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An analysis of the general benefits of a centralised VMI


system based on the EOQ model
a a a b
G. Kannan , M. C. Grigore , K. Devika & A. Senthilkumar
a
Department of Business and Economics , University of Southern Denmark , Odense 5230 ,
Denmark
b
Department of Mechanical Engineering , Anna University of Technology Tiruchirappalli
Panruti Campus , Panruti , India
Published online: 08 Mar 2012.

To cite this article: G. Kannan , M. C. Grigore , K. Devika & A. Senthilkumar (2013) An analysis of the general benefits
of a centralised VMI system based on the EOQ model, International Journal of Production Research, 51:1, 172-188, DOI:
10.1080/00207543.2011.653838

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International Journal of Production Research
Vol. 51, No. 1, 1 January 2013, 172188

An analysis of the general benefits of a centralised VMI system based on the EOQ model
G. Kannana*, M. C. Grigorea, K. Devikaa and A. Senthilkumarb
a
Department of Business and Economics, University of Southern Denmark,
Odense 5230, Denmark; bDepartment of Mechanical Engineering,
Anna University of Technology Tiruchirappalli Panruti Campus, Panruti, India
(Received 28 October 2011; final version received 24 December 2011)

Within a vendor-managed inventory (VMI) agreement, the upstream supply chain member (the vendor) takes
responsibility for managing the inventory of the downstream member (the customer) within specific levels
previously agreed upon without the need of orders from the customer side to be placed. Therefore, the vendor
can focus on optimising production efficiency and capacity planning, while the customer has to improve
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forecast accuracy. This paper analyses the benefits a VMI agreement could bring for a one-supplier, multiple-
customer case through analysing two cases: a supply chain managed in a traditional manner and VMI when
both the vendor and the customers belong to the same organisation. The analysis is based on the economic
ordering quantity (EOQ) formula and its related total cost, and the novelty is captured by evaluating one
vendor, multiple buyers, and multiple product situations. The modelling is done so as to capture the needs and
factors which occur within the pharmaceutical industry and a numerical application will be executed with data
from one of the main leaders within the pharmaceutical field.
Keywords: traditional supply chain; VMI supply chain; general benefits based on EOQ modelling;
pharmaceutical industry

1. Introduction
Due to the global expansion of large companies, competition all over the world is becoming stronger and therefore
an increasing need to obtain competitive prices is pushing industries to take on new challenging, strategic methods.
One of the recently recognised methods is the replacement of the traditional supply chain with the vendor-managed
inventory (VMI) supply chain. It has been proven in many different papers that the VMI supply chain is superior to
the traditional supply chain and can bring significant cost savings to the participants.
A traditional supply chain refers to the system within which each of the members at the different stages make
decisions regarding replenishment quantities and timing so as to minimise cost at their end of the supply chain. The
supply chain usually consists of all stages, starting at the raw material supplier and continuing on until the finished
product reaches the end customer. All the different stages are linked by their common aim of providing the right
product to the right customer in the promised time.
VMI is a replenishment supply chain technique that has been implemented since the beginning of the 1980s by
Wall-Mart and Procter & Gamble (Waller et al. 1999), and has its roots back in 1958 when Magee (1958) first
introduced the concept.
Within a VMI agreement, the upstream supply chain member (the vendor) takes responsibility for managing the
inventory of the downstream member (the buyer) within specific levels previously agreed upon without the need for
orders from the customer side to be placed. Therefore, the vendor can focus on optimising production efficiency and
capacity planning, while the customer has to improve forecast accuracy.
The success of VMI is dependent on communication between the partners, their willingness to share data,
collaboration and coordination, and an information technology system which enables fast access to critical
information (Duchessi and Chengalur-Smith 2008).
The general characteristics of a traditional supply chain and of a VMI supply chain, formed by three stages, are
presented in Figure 1.
The research here is meant to offer a simple overview of the possible outcomes after VMI implementation in a
two-stage supply chain, between the vendor and its multiple buyers. The analysis focuses on the overall supply chain

*Corresponding author. Email: gov@sam.sdu.dk

ISSN 00207543 print/ISSN 1366588X online


2013 Taylor & Francis
http://dx.doi.org/10.1080/00207543.2011.653838
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International Journal of Production Research 173
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Figure 1. Characteristics of a traditional supply chain and of a VMI supply chain.

cost impact, which VMI can show under specific conditions, based on the practical experience learned in the
pharmaceutical industry.
Using VMI in a supply chain brings transparency regarding essential information among the partners, thus
giving the opportunity at each stage to adjust the decisions in a timely manner and avoid emergency situations.
The VMI supply chain implies coordination between the partnering stages, continuous information sharing, and
regular meetings where critical issues are discussed and follow-up actions are noted.
The general benefits model analysed in this paper is based on the economic ordering quantity (EOQ) model and
is an extension of Bookbinder et al.s (2010) paper. As an extension of the aforementioned work, the model has been
adjusted to integrate different requirements and constraints from within the pharmaceutical industry. It has been
further extended from analysing a one-vendor, one-buyer deterministic demand case to analysing a one-vendor,
multiple-buyer stochastic demand case.
The mathematical model applies to two echelons, the vendor and its multiple buyers. An observation is made
here to distinguish that the buyers are not the end-consumers but represent sales organisations from each country.
At the same time both the vendor and buyers belong to the same organisation.
In the literature, one of the main challenges when implementing VMI has been identified in providing the right
incentives for all partners to do their best for the supply chain and the right contract to share the overall profits
(Nagarajan and Rajagopalan 2008).
The fact that both stages belong to the same organisation facilitates simpler developments further. There is no
need for complicated contracts for profit sharing between the two partners in a VMI case, as the most important
thing is the total supply chain profit. It can be assumed that both partners have the right incentives to increase
overall supply chain profits.
Based on the assumptions above, the traditional supply chain model is developed according to its general
characteristics within which the centralised organisation does not show any impact, while the VMI model is
developed as and when decisions are taken centrally to obtain overall supply chain cost reductions.

2. Literature review
The literature review of this paper is divided into two categories: first, an overview of general positive characteristics
observed after the VMI implementation (or) assumed to occur behind the theoretical model and then the second
174 G. Kannan et al.

part looks at the literature which clearly focused on the EOQ modeling to determine the potential benefits of a VMI
supply chain.

2.1 General characteristics of VMI outcomes


This section verifies the outcomes of a VMI relationship and presents a short literature review of different benefits
which have been recognised by other authors to be the outcome of VMI partnerships. A couple of articles have
directly addressed the general benefits which can be achieved from a VMI partnership without necessarily
developing a model to prove their arguments but through empirical research.
Lee et al. (2008) analysed how lean systems would perform with VMI, Collaborative Planning, Forecasting and
Replenishment (CPFR), and continuous replenishment and identified that expenses can be significantly decreased
and flexibility improved under VMI. Elvander et al. (2007) developed a framework for a VMI configuration with
four categories: inventory-related dimensions, information-related dimensions, decision-making dimensions, and a
system integration level. Dorling et al. (2006) evaluated VMI under oligopolistic competition and defined five steps
towards VMI implementation. Dong et al. (2007) surveyed the literature and identified that VMI is adopted when
the supplier deals with high market competitiveness and when there is good cooperation between the supplier and
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the buyer.
Blatherwick (1998), Disney et al. (2003), and Sari (2008) identified that VMI can be outperformed by other
strategies in specific situations.
A general overview of different benefits which can be achieved through a VMI partnership is displayed in
Table 1.

2.2 General benefits models of VMI based on the EOQ model


The literature review presented below focuses strictly on research papers which have developed specific models to
evaluate the benefits of a VMI supply chain based on EOQ modelling.
Bookbinder et al. (2010), Yao et al. (2007), and Razmi et al. (2010) evaluated the supply chain costs under a
traditional supply chain compared to a VMI situation. All cases considered a two-echelon model formed by a
vendor and a buyer, and the model development was based on the EOQ formula.
Bookbinder et al. (2010) compared three cases: the traditional supply chain, VMI, and central decision making.
The difference between traditional supply chains and VMI was obtained through transferring the cost of placing an
order, which was incurred by the buyer, to the vendor under the VMI. Also, the vendors cost of placing an order
has been considered to be lower than the buyers. One of the findings of the model is that both the vendor and the
buyer are better off as long as the vendors holding costs divided by the buyers holding cost are higher than the
ordering cost.
Yao et al. (2007) showed that total costs can be decreased under VMI as long as the ordering cost of the vendor
is lower than that of the buyer. However, results also show that the buyer has greater benefits than the vendor.
Razmi et al. (2010) effectuated a sensitivity analysis by varying the parameter values of the total cost function
while including a backordering cost in the calculation. While in the traditional supply chain model both the vendor
and the customer incurred costs, in the case of VMI all the costs have been attributed to the vendor. Pasandideh
et al. (2010) used an EOQ model to evaluate the impact of different parameters on the total cost when applying VMI
and when shortage is backlogged. The EOQ model developed showed that VMI could bring important cost savings
but this has its limitations on the values of the ordering costs of the two participants.
Zhang et al. (2007) analysed the total cost function incurred under a VMI partnership where an exponential
function of the ordering costs was taken. The model was applied to a one-vendor, one-buyer case and proved that
decreasing the ordering cost represents an investment which brings lower costs for all buyers. Teng et al. (2005) used
integer programming to extend the classic economic production quantity (EPQ) model to allow for time varying
cost, with deterministic demand. The findings showed that the total cost is a convex function of the number of
replenishments, for which the minimum number should be identified for savings to be obtained. Chen and Wei
(2011) examined the optimal dynamic joint decisions using a calculus-based formulation combined with dynamic
programming techniques in a vertically decentralised single manufacturer Stackelberg and single-retailer channel
over a multi-period planning horizon subject to deteriorating goods and multivariate demand function. Niranjan
et al. (2011) analysed the issues surrounding the VMI implementation using 15 features categorised as product
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Table 1. Summary: VMI general benefits.

Authors

Achabal
et al: 2000
Ching and Tai (2005)
Claassen
et al: 2008
Disney and Towill (2002b)
Dong and Leung (2009)
Duchessi and Chengalur
Smith 2008
Fox (1996)
Fulcher (2002)
Holmstrom (1998)
Kaipia
et al: 2002
Kauremaa
et al: 2009
Kiesmuller and
Broekmeulen 2010
Kim (2005)
Kuk (2004)
Kulp (2002)
Nachiappan
et al: 2007
Razmi
et al: 2010
Szmerekovsky and
Zhang 2008
Sari (2007 and 2008)
Tyan and Wee (2003)
Waller
et al: 1999
Yu and Huang (2010)

Benefits

Aligned resources with X


manufacturing
demand
Business opportunities X
created
Easier selection of X
suppliers
Efficient planning and X X X X X
replenishment
Improved coordination X
Improved forecast X x
Improved material X x x
handling
Improved on-time X X
delivery
Improved relationship X
Improvement in X
manufacturing
schedules
Increased control X
x X X x x x x X x X

(continued )
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Table 1. Continued.

Authors

Achabal
et al: 2000
Ching and Tai (2005)
Claassen
et al: 2008
Disney and Towill (2002b)
Dong and Leung (2009)
Duchessi and Chengalur
Smith 2008
Fox (1996)
Fulcher (2002)
Holmstrom (1998)
Kaipia
et al: 2002
Kauremaa
et al: 2009
Kiesmuller and
Broekmeulen 2010
Kim (2005)
Kuk (2004)
Kulp (2002)
Nachiappan
et al: 2007
Razmi
et al: 2010
Szmerekovsky and
Zhang 2008
Sari (2007 and 2008)
Tyan and Wee (2003)
Waller
et al: 1999
Yu and Huang (2010)

Benefits

Increased customer ser-


vice level
Increased performance X x
Increased product x x X x
availability
Increased productivity X x
Increased profit X
Increased sales X X
Increased visibility of X X X
information
Less emerging orders X X x
No stock-outs X
Reduced administration x X
costs
Reduced bullwhip effect X x X
Reduced coordination X
costs
Reduced demand X
variability
Reduced handling costs X
Reduced inventory costs x X x
Reduced inventory levels X X x x x x X x
Reduced IT costs X
Reduced labour X
Reduced obsolesce x X
Reduced safety stocks X
Reduced shrinkage X
Reduced supply chain X X X x x X X x X
costs
Reduced transportation X x X
costs
Reduced wholesale X x
prices
Streamlined purchasing X
International Journal of Production Research 177

related, company related, or supplier related. In addition to the researchers mentioned in Table 1, the following
researchers have also analysed the benefits of the VMI system (Disney and Towill 2002b, Sourirajan et al. 2008,
Bakal and Geunes 2009, Battini et al. 2009, Wang 2009, Liu and Cetinkaya 2010, Borade et al. 2011).
Zhang et al. (2007) developed an integrated VMI, where a joint cost model was built under the assumption of
constant demand rate and production. The model evaluates the impact on the total cost function when varying the
ordering cost. Ordering costs can be reduced through a VMI partnership, and the partners can share the benefits.
Later, a model to indicate the general benefits which a VMI partnership could bring, and adjusted to the
pharmaceutical case, will be developed.
Many authors have focused their attention on the analysis of the VMI performance based on constant demand
characteristics, for which the EOQ model represents the basis for the analysis. While researching the general benefits
of VMI based on EOQ model literature, one of the gaps identified is the fact that evaluations were done strictly
between one vendor and one buyer. The only exception is identified in Zhang et al. (2007), who considered two
buyers but focused on order cost reduction evaluation.
Based on the findings in the literature, this paper extends previous research and analyses the possible benefits
when dealing with one vendor and multiple buyers assuming a stochastic, constant type of demand.
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3. Problem definition and research scope


The objective of this paper is to develop a relevant model which integrates specific constraints from the
pharmaceutical industry and which has the ability to project the possible cost differences between a traditional
supply chain and a VMI supply chain.
Some of the aspects which the model will integrate are: constant demand, variable demand, evaluation of a two-
stage supply chain composed of a vendor and his multiple buyers, and identification of the importance of fast
reaction to demand changes and maintenance of a high customer service level as defined by the industry.
The characteristics are integrated in both traditional and VMI supply chains, while the model is based on the
EOQ model rational with the purpose of highlighting cost differences between the two. Under the VMI supply
chain, the transportation cost and the cost of issuing an order are transferred from the buyer to the vendor.
The structure of the paper is as follows: Section 4 develops the mathematical model for the traditional and VMI
supply chains, and this is then numerically applied in Section 5. The results of the numerical application are
discussed in Section 6, and Section 7 presents an overall conclusion of the paper and identifies directions for further
research opportunities.

3.1 Research highlights


The model developed in this paper extends previous works which based their analysis of traditional versus VMI
supply chains on EOQ models by acknowledging demand variability and integrating preventive actions.
Another difference which is captured within this model represents the extended number of buyers evaluated.
While previous research focused on one-vendor, one-buyer cases, the model here integrates one vendor and multiple
buyers.
Evaluating the situation of multiple buyers with whom the vendor has the possibility to establish VMI
partnerships gives more flexibility to the vendor to consolidate specific product demands. Based on this opportunity,
the model is structured to evaluate benefits depending on the number of products shared among more buyers.

3.2 Company introduction


The company studied here is one of the leading healthcare companies in the world with a revenue in 2010 of $50.6
billion. It employs approximately 120,000 people around the globe. The company is structured in four divisions:
pharmaceuticals, vaccines and diagnostics, generics, and consumer health.
The company engages 23 production sites with an outcome of over 13,000 finished products sold to 120
countries around the world. Around 10% of the companys business is outsourced to third party manufacturers.
One of the main targets of the company set by the supply chain department was identified as the need to reduce
inventory levels without impacting customer service levels.
178 G. Kannan et al.

As a solution to this matter, VMI implementation has been identified as a powerful method with a very high
probability of bringing the expected outcome. As the department preferred an analysis to integrate their specific
conditions and make sure that such a method would bring significant benefits in the long term, it has been decided
to focus on general benefit model development.

4. Mathematical model
While in a traditional supply chain the costs of each member are clearly defined, in the case of VMI, different ways
of sharing costs have been proposed in the literature.
The traditional supply chain (SC) and the VMI supply chain have been thoroughly analysed, and a clear
distinction of the cost division between the two stages has been made. One extreme case has been described by
Razmi et al. (2010), who transferred all costs to the vendor when implementing VMI. Other authors have evaluated
how total costs are influenced when transferring some of the costs from buyer to vendor in a VMI case.
Many VMI pioneers have argued that a vendor has greater benefits under VMI due to its chance of better
coordinating its production. However, this can be challenged by the fact that the vendor will need to increase the
number of resources to allow for extra responsibilities. As already mentioned in the introduction of this paper, this is
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not as critical in a centralised organisation as the overall savings are more important.
Calculations of the costs of each member have been made to capture all their relevant constraints.
In order to compensate the variability in demand, the model includes a safety stock (SS) quantity. The safety
stock represents a buffer stock maintained at any stage of the supply chain to better deal with demand variability
and to ensure high customer service levels (Chopra and Meindl 2001).
Capturing the characteristics of the pharmaceutical industry represents the main focus of the model and, based
on the numerical application, it will be possible to evaluate whether or not VMI implementation would bring
significant cost savings to the overall supply chain.
Notations
D annual demand
mi number of buyers
ni number of products
hb buyers inventory-carrying cost/item/year
ab buyers cost of issuing an order
rb buyerscost for receiving goods cost
tb buyers transportation cost
Ab buyers overall ordering cost (Ab ab rb tb)
q1 buyers EOQ for traditional supply chain case
q2 buyers EOQ for VMI case
SSb1 buyers safety stock in the traditional supply chain
SSb2 buyers safety stock in the VMI case
hv vendors inventory-carrying cost/item/year
av vendors cost of issuing an order
tv vendors transportation cost
Q1 vendors EOQ for traditional supply chain case
Q2 vendors EOQ for VMI cases
SRv vendors shipment release cost
S vendors production set-up cost
p vendors annual production

4.1 Traditional supply chain description and model


In a traditional supply chain, the buyer observes the demand, decides upon the replenishment quantity, and assumes
the risks associated with this quantity, while the vendor decides upon the production quantity (Lee and Chu 2005).
The vendor can produce a higher quantity than the buyers demand, but this then implies that there will be
International Journal of Production Research 179

inventory-holding costs incurred by the vendor until the next order is received as the vendor can only send to the
buyer the ordered quantity.
Very often this situation is encountered when the two parties belong to two different organisations. This
situation is also encountered in the case described here, as the two parties make their own decisions, despite both
stages belonging to the same organisation.
Some communication between the two parties takes place, but this is not the optimal solution and does not
necessarily influence the decisions taken within the supply chain. The buyers still place the orders when they need to
and the order quantity is identified so as to minimise costs at their end.
From pharmaceutical industry experience, it has been observed that buyers prefer to order in larger quantities
and maintain a high SS on their side in order to manage demand variability and supply inefficiencies.
Other reasons for high order quantities could be:
. slow quality assurance check ups,
. required licenses when importing goods from different countries, or
. an attempt to reduce the number of orders placed over the year to use fewer resources.
High ordering quantities do not mean only cash flow blocked in inventory but also results in higher amounts of
SS carried to manage the demand fluctuation over a longer period of time.
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The costs encountered by the two parties under a traditional SC are shown in Table 2.
Following the thinking from the EOQ model and the cost separation presented in Table 2, the total costs
incurred by the buyer can be written as:

D q 
Total costTrad sc b tb rb ab hb 1 ssb1 1
q1 2

The total cost formula assumes the number of orders placed per year and their correlated ordering cost in the first
term and the second term represent the inventory-holding costs associated with the cycle inventory and the SS
quantity maintained.
Integrating the SS as a parameter of the holding cost represents one of the differences from the model developed
by Bookbinder et al. (2010) who did not consider an SS within the calculations. The SS is added in our case to
overcome fluctuations in demand.
From the total costs above, the optimal order quantity of the buyer is deducted as:
s
2 Ab D
q1 EOQ1 Same as in Bookbinder et al: 2010 2
hb

The buyer observes the demand from the customers and its inventory levels and, based on this information, then
places an order quantity equal to that of q1 to the vendor (when a re-order point is reached). This represents a make-
to-order environment, as the delivery time from vendor to buyer includes the time the vendor needs to produce the
product as well.
Having received an order from a buyer, the vendor adjusts the production quantity according to its capacity
utilisation and tries to achieve economies of scale and increase productivity. The vendors responsibility is to fulfil
the orders received from buyers, but it has no influence on changing the delivery date in order to send a shipment to
one buyer with a significantly higher need than another buyer.
The total cost incurred by the vendor can be written as:
     
S SRv hv D Q1
Total costTrad SC v D q 1 3
Q1 q1 2 1 p 2
The novelty of the total cost formula for the vendor is identified in the inventory-carrying cost term, where Q1 is
divided in half. This division is undertaken in order to assume a reduction in the venders holding costs as most of
the products are sold to at least two buyers, which means that the remaining quantity is moved faster to the next
stage and fewer inventory-carrying costs are incurred. Even when there are more than two buyers for a product, in a
traditional SC coordination of order placements is difficult to achieve and therefore the assumption of reducing the
inventory-carrying cost only once should be feasible.
180 G. Kannan et al.

By taking the derivative of its total cost, the vendor obtains the EPQ to minimise the total cost:
v
u 4 SD
u
Q1 EPQ1 t   4
hv 1  Dp

The vendor calculates the production quantity regardless of a buyers order quantity and looks for the cost
optimisation on his side. This implies that the vendors production quantity might be greater than the buyers
demand. Nevertheless the production quantity must be at least as high as the requirements received. Producing more
than the demand means extra inventory-carrying costs for the vendor and this is a choice that the vendor will take to
optimise his benefits.
As presented above, the decisions regarding order quantity or production quantity are taken independently by
the buyers and the vendor. This is the general case encountered in a traditional supply chain.

4.2 VMI case description and model


If in the case above, each supply chain stage took its own initiative and ordered or produced quantities to enhance
the benefits at their own stage, while in the case of VMI the decisions become centralised and are opted for as long as
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they bring the highest overall savings to the supply chain.


In the case of VMI, the buyer does not decide upon the order quantity anymore, this decision is taken a stage
above by the vendor. At the same time, the vendor has the opportunity to decide the timings of the replenishments.
Under VMI, buyers do not need to invest time on order placements, they have zero costs for issuing an order,
and the transportation cost is transferred to the vendor. The freed resources can focus on different activities such as
forecast improvement, as VMI success is highly dependent on forecast accuracy.
This suggestion is in line with the findings of Holmstrom et al. (2002), who mentioned that forecast accuracy is a
key factor in the success of VMI, together with clear communication between partners.
The order placement cost of buyers is simply eliminated as they are not in the position to place orders anymore.
The vendor takes ownership of these decisions, and this gives the vendor the opportunity to better coordinate its
production scheduling.
The transportation cost is transferred to the vendor because it is the vendor who ultimately decides upon the
number of replenishments which has an impact on the transportation cost.
Another reason for transferring the transportation cost to the vendor is that the vendor must identify the
consolidation of products which can be transported to a buyer whenever a replenishment is called off. This will give
enough incentive to identify consolidation in transportation.
The costs division under VMI is done as in Table 3.
After transferring the transportation and order-issuing costs from the buyer to the vendor, the total costs of a
buyer can be expressed as:
D q 
Total costVMI SC b rb hb 2 SSb2 5
q2 2
Although the transportation cost and the cost of issuing an order have been transferred to the vendor, it does not
mean that they have the same values as they had for the buyers and therefore it becomes tv and av. The cost
differences of issuing an order for a buyer and a vendor have been considered by Bookbinder et al. (2010) as well.

Table 2. Traditional supply chain: costs partition of the two Table 3. VMI supply chain: costs partition of the two
echelons. echelons.

Costs allocation Traditional supply chain Costs allocation VMI

Vendor Buyer Vendor Buyer


Inventory carrying cost (hv) Inventory carrying cost (hb) Inventory carrying cost (hv) Inventory carrying cost (hb)
Production set-up cost (S) Issuing an order cost (ab) Production set-up cost (S) Receiving goods cost (rb)
Shipment release cost (SRv) Receiving goods cost (rb) Shipment release cost (SRv)
Transportation cost (tb) Issuing an order cost (av)
Order cost Ab (Ab ab rb tb) Transportation cost (tv)
International Journal of Production Research 181

The SS has different values for the two models as VMIs success is dependent on forecast accuracy improvement
and this means that a lower SS will be possible under VMI due to the improved forecast.
As observed in the total cost formula in Equation (5) above, the buyer encounters fewer costs than in a
traditional SC. Besides the transfer of the transportation and order-issuing costs to the vendor, fewer inventory-
carrying costs are paid due to the lower safety stocks required. The benefit of having fewer costs represents the
trade-off for the fact that now, the vendor is the one deciding the replenishment quantities and the timing.
Under VMI, the vendor decides production, replenishment quantity, and replenishment timing. This gives the
vendor the possibility of optimising production scheduling, transportation costs, and inventory-carrying costs. Due
to the improved communication between the two stages, the vendor has better information about the demand
fluctuations and can better prepare for such events.
Under VMI, the total cost of a vendor is:
       
S SRv tv av hv D Q2
Total costVMI SC v D D q2 1  6
Q2 q2 ni q2 ni q2 2 p mi
The novelty of the formula above represents the fact that transportation and order-issuing costs are reduced, as the
assumption made in the beginning stated that each buyer that enters a VMI partnership should be buying at least
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two products from the vendor.


ni represents the number of products handled for one buyer and means that the higher the total number of
products, the better the chance for transportation consolidation and therefore the higher the reduction in
transportation and order-issuing costs.
The pharmaceutical business, by nature, deals with many different products and it is normal that each buyer has
many products replenished from a vendor. Consequently, it can be assumed that joint product replenishment is
possible and the user can take advantage of transportation consolidation and overall reduced costs.
The total number of products handled for one buyer has an impact on the cost of issuing an order as well. When
the vendor evaluates the replenishment timings and quantities he can follow up on the status of different products
handled for a specific buyer and makes a decision to replenish several products at the same time. This will have a
positive impact on the cost of issuing an order, which will be decreased due to order consolidation.
Due to the centralised decision making existent at the vendor, coordination can be achieved by consolidating the
different buyers needs for a specific product, and this gives the option of producing all the orders together and also
of sending shipments to the identified buyers right after production. This assumption impacts the inventory-carrying
cost term of the vendors total cost, which is reduced incrementally with mi as the number of buyers purchasing the
same product is increased.
Further potential savings which are not captured in our formula could be identified in the set-up cost reduction
that could also be encountered due to order consolidation and the possibility of producing larger quantities at one
time.
The values of Q2 and q2 are derived using Equations (7) and (8) to optimise the total cost function.
v
u  
u2D SRv tv av
t ni ni
q2 EOQ2 7
hv

v
u 2 m SD
u i
Q2 EPQ2 t   8
hv 1  Dp

In this case, the EOQ is no longer a variable for the buyer, but is calculated so as to optimise the vendors total cost
function. The vendor is the one identifying these quantities and informs the buyer the value of a replenishment
quantity q2.
The central decision making, which is opted for under VMI, is meant to improve total supply chain profits.
Improved supply chain profits under centralised decision making have been recognised by many authors, but Toptal
and Cetinkaya (2006) have proven its efficiency through numerical analysis.
Throughout this model, the differences in the formulas for a traditional versus a VMI supply chain have been
captured. These are consolidated in Table 4.
182 G. Kannan et al.
Table 4. Summary of total costs and EOQ/EPQ data.

Costs and EOQ/EPQ overall summary

Vendor Buyer

Traditional supply chain


      D q 
S SRv hv D Q1 TCTrad SC b tb rb ab hb 1 SSb1
TCTrad SC v D q1 1  q1 2
Q1 q1 2 p 2
s s
2 Ab D 2 Ab D
q1 EOQ1 q1 EOQ1
hb hb

VMI supply chain


        D q 
S SRv tv av hv D Q2 TCVMI SC b rb hb 2 SSb2
TCVMI SC v D D q2 1  q2 2
Q2 q2 ni q2 ni q2 2 p mi
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v v
u 2m SD u  
u i u2D SRv tv av
Q2 EPQ2 t   t ni ni
hv 1  Dp q2 EOQ2
hv

Table 5. A Class SKU parameters (general benefits).

Parameters used for A class SKUs

hb $12,825 hv $1280
ab $1000 av $1000
rb $1000 SRv $1000
tb $500 tv $500
Ab $2500 S $2000
SSb1 400 units P 7200 units
SSb2 350 units D 6000 units

5. Numerical application
This section applies the model developed in the previous section and evaluates the two types of supply chains
impact on costs in different situations. The model is applied to three categories of products, A, B, and C, so as to
observe the impact on cost savings based on product classification.
This evaluation should give an appropriate understanding if VMI implementation, it should cover all ranges of
stock keeping units (SKUs) or only parts of them, and, even more importantly, it should evaluate if higher benefits
are reached under VMI compared to traditional systems.
For each category of SKU, four different cases have been analysed, and below a short overview of the results is
presented. More details for the calculations are given in appendix A.

5.1 A Class SKUs impact


The various parameters used in the A class SKU are shown in Table 5.
Four different cases have been considered in which the number of buyers or the number of products handled for
the same buyer were varied. The number of buyers and products were chosen as variables because they are key
International Journal of Production Research 183
Table 6. A Class SKUs: Cost savings under VMI (general benefits).

Buyers Products Case 1 Buyers Products Case 2 Buyers Products Case 3 Buyers Products Case 4

2 nuyers 10 buyers 2 buyers 10 buyers


mi ni 2 products mi ni 2 products mi ni 10 products mi ni 10 products

2 2 $384,391 1 2 $384,391 2 1 $199,682 1 1 $199,682


2 2 $384,391 2 2 $384,391 2 2 $384,391 2 2 $384,391
2 2 $384,391 3 2 $393,675 2 3 $453,728 3 3 $463,012
2 2 $384,391 4 2 $399,210 2 4 $490,314 4 4 $505,133
2 2 $384,391 5 2 $402,987 2 5 $512,964 5 5 $531,560
2 2 $384,391 6 2 $405,775 2 6 $528,379 6 6 $549,764
2 2 $384,391 7 2 $407,942 2 7 $539,552 7 7 $563,104
2 2 $384,391 8 2 $409,689 2 8 $548,025 8 8 $573,323
2 2 $384,391 9 2 $411,136 2 9 $554,670 9 9 $581,415
2 2 $384,391 10 2 $412,360 2 10 $560,023 10 10 $587,992
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$600,000

$500,000
Cost savings under
$400,000 VMI Case 1

Cost savings under


$300,000 VMI Case 2

Cost savings under


$200,000 VMI Case 3

Cost savings under


$100,000
VMI Case 4

$0
1 2 3 4 5 6 7 8 9 10

Figure 2. Cost savings under VMI (general benefits) for A Class SKUs.

parameters within the developed VMI model. The cost savings of an A SKU obtained under different circumstances
from the VMI model compared to the traditional model are shown in Table 6 and in Figure 2.
The savings obtained for the A range SKUs are quite high, considering that even the lowest savings that could be
achieved extend up to $200,000 per year.
It is observed from Figure 2 that the greatest impact on savings comes from the number of products handled for
one buyer. Both cases 3 and 4 are giving close savings when the number of products are considered as 10 (no matter
how big the number of buyers is).
The conclusion is that handling a larger number of products for one buyer under VMI will bring significant cost
savings due to reduction in transportation, administration, and inventory-carrying costs.
Having a larger number of products purchased by a larger number of buyers will bring the highest cost savings
over all the supply chain and both partners will gain significant benefits.
In cases 1, 2, and 3, it has been observed that although overall supply chain costs have been significantly
decreased, but the vendor will incur higher costs under VMI than under the traditional system. This is in line with
some of the findings of other researchers (Mishra and Raghunathan 2004, Yao et al. 2007, Pasandideh et al. 2010,
Zavanella and Zanoni 2009), but at the same time, due to the fact that overall supply chain cost savings are the most
important for both members, this issue is not further debated here.
184 G. Kannan et al.
Table 7. B Class SKU parameters (general benefits).

Parameters used for B class SKUs

hb $3000$ hv $800
ab $900 av $900
rb $800 SRv $800
tb $450 tv $450
Ab $2150$ S $1000
SSb1 350 units P 7300 units
SSb2 200 units D 7100 units

Table 8. B Class SKUs: cost savings under VMI (general benefits).

Buyers Products Case 1 Buyers Products Case 2 Buyers Products Case 3 Buyers Products Case 4

2 buyers 10 buyers 2 buyers 10 buyers


mi ni 2 products mi ni 2 products mi ni 10 products mi ni 10 products
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2 2 $442,037 1 2 $442,037 2 1 $370,909 1 1 $370,909


2 2 $442,037 2 2 $442,037 2 2 $442,037 2 2 $442,037
2 2 $442,037 3 2 $444,326 2 3 $468,567 3 3 $470,856
2 2 $442,037 4 2 $445,691 2 4 $482,506 4 4 $486,160
2 2 $442,037 5 2 $446,622 2 5 $491,109 5 5 $495,694
2 2 $442,037 6 2 $447,309 2 6 $496,951 6 6 $502,224
2 2 $442,037 7 2 $447,844 2 7 $501,178 7 7 $506,985
2 2 $442,037 8 2 $448,274 2 8 $504,378 8 8 $510,616
2 2 $442,037 9 2 $448,631 2 9 $506,886 9 9 $513,480
2 2 $442,037 10 2 $448,933 2 10 $508,904 10 10 $515,800

$600,000

$500,000
Cost savings under
$400,000 VMI Case 2

Cost savings under


$300,000 VMI Case 3

Cost savings under


$200,000 VMI Case 1

Cost savings under


$100,000
VMI Case 4

$0
1 2 3 4 5 6 7 8 9 10

Figure 3. Cost savings under VMI (general benefits) for B Class SKUs.

5.2 B Class SKUs impact


The various parameters used in the B class SKUs are shown in Table 7.
The cost savings of a B class SKU obtained under different circumstances from the VMI model compared to the
traditional model are shown in Table 8 and in Figure 3.
International Journal of Production Research 185

B class SKUs have a significant impact on cost savings, and for this specific case the maximum savings are close
to the ones obtained from the A SKUs. Looking at the four cases, it is observed that the same pattern as for the case
of A SKUs is followed.

Table 9. C Class SKU parameters (general benefits).

Parameters used for C class SKUs

hb $300 hv $200
ab $600 av $600
rb $700 SRv $700
tb $400 tv $400
Ab $1700$ S $500
SSb1 3300 units P 51,000 units
SSb2 2500 units D 44,500 units
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Table 10. C Class SKUs: cost savings under VMI (general benefits).

Buyers Products Case 1 Buyers Products Case 2 Buyers Products Case 3 Buyers Products Case 4

2 buyers 10 buyers 2 buyers 10 buyers


mi ni 2 products mi ni 2 products mi ni 10 products mi ni 10 products

2 2 $269,538 1 2 $269,538 2 1 $227,695 1 1 $227,695


2 2 $269,538 2 2 $269,538 2 2 $269,538 2 2 $269,538
2 2 $269,538 3 2 $273,908 2 3 $284,654 3 3 $289,024
2 2 $269,538 4 2 $276,513 2 4 $292,453 4 4 $299,428
2 2 $269,538 5 2 $278,291 2 5 $297,209 5 5 $305,962
2 2 $269,538 6 2 $279,603 2 6 $300,412 6 6 $310,478
2 2 $269,538 7 2 $280,623 2 7 $302,715 7 7 $313,801
2 2 $269,538 8 2 $281,446 2 8 $304,450 8 8 $316,358
2 2 $269,538 9 2 $282,127 2 9 $305,805 9 9 $318,393
2 2 $269,538 10 2 $282,703 2 10 $306,891 10 10 $320,056

$600,000

$500,000
Cost savings under
$400,000 VMI Case 1
Cost savings under
$300,000 VMI Case 2
Cost savings under
$200,000 VMI
Cost savings under
$100,000
VMI Case 4

$0
1 2 3 4 5 6 7 8 9 10

Figure 4. Cost savings under VMI (general benefits) for C Class SKUs.
186 G. Kannan et al.

5.3 C Class SKUs impact


The various parameters used in the C class SKUs are shown in Table 9.
The cost savings of a C class SKU obtained under different circumstances from the VMI model compared to the
traditional model are shown below in Table 10 and in Figure 4.
The pattern of cost savings for the four cases for a C SKU follows the same pattern as for an A SKU, although
the cost-saving impact is much lower.

6. Results and discussion


Having analysed the three product categories, it can be concluded that VMI has a positive impact towards reducing
overall supply chain costs. The overall cost savings are higher or lower depending on the category of the SKUs.
Another significant impact on the savings is observed to occur based on the number of SKUs handled for the same
buyer or the number of buyers utilising the same SKU.
Even though under VMI, two of the buyers costs have been transferred to the vendor, the overall supply chain
costs are significantly increased.
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Therefore, for a successful VMI application and significant improvement in the results within the
pharmaceutical industry, the focus should be on identifying and choosing the right products and buyers as
mentioned below.
(1) Universal products which are purchased by many different buyers (this gives the flexibility to reach the
desired EPQ without incurring extra inventory-holding costs)
(2) Buyers who are purchasing a larger range of SKUs (this is an important factor for the cost reduction of
transportation consolidation and administration)
(3) Focus on A and B classes of products as they will bring higher savings than the C class in the beginning of
the implementation. Nevertheless, C class SKUs also have a cost-saving impact and they should not be
completely ignored but could be transferred to VMI at a later stage, when the first level of implementation is
complete. This will give more confidence and trust to the process by the participants
The application above has been executed for a narrow range of SKUs, however great improvements in the cost
direction have been proven to be possible. This analysis proves that adopting VMI within the pharmaceutical
industry, under the conditions mentioned in this research, will result in significant overall supply chain cost reduction.

7. Conclusion and future scope


Within this paper an assessment of the general benefits of VMI has been executed through a model developed based
on the EOQ rational. The model captures constant demand uncertainty; one vendor, multiple buyers, multiple
products; and conditions specific from the pharmaceutical industry.
Some of the buyers costs have been transferred to the vendor under the VMI partnership as compared to the
traditional supply chain. Nevertheless, in most situations, the costs which result from the VMI method are lower
than the costs previously encountered. Both stages belong to the same organisation and, as long as the overall
supply chain costs are decreased, the members of the partnership should be motivated to apply VMI.
The results of the model have shown that significant cost reductions can be achieved under the specified
circumstances, and therefore it is recommended to implement VMI in the pharmaceutical industry as long as the
specified conditions are observed.
Furthermore, the savings achieved are more or less significant depending on the ABC classification of the
product, where the A and the B SKU types have a stronger impact.
Another finding of the model is that inventory costs are reduced over all of the supply chain. This is the result of
improved communication and on time information sharing, which ultimately impacts the levels of safety stocks
maintained at each of the parties, but it is also due to better production scheduling at the vendor.
Further research of the current model can be undertaken to extend the existing work and identify the
implications when VMI implementation incorporates multiple vendors and multiple buyers, and maintains the other
constraints such as variable demand and multiple products as above.
International Journal of Production Research 187

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Appendix A
A detailed calculation of the A, B, and C classes of SKUs, which shows the costs encountered under the traditional supply chain
and the VMI supply chain within the four cases, can be found at the following website: http://sites.google.com/site/gkannan80/
assignments/vmi-ijprpaperappendix-a