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SOUMYADEEP SINHARAY

SRIJIT SENGUPTA

ROHIT JAIN

IMT GHAZIABAD PGDM FINANCE 2009 2011 BATCH

Abstract

Purpose: The retail industry in any country is heavily dependent on the inventory system it uses to
continuously replenish its shelves. The choice of the inventory management system is of utmost
importance to the retail industry because a trade-off has to be found between the total inventory
cost (comprising of the carrying/ holding cost, ordering cost and the shortage cost) and the level of
customer service ( which is the probability of meeting customer demand without experiencing a
shortage of inventory). The purpose of this paper is to analyze the impact of using a Vendor
Managed Inventory System (VMI) to manage the inventory in the retail industry through the new
age computer software suit known as Electronic Vendor Managed System (eVMI) .The paper also
discusses about the possibility of enhanced operations in the Indian Retail Industry as a consequence
of the successful implementation of eVMI.

Design/methodology/ approach: This conceptual paper is written based on secondary study,


research and observations from magazines reports and notes. The author has described how a VMI
system operates and how this is implemented through software suites like eVMI.

Findings: This paper shows how eVMI/ VMI are useful in the retail industry and how its successful
implementation can yield both profitability and level of customer service to this industry.

Practical Implications: The paper focuses on how the successful implementation of eVMI/ VMI can
benefit the operations in the retail industry. These implications are supported by facts of successful
implementation of the system in the U.S. retail industry. As the Indian retail market is growing at a
frantic pace and catching up with the organised retailing sector of most of the developed nations an
analysis of the still untapped eVMI potential in the Indian retail industry has major practical
implications.

Originality/ Value: Research papers and conceptual papers regarding the implications of eVMI
technologies in the retail industry are rare. This is the motivation for the paper.

Keywords: Retail Industry, Organised Retailing, Vendor Managed Inventory (VMI), Electronic Vendor
Managed Inventory (eVMI).

Paper type: Conceptual paper.


Introduction

There has been an increasing competition and the rapid adoption of advanced information
technology has prompted retailers and suppliers to reengineer their supply chains and examine
collaborative supply chain efforts to reduce costs by a lot of extent and improve efficiency. Now a
day retailers͛ sharing of point-of-sale (POS) data using electronic data interchange (EDI) systems
have become common thing. Vendor-managed inventory (VMI) has emerged in this context as an
initiative that takes the collaborative efforts beyond information sharing and allows the supplier to
exercise some amount of control on the actual inventory levels at the retailer. In case of a typical
VMI agreement, the supplier controls the order quantities delivered to the retailer, with a possible
subject to contractual limitations specifying minimum service level requirements, etc. (see Fry et al.
2001). Wal-Mart and Procter & Gamble (P&G) represent one of the first large-scale successes of such
VMI applications for their business. Their partnership began in 1985 and significantly improved
P&G͛s on-time deliveries to Wal-Mart while increasing inventory turns (Buzzel and Ortmeyer 1995).
VMI projects, including those implemented at Dillard Department Stores, JC Penney and Wal-Mart
have shown sales increases of 20ʹ25 and 30% inventory turnover improvements (Buzzel and
Ortmeyer 1995).

Our goal in this paper is to examine the effect of vendor-managed inventory application in the
supply chain of giant retailers. Channel power refers to an agent͛s ability to control the decision
making process; it can be a function of the agent͛s relative size, market presence, customer loyalty,
etc. In this paper, we analyze a VMI application between suppliers who delivers product to a retailer.
The supply chain follows a continuous review º inventory policy, according to which the retailer
decides the reorder point , and the supplier determines the replenishment quantity  (a similar
model is used in Corbett 2001). In this way, the supplier controls the delivery amount ( ) and the
retailer retains some control over service levels (). The retailer incurs an inventory holding cost per
item, per unit time. The supplier incurs an inventory holding cost of his own as well as a fixed
replenishment cost per order. Penalty costs from stock-out are split between supplier and retailer;
this represents the situation where a retailer stock-out leads to a loss of customer goodwill (and
possible lost future sales) at both the retailer and supplier. Production at the supplier occurs at a
deterministic linear rate. In cases where the supplier͛s on-hand inventory is insufficient to cover the
retailer͛s order, we assume that the supplier can outsource the shortfall from a third party. There
exists a positive delivery lead time and customer demand during the lead time is normally
distributed.

To better capture the overall benefits of the VMI agreement, we compare supply chain performance
under a VMI contract with the performance achieved under a centralized supply chain and under a
traditional retailer-managed inventory (RMI) supply chain. In case of a centralized supply chain,
there exists a single decision maker who decides on both reorder point and replenishment quantity,
while under RMI the retailer alone determines both the reorder point and the replenishment
quantity, but ignores the supplier͛s cost function.

We have found out what all are the different stages of VMI in application in retail industry as a large.
Also the way they are using VMI so as to maximize their business profits is highlighted in this paper.
The remainder of this paper is organized as follows. To better motivate our analysis, the next section
provides a review of the literature of the related work. Next we come up with all the different
features of the VMI system and their business applications. Finally, we present conclusions and
managerial insights in the final section.

Our research paper focuses the successful implementation of VMI systems in US retail industry. But
this does not mean that successful implementation of VMI is restricted only to certain regions and
certain industries. VMI has wide scope across industries and across regions. Thus the fledgling Indian
retail industry can find VMI as the next step in the retail revolution.

Motivation and Related Work

Our work relates to several existing research streams, including papers that examine VMI contracts,
models for general º   inventory policies and works that explore the implications of channel
power.

Our approach of the analysis of VMI application closely follows the approximate cost formulation
proposed by 
     º for a centralized system. This approach is amenable to
analytical solutions of the agents͛ best response functions, which are crucial for our purpose of
analyzing the impact of channel power on performance. For this reason, we favor the approximate
model of 
     º over the exact formulation proposed by Zheng (1992) for a
centralized supply chain. For recent developments on continuous review models, we direct the
reader to    º º º   !ºWe build on
these existing models by including the game theoretic framework to account for channel power and
extending the models to both the retailer managed and VMI scenarios.

VMI programs, pioneered by companies such as Wal-Mart, P&G, Campbell Soup º"  
#$%
 &   ' () º!!  & $. have become popular in practice due to
continued advances in information technology and also increasing supply chain competition.
Correspondingly, there are many recent academic papers that examine vendor-managed inventory.
"$     *  º   "   !!   use empirical evidence to compare the
benefits of VMI and information sharing. The paper concludes that most of the benefits of VMI could
be achieved by information sharing alone. +
     !  º, formulate a model that
compares RMI with a specific VMI agreement where the retailer basically rents space to the supplier.
)--    º, have investigated the benefits of VMI in a supply chain with one supplier
and + retailers under periodic review. The authors have assumed that under VMI the timing and
magnitude of shipments to the retailers is decided by the supplier. They find that VMI is always more
beneficial than information sharing alone. '  *      º study a VMI agreement
where, similar to our paper, decision rights are split between retailer and supplier. However,
'  *        model a scenario where the supplier controls inventory replenishment
and the retailer determines the product price, whereas we assume price to be exogenous and we
allow the supplier to determine replenishment quantity , and the retailer to choose service level ..
Bernstein and Federgruen also assume that the supplier covers all holding costs, i.e., a consignment-
type agreement, where we assume that the supplier and retailer pay separate holding costs.

 º have examined a specific type of VMI agreement called a º.contract, between a
supplier and retailer. In this setting, the supplier controls the inventory replenishment policy at the
retailer subject to limits on service level and maximum inventory chosen by the retailer (the . 
quantities). The authors contrast the performance of the VMI contract with RMI and identify the
scenarios where VMI performs best in comparison to RMI. "$   º have examined the
coordination in two-echelon supply chain with one supplier and + retailers. The supplier and
retailers follow continuous review º policies, and, as in this research, the total backorder penalty
cost is split between supplier and retailer. Under VMI, the supplier is responsible for choosing the
policies at each of the retailers in the supply chain. Cachon shows that VMI achieves the optimal
solution only if the supplier and the retailers make fixed transfer payments to participate in the VMI
agreement.

+/    /  º& also compared the performance of RMI and VMI under
continuous and periodic review policies. The study is very much reflected in our study. As part of the
VMI agreement, the authors explore various subsidizing schemes, e.g., the supplier subsidizes the
retailer͛s penalty and holding costs or the supplier subsidizes retailer͛s holding cost and the retailer
subsidizes supplier͛s replenishment cost. These two parameter create contracts are shown to
coordinate the channel under certain conditions.    º0 propose an º1  VMI contract
that coordinates a supply chain with one retailer and one supplier.
According to this contract, the supplier acts as a Stackelberg leader, manages the retailer͛s inventory
and bears inventory carrying cost; the retailer decides the targeted sales at the start of the selling
season. The contract variable 1 determines how sales and penalty costs are split between supplier
and retailer; indicates a holding cost subsidy paid by the retailer to the supplier for each unit left
unsold at the end of the season.

In a related study, "2  º examines the impact of incentive conflicts and information
asymmetry on performance in a two-player decentralized supply chain, which follows a continuous
review (Q, R) policy. The author also uses a principal-agent approach to model scenarios where the
principal, either the buyer or the supplier, acts as the leader in the supply chain, but lacks full
information on the agent͛s costs, while the agent follows and possesses full information. "2 
finds that in the absence of a central planner with full information, no party can induce jointly
optimal behavior for all agents in the supply chain without sacrificing his own profits. This conclusion
is related to an important finding in our work, which shows that while the system prefers one of the
agents to lead, neither party has sufficient incentive to exercise channel power on their own.

Consignment arrangements are often closely related to VMI agreements. Under consignment, the
responsibility of inventory decision making is transferred to the supplier as in VMI, but ownership of
goods is retained by the supplier until the moment of sale (see Bolen 1988; Narayanan and Raman
1998 could also be considered a consignment-type contract). These contracts are popular in a
variety of industries in various countries (3   - . Due to their characteristics,
such contracts are often appealing to and initiated by the retailers, who are typically represented as
the powerful players in the supply chain º  *      & Thus, in addition to VMI,
consignment agreements may represent a potential environment where unequal splits of power are
likely to exist.

An important contribution of our research is that it explores the impact of channel power in a VMI
agreement. The topic of channel power has been earlier defined, as the ability of a firm to influence
the intentions and actions of another firm º*  4! *   has seen some examination in the
social, political and marketing literature. However, to the best of our knowledge, this topic has seen
relatively little development in the operations management literature and, as "$  ºnotes,
additional research is needed on this issue. "$  º states that the use of a profit reservation
level and first mover approaches are possible ways to model power. Here, we adopt the latter
approach and use a game-theoretic framework to characterize players͛ actions. For empirical works
that study the issue of power within an operations management framework, we direct the reader to
#  '  º and '   # º& For papers in the marketing literature that
study the issue of power defined as the proportion of channel profits that accrue to each of the
channel members and use a game theoretic approach to determine price, we direct the reader to
" º and %
 º

+  **     º& compare a vertically integrated supply chain in their paper, a
decentralized supply chain and a drop-shipping supply chain. Under a drop-shipping contract, the
wholesaler, or the manufacturer, ships the product directly to the end customer without any stop in
between them; thus, the retailer is relieved of any inventory responsibility and inventory-related
costs.
VMI/ eVMI in the Retail Industry: Application and Benefits

In this era of cut throat competition retailers are trying to implement every supply chain
optimization process that will reduce their costs and inventory levels and increase profits. Efficient
supply chain management mandates the exchange of rapid and accurate information throughout a
supply system. Vendor Managed Inventory (VMI) is designed to improve that transfer and to provide
major cost saving benefits to both suppliers and retailers. Vendor Managed Inventory is a
continuous replenishment system that uses the transfer of information between the retailer and the
supplier to allow the supplier to manage and replenish products/ orders at the store or warehouse
level. In this system, the retailer supplies the vendor with the information necessary to maintain just
enough merchandise to meet customer demand. This enable the supplier to better forecast the
amount of product it needs to produce or supply. Thus, VMI is a backward replenishment model
where the supplier does the demand creation and demand fulfilment. In this model, instead of the
customer managing his inventory and deciding how much to fulfil and when, the supplier does.

The VMI system provides more transparency to the supply chain and the suppliers and retailers can
improve production planning, inventory turnover, reduce inventory surpluses and stock-outs. With
information available at a more detailed level, it allows the manufacturer to be more customer-
specific in it͛s planning.

In the conventional inventory management system, first the retailer does a sales forecast. After that
it checks the inventory and sales information to place the orders. After the order is placed with the
vendor through an EDI document the vendor checks whether it can meet the order. If it can, the
vendor ships the order to the either the retailer͛s store or its warehouse. Soon after this the vendor
ends the invoice to the retailer. When the retailer obtains the product, the invoice is matched with
the product and the payment is made to the retailer through the inventory management system.

In the VMI process the forecasting and purchase order creation are performed by the supplier/
vendor. The retailer sends the sales and inventory date to the vendor through EDI and the vendor
creates the purchase order based on the inventory levels and the fill rates. The vendor is responsible
for creating and maintaining the stock plan for the retailer and so the retailer is free from the
forecasting and order creation responsibilities. The vendor sends a shipment notice before sending
the product to the retailer and an invoice of the products delivered. Upon receiving the order the
retailer does the invoice matching and pays the vendor through the account payable systems.

The activities that are involved in the implementation of the eVMI are explained in sequence. The
Point of Sale (POS) and the On Hand information is generated at the retailer end. This information is
sent to the retailers end and stored in the data warehouse. The above data is used along with the
model base to form the sales orders that are sent to the Manufacturer/ Distributor͛s Common
Distribution System.The Common Distribution System is used to coordinate the product shipments
to the retailers to finally end the VMI cycle.

At the retailer end whenever a product is sold the POS information gets stored in the eVMI
database. Similarly, the inventory level of the products known as the On Hand information is stored
in the eVMI system. The eVMI system uses the above information which is stored in the data
warehouse and the model base which is the collection of the business metrics to form the
replenishment orders. These replenishment orders are then directed to the Common Distribution
System (CDS) which is responsible for the distribution of the replenishment orders to the respective
retailers thus completing the VMI cycle. The Order Status of the shipped/cancelled/pending orders is
updated in the eVMI system so that it can be used for the next round of decisions. Finally, the data
from the eVMI system and the CDS are used by the Business Objects Application to prepare the
customized reports that help in executive decision making.

Problems faced by the supply chain members in absence of VMI/ eVMI systems are lack of desired
service levels for the end customers as well as the retailers, unused inventories throughout
the supply chain, high probability of returns and stockouts, higher product costs, higher
logistic costs, ineffective promotions and underutilized assets both by the vendor and the
retailers, high cycle time in the inventory replenishment system.

The advantages to the retailers due to the VMI/ eVMI systems are reduced inventory,
reduced stock-outs, reduced forecasting and purchasing activities and increase in sales. The
advantages to the supplier are improved visibility which leads to better forecasting, reduces
purchase order errors and potential returns, improvment in SLA and encouragement in
supply chain cooperation.

Conclusion

The Indian economy is growing at a frantic pace, being the second fastest growing economy in the
world after China in terms of GDP. Most of this growth is fuelled by the service sector in India. The
burgeoning retail industry comprises an important component of this growing service sector. Though
the retail industry is bringing in the revolution of organised retailing in the country, it is still facing
operational difficulties. The key cause for this operational inefficiency is the poor integration
between the retailer and supplier. None of the retailers has so far an automated system for
information exchange with their suppliers. In developed countries, retailers practice Vendor
Management Inventory (VMI) systems, where the supplier has access to the point of sales data of
the retailer and plans automatic replenishments responding to the stocks available at the retailer.
Thus implementing VMI/ eVMI approach to inventory management can yield significant returns to
the organised retailing operations in India and can add to both the profitability as well as the quality
customer service aims of the Indian retail companies. If an organization can achieve 7-9% reduction
in procurement cost then money invested in vendor management solution generally pays off. This
paper thus tries to project the benefits of using a VMI/ eVMI system in the retail sector so that the
study can be a basis for the Indian retail companies to implement the same towards building their
competitive advantage.

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