Six Steps to a Successful VMI System

Vendor Managed Inventory (VMI) systems came into vogue in the 1990’s as a way to decrease supply chain costs. Unfortunately, inventory crises left many manufacturers greatly disappointed when their new systems did not create the promised return on investment. Robert Schoenthaler, VP of SC solutions at KPMG Consulting Inc. has pointed out, “The lesson learned in supply chain management is that it is a journey, not something that can be solved in a single project. In the 1990s there was an explosion of growth in planning tools. Now the question of ‘how do I execute’ is becoming more important.”

VMI is not a perfect solution to inventory problems. Susan Cohen Kulp, a researcher at Harvard University, recently finished a study on the relationship between VMI systems and higher profits. Not surprisingly, she found that implementation does not always return better results than a traditional supplier relationship. Her study found that information precision and reliability, combined with an effective sharing mechanism, were the key factors in obtaining higher supply chain profits.

So, how do you implement a successful VMI system?

1. COMMUNICATE expectations of all parties. Customers and suppliers must make the effort to sit down and discuss the goals and objectives of implementing VMI. The importance of this step cannot be overstated. Both parties’ hardware and software requirements must be identified, and an understanding must be reached in terms of how both companies’ systems will communicate. Then a plan for implementation must be mapped, specifically identifying each party’s financial and other responsibilities.
2. Customer must commit to sharing PRECISE information. Suppliers must have visibility into the customer’s internal sales and inventory information. Without accurate data, ability to quickly meet demand will be impaired.
3. Suppliers must ensure RELIABLE transmission, receipt, and use of information. To facilitate step 2, the supplier must be able to guarantee that the customer’s trusted information will be communicated, received, and utilized securely and thoroughly to meet the designated needs. Time should be spent during the planning phase discussing information precision and reliability.
4. Sufficiently TEST systems before going live. As with any new system, testing will uncover any bugs or inefficiencies and can help to avoid future headaches.
5. Expect implementation to be a PROCESS not a project. Remember that there is no on/off switch. Adjustments will have to be made as demand levels fluctuate, and no system will be perfect 100% of the time.
6. Plan to spend sufficient TIME AND MONEY to make it work. Most successful VMI systems we’ve read about took 2-2.5 years to put into operation, and cost hundreds of thousands of dollars for IT and training. Spending (or finding) the time to create a comprehensive system can be a challenge.

Inventory Fundamentals

Inventories usually represent between 20 and 60 percent of total assets of a Manufacturing Organization.
Aggregate inventory management works according to their classification (raw material, work in progress, and finished goods) and the function they perform rather than at the individual unit level. It involves:

1. Flow and kinds of inventory needed
2. Supply and demand patterns
3. Functions those inventories perform
4. Objectives of inventory management
5. Costs associated with inventories.

Item inventory management is also managed at the item level. Management rules include:

1. Which individual items are most important?
2. How individual items are to be controlled
3. How much to order at one time
4. When to place an order

Raw Materials are purchased goods received which have not entered the production process, including materials, component parts and subassemblies

Work In Progress (WIP) is raw materials that have entered the manufacturing process and are being worked on

Finished goods are ready to be sold as competed items

Distribution inventories are finished goods located in the distribution system

Maintenance, repair and operational supplies (MRO) are items that are used in production but don’t become part of the final product, including hand tools, spare parts, etc.

Anticipation inventories are built up in anticipation of future demand (i.e. created ahead of Christmas)

Safety stock is to cover unpredictable fluctuations in supply, demand or lead time. It prevents stockouts

Cycle stock Lot-sized inventory are items purchased or manufactured in quantities greater than needed immediately. This is done to take advantage of shipping discounts or minimize setup costs.

Transportation inventories exist due to the time needed to move inventories. They are also called pipeline or movement inventories.
The average amount = (transit time in days) * annual demand / 365

Hedge inventory (usually done with commodities) is done if prices fluctuate and buyers expect prices to rise, so they buy more now

Inventory management objectives include:

1. Maximum customer service (orders shipped on schedule, stockouts)
2. Operating efficiency (build seasonal inventories, larger production runs, but in larger quantities).
Balance this against costs and tied up $$ in assets

Item cost is the price paid for a purchased item (includes direct costs like transportation, customs and insurance) also called landed price. Can also be determined in house including direct material, direct labor and factory overhead

1. Carrying costs include all expenses incurred by the firm due to volume:
2. Capital costs or opportunity cost of $$ tied up in inventory
3. Storage costs including space workers, and equipment
4. Risk costs include obsolescence, damage, theft and deterioration.

Typically 20%-30% of inventory costs are carrying costs

Ordering costs are associated with placing an order either with the factory or a supplier. It does not depend on quantity ordered.

1. Production control costs
2. Setup and teardown costs
3. Lost capacity cost
4. Purchase order costs

Average cost = (fixed cost / number of orders) + variable cost
Stockout costs expensive due to back order costs, lost sales and lost customers
Inventory turns = annual cost of goods sold / average inventory

ABC inventory determines the relative importance of items and then has different levels of controls

‘A’ items – 20% of items account for 80% of dollars
‘B’ items – 30% of items account for 15% of dollars
‘C’ items – 50% of items account for 5% of dollars

To calculate ABC:

1. Determine annual usage
2. Multiple annual usages by cost to get total dollars
3. List items by annual usage
4. Calculate cumulative annual dollar usage and percentages
5. Group ranked items into A, B and C categories

ABC rules are:
1. Have plenty of low-value “C” items (order a years at a time and carry plenty of safety stock)
2. Use money and control effort saved to reduce inventory of high-value items (‘A’ items)

‘A’ items – high priority – tight control and frequent review, expedite when needed
‘B’ items – medium priority – good controls with normal attention and processing
‘C’ items – low priority – use simple controls and order many items

Summary One needs to balance cost of carrying inventory against:

1. Customer service
2. Operating efficiency (longer production runs and fewer setups)
3. Cost of placing orders (decrease with less orders)
4. Transportation and handling costs (smaller orders cost more per item)

Lean Manufacturing: Losing weight through VMI

Lean manufacturing treats work in progress (WIP) as a waste. In fact every imperfection in the system creates the requirement to build work in progress in the system. So the WIP is also known as the mirror of wastes in the system.

On the other hand, most of the brand owners and buyers are moving towards a concept called VMI or vendor managed inventory. Basic principle of VMI is managing inventory by the vendor on the behalf of the buyer. By doing this, customers can focus on their core business of selling. Most of the times buyers are prepared to pay some extra money to the vendors for managing their stocks on their behalf.

Vendor-managed inventory (VMI) systems are a proven technique for improving the efficiency of supply chain operations. VMI is made possible by the implementation of an electronic means of exchanging inventory information between the buyers and sellers of products. These electronic links eliminate many of the built-in delays associated with traditional ordering systems and enable the establishment of collaborative inventory management systems. Experience has shown that improvements in these two areas can result in the elimination of between 20 percent and 30 percent of the previously required supply chain inventory. However, in order to achieve this level of success, it is critical for those companies that have not yet implemented VMI to follow a best practice approach.

Successful VMI programs take advantage of a key supply chain relationship that has been reaffirmed many times over. When trust, cooperation, and business integration among trading partners increase, the level of inventory in the pipeline can go down significantly. Assuming normal business conditions, this can be a direct, inverse relationship that leads to significant improvements to the bottom line for all participants.

VMI veterans, as well as newcomers to the process, will eventually agree on one point: existing VMI processes work fine for dealing with predictable demand, but have significant problems dealing with the less predictable flow that results from sales, promotions, and other special activities. This occurs because the electronic data interchange (EDI) transactions that support VMI lack the flexibility to support true inter-company collaboration in planning for these events.

Benefits for the buying organization:

• Lower costs: Much of the inventory planning will be done by the supplier.
• Less inventory: Better planning leads to lower safety stock levels.
• Better fill rate: Fewer stockouts, resulting in better sales and higher customer satisfaction.

Benefits for the selling organization:

• Sticky customers: The implementation of VMI processes leads to a tighter relationship with buying organizations, making them less likely to switch to a competitor.
• Reduced inventory: Increased supply chain visibility enables better inventory planning.
• Reduced cost: VMI enables tighter integration of vendor needs and production planning, resulting in more stable production and fewer "rush" orders.

The most common process used to support VMI is EDI-based exchange of two X12 transaction sets: the “852 Product Activity Transaction” and the “855 Purchase Order Acknowledgement”.

Electronic Data Interchange (EDI)
EDI is an inter-company, application-to-application communication of data in standard format for business transactions. Electronic Data Interchange (EDI) is a set of standards for structuring information that is to be electronically exchanged between and within businesses, organizations, government entities and other groups. The standards describe structures that emulate documents, for example purchase orders to automate purchasing. The term EDI is also used to refer to the implementation and operation of systems and processes for creating, transmitting, and receiving EDI documents.

Electronic Data Interchange (EDI) can be formally defined as 'The transfer of structured data, by agreed message standards, from one computer system to another without human intervention'. Most other definitions used are variations on this theme.

ASC X12 (also known as ANSI ASC X12) is the official designation of the U.S. national standards body for the development and maintenance of Electronic Data Interchange (EDI) standards. The group was founded in 1979, and is an accredited standards committee under the American National Standards Institute (ANSI). The acronym stands for "American National Standards Institute Accredited Standards Committee X12", with the designation of X12 being a sequential designator assigned by ANSI at the time of accreditation with no other significance.

ASC X12 has sponsored more than 315 X12-based EDI standards and a growing collection of X12 XML schemas for health care, insurance, government, transportation, finance, and many other industries. ASC X12's membership includes 3,000+ standards experts representing over 350 companies from multiple business domains.

852 Product Activity Transaction
A warehouse distributor or retailer who advises a trading partner of inventory, sales, and other product activity information can use the Product Activity Data Transaction (852) set. Product activity data enables a trading partner to plan and ship, or propose inventory replenishment quantities, for distribution centers, warehouses, or retail outlets. Each pair of trading partners should determine the frequency of data transmission. Data should be transmitted at least once per planned replenishment cycle, although more frequent data transmission is worthwhile. The balance of data transmission and processing costs must be balanced with the benefit of more frequent data.
Similarly, trading partners should determine whether all part numbers should be included in each transmission or only those with activity. For instance, a monthly transmission could include on-hand balances for each product while weekly transmissions would include only those products having sales, returns, or inventory adjustment activity. The transaction set is constructed to allow up to 200 reporting locations to be included in each transmission, and up to 999,999 products. This guideline recommends minimizing the amount of data being transmitted to satisfy requirements for trading partner automatic replenishment of inventories. After the trading partner processes the data, the receiver of this transaction set would send a purchase order acknowledgment to the sender. The purchase order acknowledgment would include purchase order numbers being assigned for each reporting location, the date the order was processed, and the items and quantities being on order.

855 Purchase Order Acknowledgement
The electronic purchase order acknowledgement will typically contain exception-only information provided by the supplier about the customer’s purchase order, such as:

• A part ordered has been superseded, and the superseding part is being shipped;
• A part ordered is obsolete, and cannot be provided;
• A quantity ordered is being changed to match minimum or multiple quantities offered by the supplier; or,
• A part offered will be shipped from a special distribution point, and won’t be included with the regular shipment.

This information referenced on the purchase order acknowledgment is currently included on the shipment packing slip. However, when the distributor does not know the information until the shipment is received, confusion occurs during the receiving function. Because the supplier knows of these exceptions when the customer’s order is first processed, the exceptions can be electronically transmitted to the customer in advance of shipment receipt. In that way exceptions are greatly reduced:

• Unexpected, superseding parts received are known in advance;
• Other actions can be promptly taken to find obsolete parts;
• Unexpected quantities are known in advance; and,
• Multiple shipment receipts can be planned.

The distributor would likely integrate the purchase order acknowledgment into his purchasing system, and allow an audit modification of the original purchase order. Therefore, receiving operations continue unchanged while exceptions decrease dramatically.

Process:

On a daily basis, the retailer organization calculates sales and inventory data for each item and forwards this information to the appropriate suppliers using the 852 Product Activity Data transaction. Upcoming promotional plans can also be forwarded within these electronic documents. Software on the manufacturer’s end calculates the level of retailer inventory required to support the current level of sales activity and planned promotions. The manufacturer’s system creates the corresponding purchase order and sends an 855 Purchase Order Acknowledgment back to the retailer. The retailer feeds this information into its system as if it were an internally generated purchase order. The entire cycle can take less than one day, compared to four to six days under the old system.

Because this electronic exchange of product information enables the entire process to move much faster than the old paper-based system it replaced, both the retailer and the manufacturer can achieve significant cost savings due to reduced supply chain inventory levels. The retailer needs less safety stock inventory in its distribution center(s), and the manufacturer is able to implement better production scheduling to match real demand and, therefore, carry fewer inventories in its distribution center(s).

The retailer also benefits from improved customer service: experience has shown that manufacturers can frequently forecast sales of their products better than the retailer can since the manufacturer has access to sales activities of the same products from multiple retailers and gets a better picture of actual demand and promotional results across a much broader marketplace.

VMI can directly impact the bottom line by reducing inventory levels, but it also improves top-line revenue by elimination of stockouts, which cause customer dissatisfaction in addition to the lost sales opportunity. Helping to drive the top line is often more exciting to top management than cost reduction and assists in making the supply chain function a more equal partner in running the business.

Inventory in finish goods form is harder to manage. But when the inventory is managed by vendors they can manage it in other forms for an example as raw materials and as semi finish goods. Vendors will happy to have a VMI type of orders than a normal order. But the reality is in whatever form inventory is a waste. So in the ideal scenario vendors would manufacture goods as and when the buyer wants it and then will dispatch to the vendor instead of pulling goods from the inventory and sending it to the buyer.

Although VMI or vendor managed inventory have the term "managing the inventory" it does not necessarily mean that vendor should have a huge inventory. A lean manufacturer would be able to get the best advantage of this concept than a traditional manufacturer if managed carefully. Having a front end working in VMI model and the back end of the business working with lean manufacturing makes a powerful combination. Vendors order goods when they want it in small frequent batches. Manufacturers do their manufacturing when they receive the order in small batches with a very short lead-time. Isn’t this the ultimate lean manufacturing system?