A supply chain model of vendor managed inventory

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Abstract

This research evaluates how vendor managed inventory (VMI) affects a supply channel. Specifically, VMI always leads to a higher buyer's profit, but supplier's profit varies. In the short-term, VMI is found to reduce total costs of the channel system, but under certain cost conditions between buyer and supplier, it could decrease the purchasing price and supplier's profit. In the long-run, it could more likely increase supplier's profit than in the short-run. Finally, VMI is an effective supply chain strategy that can realize many of the benefits obtainable only in a fully integrated supply chain.

Introduction

Vendor managed inventory (VMI), also known as consignment inventory on other occasions, has been widely used in various industries. For instance, one survey found that in hospital materials management, VMI achieved higher penetration than just-in-time and stockless methods (Gerber, 1991). Another survey of the mass retail industry indicated that VMI programs would multiply in the next few years (Andel, 1996). Major retailers such as Wal-Mart, Kmart, Dillard Department Stores, and JCPenney are among the earlier adopters of VMI. Telecommunications giants such as Lucent Technologies are in the process of converting much of their materials management systems to VMI. This recent popularity of VMI has led to the claim that vendor managed inventory is the wave of the future and the concept will revolutionize the distribution channel (Burke, 1996, Cottrill, 1997). Whether such a trend will persist depends on the economic benefits brought to the members along a supply chain by a VMI program. There is, however, lack of in-depth economic analysis of such a program, especially in terms of its impacts on the parties involved. For instance, while consignment in the health care industry has become more and more popular in recent years, confusion exists as to when and why consignment is effective.

There is evidence that VMI is beneficial to both a buying company and a supplying company, though the supplier may take a longer period of adjustment and reconfiguration before the benefits of VMI can be realized. Northwestern Steel and Wire as a supplier, reported by Nolan (1998), was able to generate more volume after VMI because inventory turns were up. Northwestern's customers placed more orders with Northwestern after seeing real benefits and efficiency gains with the VMI programs.

On the other hand, some parties involved in a VMI relationship, suppliers in particular, are less certain about these potential benefits and tend to accept VMI as a necessity due to intense global competition. For instance, Air Products and Chemicals (AP&C) is faced with the dilemma that its customers want zero inventory, thereby tying up more of AP&C's working capital. The company does not believe this would improve business process but rather would increase the total administration and processing costs (Gamble, 1994).

A VMI-consignment is essentially an arrangement whereby the owners of goods, the “consignor”, delivers its goods to another party, the “consignee”, for use or for sale by the consignee, with the proceeds of the sale being remitted to the consignor only after the actual use/sale (Fagel, 1996). A typical VMI program involves a supplier which monitors inventory levels at its customer's warehouses and assumes responsibility for replenishing that inventory to achieve specified targets through the use of highly automated electronic messaging systems (Copacino, 1993). The supplier thus makes the replenishment decision, rather than waiting for the customer to reorder the product. Anecdotal evidence suggests that a consignee may enjoy reductions in holding costs and some operational costs plus cash flow benefits (e.g., Benefield, 1987), while a consignor needs to bear the burden (of inventory carrying and demand forecasting) but probably gain chances to improve other production and marketing efficiency (Cottrill, 1997). Thus a systematic evaluation of the profit implications of a VMI program on both trading partners will certainly facilitate future supply chain coordination.

One aspect of VMI, information sharing, has recently been addressed. It is believed that since the parties involved share sales information under VMI, less information distortion should be expected (Lee et al., 1997, Chen et al., 2000). As a consequence, inventory and other production costs will likely be reduced while capacity utilization will be increased, as demonstrated by Xu et al. (2001) and Waller et al. (1999). There is also a large set of literature written around the theme of channel coordination. Thomas and Griffin (1996) provide a comprehensive review of the topic. A few notable studies related to buyer–vendor coordination include Lee and Rosenblatt (1986), Banerjee (1986), Anupindi and Akella (1993), Kohli and Park (1994), and Weng (1995) which analyze the separate or joint optimal ordering policies and/or the optimal pricing/quantity discount schedules. Hung et al. (1995) develop a simple inventory control method for a consignment system for determining delivery period and safety stock level in the COCK system of Philips (Taiwan). However, no studies have examined the optimal ordering and pricing schemes under a VMI program. The impact of VMI on both parties involved, buyer and vendor, has not been evaluated either.

The purpose of this paper is to evaluate the short-term and long-term impact of VMI on supply chain profitability by analyzing the inventory systems of the parties involved. The impact of VMI is also compared with that of full channel coordination. It is found that in the short-term VMI can accomplish what full channel coordination is set to accomplish. We formulate appropriate mathematical models for a buyer–supplier channel structure, examine the effects of a VMI strategy on the various cost components of both parties, and then analyze the role of VMI in a supply chain initiative. In particular, the effects of an integrative VMI program on total relevant costs and profits will be investigated.

Section snippets

Model structure

We investigate vendor managed inventory issues using a model based on supply chain relationships with a focus on inventory systems, purchase prices and purchase quantities. The model contains two parties along a supply chain: a buyer and a supplier (e.g., an OEM supplier). The buyer company purchases its final product (or a major component of it) from the OEM supplier. Thus the final product sales quantity of the buyer is the same as the purchase quantity or directly proportional to it. The

The short-term motivation of VMI

VMI leads to immediate changes in both buyer's and supplier's inventory management, which can be considered as the direct, or short-term, effects of VMI implementation. At the early stage of VMI, sales and purchase quantities are relatively stable due to the market constraints and other contractual or public agreements with other parties. For this reason, the short-term effects will be evaluated to the extent that the annual purchase quantity y is the same as before. Purchase price, however,

The change of optimal purchase quantity under VMI

Over a longer period of time after VMI is implemented, the indirect effects of VMI, such as changes in purchase quantity, will be observed. It has been reported in practice that companies with VMI had expected an increase in sales eventually, which would also bring up purchase quantity (Gamble, 1994, Andel, 1996, Nolan, 1998). Such expectation is indicated in Lemma 4 and Fig. 1.

Lemma 4

In the long-run, the purchase quantity with VMI is higher than that without VMI.

Proof

Please see Appendix A.

Annual sales

The short-term effects of inventory program change

As discussed in Section 2, we are equally concerned with the channel profit as it represents the effectiveness of a supply chain. First of all, the difference of joint (channel) profit before and after a VMI program can be easily shown by:Bc(y)+ΠSc(y)]−[ΠB(y)+ΠS(y)]=sBhBy21/21+sSsB1/21+hShB1/22⩾0.Note that y is added in the profit function above to highlight that the same purchase quantity is maintained before and shortly after the VMI implementation. This result indicates that as long as

A specific case under linear demand

We assume the demand function can be represented by a simple linear relationship between price and quantity: p(y)=aby and a,b>0. In addition, the cost function of the supplier is assumed to be: c(y)=δy+0.5θy2 and δ,θ>0. Please note that c(y) and c″(y)>0, and p(y)<0.

The example is largely based on the information from a consignment item in a telecommunications equipment manufacturer (as a supplier) and its client. In their specific case, the manufacturer's order setup cost sS=1500, which is

Conclusion and managerial implications

This study has focused on VMI's role as a strategy of integrated supply chain and evaluates its attractiveness to the two parties involved. It reveals that a VMI program will be effective in reducing the inventory-related costs for the system of buyer-supplier channel as a whole, even without changing any cost characteristics of the channel or demand level at the end market, a condition described as direct changeover or short-term. It achieves this through optimizing shipment quantities as

Model limitations and future research

Just like most research, our analysis has limits, which are briefly examined here. For instance, it is possible that after the supplier takes over the buyer's inventory via VMI, the order set up cost at the buyer's location can be reduced through new ordering procedure or better communications scheme such as Electronic Data Interchange. In this case, the supplier's profit under VMI will be higher than that when there is no change in the order set up cost. It is thus even easier for both buyer

Acknowledgements

The authors would like to thank the College of Business, University of Texas at San Antonio, for generously providing research support for this project. The authors also would like to thank Philip Evers, Jerome Keating, and two anonymous referees for their helpful comments on earlier versions of this paper.

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