VMI Whether used in manufacturing, sub-contracting, or maintenance repair operations (MRO), vendor-managed inventory drives efficiencies while delivering significant benefits to cash flow and capital requirements. VMI is an indispensable element in many companies demand-driven supply chain programs because it aligns business objectives and streamlines supply chain operations for both suppliers and their customers. In the case of consignment inventory, the customer holds vendor-owned inventory on-premises and purchases stock only as it is consumed. Consigning stock to the local warehouse reduces inventory risk and repetitive operational costs while smoothing out the effects of uneven demand flow. Because ownership of the inventory stays with the vendor, production lines focus on their core missions, and businesses manage cash and capital better, and still gain the benefit of supply chain management. Consignment frees up a significant amount of working capital for the customer, while the supplier retains complete control over replenishment and is unencumbered by a traditional order cycle. VMI: The Start of a Productive Relationship How do we fully quantify the long-term business benefits of a closer, more efficient working relationship between customer and supplier? Actually, we really can t. VMI is a rising tide that lifts both boats, a win-win partnership that delivers many non-tangible benefits based on mutual good will, enlightened self-interest, smarter planning and most-favoured status. So how do we quantify the value of a vendor managed inventory program? Well, in fact there are several important financial impacts that deserve close examination. Let s look at these areas. Take, as an example, a hypothetical company we will call Far & Wide International. Farwide is a major discrete manufacturer with the following profile in relation to one of its major suppliers: Inventory on hand 1.0 million Number of inventory items from supplier 5,000 Warehouse space 500m 2 Warehouse space cost/m Shortages per month 50 Obsolescence rate 8% PO lines created per month 150 3

4 PO changes per month 85 Off-contract POs created per month 95 % of inventory converted to VMI 50% Note that Farwide estimates the percentage of inventory to be converted to VMI at 50%. We must remember to do our estimates based on this available VMI inventory only. Stop Ordering and Start Saving VMI changes the traditional order process; instead of sending purchase orders, customers electronically send daily demand information to the supplier. The supplier generates replenishment orders for the customer based on this demand information and the process is guided by mutually agreed-upon objectives for the customer's inventory levels, fill rates and transaction costs. Calculate Your TCPO (Total Cost of Purchase Orders) In the case of Farwide International, about 150 new PO lines are created each month for a particular supplier; with another 95 off-contract PO lines needed too. When all the costs associated with processing a PO are counted including creation, printing, posting, reviewing, invoice matching, discrepancy handling and closing, the total amounts to 250 per purchase order. Therefore, Farwide spends a not inconsiderable 95,000 per month on supplier POs. In addition, PO changes number about 85 per month and the average cost of a change is around 122. We estimate that 50% of these costs are addressable by the VMI program, (in line with the 50% of available inventory identified in the profile above). The result is 520,000 per year of order processing expense that can be attacked by converting to a VMI program. By implementing VMI, Farwide can escape 50% or more of this expense and reallocate 50% of buyer time to higher-value activities. In financial terms, the company can save 285,000 or more each year by giving the supplier visibility and responsibility for keeping the warehouse shelves full. A Tangible Cost Reduction VMI fundamentally reduces the cost of purchasing administration by reducing the effort expended in maintaining purchasing information, reconciling invoices to purchase orders and other administrative tasks. Fewer orders also results in downstream savings in warehouse pick time, transportation scheduling, accounts receivable and invoice reconciliation. 4

5 By shifting more responsibility for replenishment to the supplier, who will monitor demand and inventory frequently, Farwide can expect fewer rush orders and fewer orders overall. No More Shortages A good VMI partner quickly detects the need to replenish, which should result in minimal stock-outs and shortages. A typical supplier planner manages fewer items than a typical customer buyer. With full visibility to true demand and possessing better information about lead times, product launches and packaging changes, the supplier can better manage order calculations. Suppliers also tend to favour their VMI partner customers in times of scarce supply. Farwide International has historically experienced about 50 severe shortages or stock-outs in an average month. Again, because the VMI program impacts about 50% of inventory, we will estimate that VMI can address 50% of stockouts or 300 stock-outs per year. The business cost of a stock-out, factoring in real-world line shut-downs, averages 2,037. We estimate that better replenishment management from VMI can reduce those stock-outs by 50%, thereby saving Farwide 305,000 in annual stock-out-related costs. Obsolescence Reduction About 8% of Farwide inventory is spent on obsolescence. Applying 8% to half the supplier inventory represents a 40,000 price tag. The overall impact of better inventory management, driven by a devoted and attentive supplier-side planner, is dramatic. More reliable replenishment and better sensing of direct demand produces a level of inventory efficiency that lets Farwide run leaner with increased confidence. Farwide can actually lower its obsolescence price tag dramatically by 75%. This produces a bottom-line reduction in losses from obsolescence of 30,000. Less Inventory Takes Up Less Space Finally, good vendor management can result in a real reduction in on-hand inventory of 10% or more. In the case of Farwide, they estimate an 11% reduction for the one-half of its 1 million inventory that is available for conversion to VMI, reducing total inventory by 33,000. This also reduces the warehouse footprint for supplier inventory. Farwide allocates 10m 2 of warehouse floor space per 100 stock items, with a carrying cost of 0.34 per m 2. They can reallocate warehouse space and generate savings of over 11,000 per year. 5

6 Summing Up: The Final VMI Tally Establishing direct vendor access to the demand signal results in more responsiveness and lower on-hand inventory. Products stream into place with continuous replenishment at the point of consumption. Transforming from a push supply chain to a pull approach reduces and streamlines order processing operations. In the case of Far & Wide International, the financial benefits add up as follows: Savings from reduction of stock-outs 305,000 Savings in order processing costs 285,000 Savings in costs of obsolescence 30,000 Savings in warehouse carrying costs 11,000 As you quantify the prospective financial impact of a VMI program, consider the following: Identify the percentage of a supplier s inventory that will be converted to VMI Determine an estimate for reduction in inventory due to VMI. Waer uses 11 per cent. Be sure to include savings produced by a smaller footprint in the warehouse. Estimate the percentage of stock-outs that can be avoided through VMI. We use a base estimate of 50 per cent. Be sure to include the full business cost of stock-outs in your savings calculation. Add up the costs of purchase order creation and change orders related to the percentage of inventory to be converted to VMI. Again, include all costs associated with processing. We use a savings rate estimate of 50 per cent. Make a determination of how much impact supplier management will have on your ability to run a leaner inventory while maintaining service levels. We start with an estimate of 75 per cent savings in obsolescence costs. For more information on how to implement a powerful and practical VMI methodology across a global network of suppliers, OEMs, distributors and others, learn about the easy-to-implement, Cloud-based solutions available from Waer Systems. 6

7 Waer Systems specialises in the design, development and implementation of flexible software solutions for organisations with complex supply chain and reporting needs. The company was established in 2000, initially to meet the need for improved supply chain execution and warehouse management within the global aerospace industry. Today, our innovative, elegant solutions deliver increased process efficiency, optimised parts/asset management and realtime information flow to market leaders in a range of sectors. Waer Systems Limited Eight The Quadrant Marlborough Road Lancing, West Sussex BN15 8UF UK Tel: +44 (0) Fax: +44 (0) Waer Systems France Bureau de Toulouse - SBAC 5 Avenue Albert Durand Aéroport Bâtiment Blagnac, Toulouse France Tel:

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