Inventory management can be a challenging task for any business owner, especially when it comes to balancing supply chain management and demand. Enter Vendor Managed Inventory (VMI).
This supply chain wholesale purchase agreement involves vendors or suppliers managing and optimizing their inventory while it’s in the possession of a buyer or retailer. Essentially, the vendor takes care of the inventory and ensures that it is restocked without the buyer having to initiate purchase orders.
Key Takeaway: Vendor managed inventories are where buyers and sellers agree to share a bit of risk in pursuit of a much greater reward. Done right, it’s a win-win.
In this blog, we will explore the ins and outs of VMI, including how it works, and its benefits. We’ll also look at why it can be a game-changer for businesses looking to streamline their inventory management processes (see what is inventory).
Here’s how VMI works and why it’s so beneficial to two businesses at the same time.
What Is Vendor Managed Inventory?
The vendor managed inventory definition is a supply chain agreement where vendors or suppliers manage, maintain, and optimize their inventory while it’s in the possession of a buyer.
In other words, it’s an wholesale inventory management system where inventory is replaced for the buyer or retailer without them having to initiate a purchase order. The buyer or retailer shares their inventory data with a vendor and the vendor determines order size and frequency. All you have to do is find a wholesale directory and look up some suppliers.
But why on earth would a vendor or supplier go to the trouble of managing inventory that’s out of their hands? What’s in it for them? And how does it work with different types of inventory? Let’s look into how vendor managed inventory works and why it’s beneficial.
How a Vendor Managed Inventory System Works
Vendor managed inventories are owned by the vendor, but located at the buyer or retailer premises. It’s a form of consignment inventory, where a vendor consigns their inventory to the care of another while still maintaining ownership of it.
So, how does vendor managed inventory work? Here’s how a vendor managed inventory system works:
- Both the vendor and buyer agree on what goals and metrics define success for their VMI relationship. These are usually in-stock performance, inventory turnover rate, and transaction cost. Other parts of the agreement will address whether or not the buyer pays for the inventory on acquisition or on sale to the end user. Along with how excess inventory will be returned.
- The vendor ships inventory to the buyer or retailer.
- The vendor monitors the sales patterns and inventory levels of their products at that buyer or retailer.
- The vendor makes reordering and replenishment calculations based on demand forecasting and lead time.
- The vendor’s VMI specialist or planner reviews the calculations and places the replenishment orders.
Successful VMI relationships are all about vendors knowing when to replenish their buyers’ inventories. And the key to that is buyers sharing their sales and demand planning data with their vendors.
Vendor Owned Inventory Management
Vendor owned inventory management is based on healthy communication between buyers and vendors. If a vendor isn’t familiar with a buyer’s demand trends, they’ll have no idea how much inventory to send. Or how often to send it. That can lead to overstock, understock, wasted inventory and effort, and a lot of blame.
Here are some tips for buyers to master vendor owned inventory management:
- Be generous with your data. Share frequently what you’re comfortable sharing, including inventory levels, seasonal spikes, and seasonal lulls.
- Protect your data, too. Successful vendor managed inventories are based around sharing sensitive sales information. Make sure you have an iron-clad confidentiality agreement before giving suppliers access to your inventory information.
- Become experts on your vendors. You’re giving another organization access to your data and control of your inventory. You’d better make sure you’re confident in their ability and trustworthiness. Do your research, get references, read reviews.
- Create a VMI contract that specifies in detail what inventory the vendor will manage, minimum and maximum inventory levels, and return policies.
- Expect reputable small- and medium-size vendors to be your best and most reliable VMI partners. Enormous, national supply chains are unlikely to give you best-in-class customer service. They simply deal with too many other buyers.
- Be up front about any other factors that may affect buying behavior. Like planning to carry a similar product line from a competitor or starting to sell the product through another channel, like a wholesale marketplace.
- Set minimum/maximum limits on how much inventory you’re willing to hold or how much physical space you’re willing to reserve for the inventory.
On the flip side, here are some ideas for suppliers or vendors to get the most out of vendor owned inventory management:
- Explore options with your buyers to get more value than just storage. Ask about prime shelf space. Or about educating staff members about your products (so they can sell more effectively). And ways to integrate your branding in their store or on their website.
- Be proactive about seeing your buyer’s demand forecasting, inventory levels, sales numbers, and buyer behavior analytics.
- Get representatives on the ground in the retail outlets that carry your products. Make sure display, branding, and selling points for their merchandise inventory are optimized and emphasized.
The Most Important Vendor Managed Inventory Metrics
Metrics and key performance indicators (KPIs) are crucial in the vendor-managed inventory model. Retailers and suppliers agree to follow certain metrics as part of their VMI agreement. Let’s see the most important metrics that are part of a vendor managed inventory agreement.
- Inventory turnover rate. This KPI shows the number of times inventory is sold within a said period of time (usually a year). A high inventory turnover rate shows an increase in sales and a frequent need for restocking by the vendor. A low turnover rate shows weak sales and excess inventory.
- Stock to sales ratio. This indicates the amount of inventory currently in storage compared to the number of sales.
- Sell-through rate. It’s a percentage that indicates the number of goods sold compared to the number received.
- Backorder rate. The number of delayed orders as a percentage of all placed orders. If the percentage is too high, that means the vendor managed inventory model needs to be optimized.
- Order fulfillment rates. It indicates the percentage of orders filled.
- Stockout rate. This number shows the percentage of orders that could not be filled because the items were out of stock.
Vendor Managed Inventory Example
Here’s a vendor managed inventory example using a hypothetical home improvement store, Home World.
Let’s say Home World sells Maytag refrigerators. Home World has a VMI contract with Maytag. Home World consistently sends Maytag, through EDI or online, data that details their refrigerator sales patterns and stock levels.
Using this data, Maytag considers their lead times and creates replenishment calculations. An inventory specialist at Maytag reviews those calculations and places all the replenishment orders for Home World.
A successful, profitable relationship between Home World and Maytag absolutely depends on the consistent sharing of accurate information. There’s no other way to pull off a successful vendor managed inventory system.
Let’s look at a more detailed example that shows those metrics we spoke about earlier. This time we'll be using a wholesale snacks vendor.
Say a retailer, ABC Supermarket, sells a popular brand of wholesale popcorn from a vendor, XYZ Snacks. The two parties agree to a VMI arrangement, with the following metrics and goals:
- In-stock performance: ABC Supermarket wants to ensure that they always have XYZ Snacks' products in stock, with no stockouts.
- Inventory turnover rate: XYZ Snacks wants to optimize their inventory turnover ratio equation to reduce excess inventory and associated costs.
- Transaction cost: Both parties want to reduce transaction costs associated with online ordering and managing inventory.
Under the VMI agreement, XYZ Snacks owns the inventory, but it's located at ABC Supermarket's premises. The process works as follows:
- ABC Supermarket shares its sales data and demand forecasting information with XYZ Snacks.
- Based on this information, XYZ Snacks calculates the optimal order size and frequency needed to maintain inventory levels and meet demand.
- XYZ Snacks ships the necessary inventory to ABC Supermarket.
- A VMI specialist or planner from XYZ Snacks monitors ABC Supermarket's inventory levels and sales patterns to ensure optimal stock levels are maintained.
- When it's time to reorder, the VMI specialist or planner from XYZ Snacks places the replenishment order with their own inventory, which is then shipped to ABC Supermarket.
By using VMI, both ABC Supermarket and XYZ Snacks benefit from reduced inventory costs, optimized inventory levels, and improved in-stock performance. Additionally, the VMI arrangement simplifies the ordering and replenishment process, reducing transaction costs for both parties.
Manage and track your multiple vendors and streamline the entire procurement process. Download our free easy-to-use Wholesale Vendor Management Spreadsheet Templates.
What Companies Use Vendor Managed Inventory?
Some of the biggest companies that use vendor managed inventory are:
- Walmart
- Home Depot
- Amazon
- Bosch
- Procter & Gamble
Vendor Managed Inventory Advantages and Disadvantages
Here are the million dollar questions.
Why on earth would a supplier go to the trouble of managing someone else’s inventory? And why would a buyer give up control of their inventory, one of their most precious assets?
Well, done correctly, VMI is actually a win-win for both vendors and buyers. A significant advantage of vendor managed inventory (VMI) is a decreased cost in inventory management that benefits everyone.
Here’s how it shakes out:
Advantages of Vendor Managed Inventory to the Buyer
- Reduced risk because buyers don’t have to invest (or invest as much) in inventory they may not be able to sell.
- No more cash flow restrictions. Money isn’t tied up in sitting inventory because inventory isn’t paid for until it’s sold. And/or vendors bring their entire analytical ability to bear on replenishment, making sure inventory is optimized.
- Lower inventory levels. With suppliers accepting the risk of inventory not selling, you can be sure they’re cognizant of overstock and potentially obsolete or expired inventory. That means they’ll err on the side of caution and opt for lower inventory levels and more frequent shipments.
- Lower carrying costs. Lower inventory levels means lower carrying costs because you reduce all your excess stock and eliminate the cost of storing and maintaining it.
- Less or no safety stock. Safety stock, buffer stock, and safety stock tie up lots of money and effort. They also carry risk. When your supplier takes control of inventory management process, they’ll be able to combine your data with their familiarity with their lead time to eliminate the need for extra stock.
- Reduce inventory shrinkage. Shrinkage is an unavoidable part of carrying inventory. The less inventory you keep on hand, the less shrinkage you’ll experience.
- Less or no stockouts. It’s in a vendor’s best interest to keep buyers happy or they’ll find another vendor. By establishing fluid, consistent replenishment with a vendor managed inventory system, you’ll eliminate the uncertainty around random and periodic ordering. Your vendor will always know exactly how to juggle lead time with demand, because they’re used to doing it.
- Planning, ordering, and inventory management costs decrease because they’re all shifted to the vendor, supplier, or manufacturer.
- Sales and brand loyalty grow because product knowledge among staff grows due to frequent contact with vendor representatives. This doesn't quite apply to MRO inventory, of course.
Vendor Managed Inventory Benefits for Vendors and Suppliers
- More control over in-store product display, organization, and branding.
- Able to leverage the sales expertise of in-store staff, which ultimately boosts sales and brand loyalty.
- Decreases the magnitude of the bullwhip effect. Which is a phenomenon that sees material orders increase in contrast to demand swings the further up the supply chain you go.
- Accurate demand forecasting for products. With visibility into sales patterns, stock level, and demand forecasting, vendors can anticipate inventory needs and customer orders.
- Reduces carrying costs. With more accurate understanding of your products’ demands, you’ll know how much of your manufacturing inventory (be it work in process inventory, raw materials inventory, or finished goods inventory) is in your warehouse at a given time. Then you can decrease the amount of in transit inventory in the pipeline and safety stock on hand.
Potential Obstacles with a Vendor Managed Inventory System
There are vendor managed inventory benefits and challenges. Some of the potential disadvantages of using a VMI system are:
- Some suppliers aren’t data analytics organizations. They’re not up to the data analysis that VMI requires. Make sure you verify that the vendor you’re entering into an agreement with is comfortable with numbers.
- It’s more difficult to dissolve the relationship if it’s not working out. A VMI relationship involves two organizations integrating with each other. Deeply integrating. It requires more effort to disengage and walk away with that amount of integration.
- You’re vulnerable any time you share your data with an outside party, and VMI partnerships are no exception. Again, make sure you have an airtight confidentiality agreement.
Vendor Managed Inventories Are Symbiotic
Vendors, have you found the buyer who will protect you from the predatory octopus of unoptimized in-store displays and disinterested salespeople?
Buyers, have you found a vendor who will freely transport you across the raging sea of unreliable inventory management to the tranquil shores of profitability?
If not, look into vendor managed inventory.
Frequently Asked Questions About Vendor Managed Inventory
Vendor managed inventory (VMI) is a powerful inventory and warehousing solution for buyers and suppliers. It can be confusing to understand why or how it’s used, though. Review these commonly asked VMI questions and our answers below:
What companies use vendor managed inventory?
Vendor managed inventory (VMI) is being used by more companies to the benefit of both supply and demand side. Here are some companies that use vendor managed inventory:
- Procter & Gamble
- ZF Group
- Walmart
- Amazon
- The Home Depot
- Bosch
What is the purpose of vendor managed inventory?
Vendor managed inventory (VMI) is a type of inventory system where vendors use a buyer’s premises to store products, but still have control over their inventory. VMI is used by suppliers to outsource product storage to and by buyers to reduce the amount of product receiving they're involved in.
Ultimately, VMI creates a smoother flow of goods from supplier to buyer, at a lower cost, and with greater insight into demand changes. VMI simplifies and reduces the amount of information buyers and suppliers share with each other, so they can maximize profitability in less time.
How do you analyze vendor performance?
Vendor performance is analyzed by establishing vendor key performance indicators, or KPIs. A KPI is any business metric that can be measured across time with the intent to improve it. For example, vendor KPIs can be invoice accuracy, lead time, vendor availability, and defect rate.
It’s important to establish KPIs in a vendor performance management system, or VPM system, before working with a new vendor. This allows you to record the vendor’s baseline data at the outset, so you can compare ongoing data to the starting point.