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)