Term II: Supply Chain Management (SCM)

Session 13: Vendor Managed Inventory (VMI)

Rohit Gupta
Operations Management Area
IIM Ranchi
Email: rohit.gupta@iimranchi.ac.in
Supply Chain (Inventory) Coordination

“The more inventory a company has, the less likely they will have what they need”
– Taiichi Ohno

All business entities are worried about their inventory levels.

For most businesses, inventories represent a substantial portion of what the firm owns.

Changes in inventory levels will result in significant changes in both gross as well as net
profit levels.

Changes in inventory levels tend to be indicative of broader business trends and therefore
warrant close attention.
How does Wal-Mart continue to manage Every Day Low Price (EDLP)?

 Due to its large size, Wal-Mart enjoys strong negotiating power over her vendors.
 Wal-Mart offers long-term and high-volume purchase contracts to her vendors, and is
therefore able to negotiate the best prices. Several vendors are entirely dependent on Wal-
Mart for their business, which allows the retailer to squeeze the best possible agreement
from them.
 Wal-Mart employs vendor-managed inventory (VMI) method, where her suppliers are
responsible for managing their goods inside the retailer’s (Wal-Mart) warehouses.
 As a result, inventory management becomes stronger and more vendor specific, which
results in 100% order fulfillment.
 This strategies prevent the issues of inventory shortage or surplus, which helps in reducing
the cost of goods and services.
 Her efficient supply chain has allowed Wal-Mart to become the price leader in the U.S.
retail market.
Forbes Report (September 9, 2014)
 Case 1: Decentralized Supply Chain
[No VMI Agreement between Supplier & Retailer]

Supplier Retailer Final Goods Market

(Produces FG) w (Sells FG) Market Demand: q = a – p

Supplier’s per unit Buyer’s per unit Retail Price: p = a – q

production cost: s cost: c = p(q)

w: Supplier’s per unit selling price

As in this model we are analyzing the effect of VMI on Supply Chain structure, therefore
we are going to explicitly incorporate the associated inventory costs (i.e. Ordering Cost &
Inventory Carrying Cost).
For this purpose, we assume the following: Total Inventory Cost
AS : Setup Cost of the Supplier of the Supplier:
hS : Per unit Inventory Carrying Cost of the Supplier   q   QS  
AB : Ordering Cost of the Retailer TCS QS    AS     hS 
  S 
Q 2  
hB : Per unit Inventory Carrying Cost of the Retailer Total Inventory Cost
QS : Economic Order Quantity of the Supplier of the Retailer:
QB : Economic Order Quantity of the Retailer    
Q 
TCB QB    AB 
q
   B hB 
  QB   2  
 Case 1: Decentralized Supply Chain
[No VMI Agreement between Supplier & Retailer] (Cont…)

Supplier Retailer Final Goods Market

(Produces FG) w (Sells FG) Market Demand: q = a – p

Supplier’s per unit Buyer’s per unit Retail Price: p = a – q

production cost: s cost: c = p(q)
2 AS q
We can obtain, EOQ of the Supplier: QS* 
hS
Optimal Total Inventory Cost: TCS QS*    2 AS hS q
Similarly we obtain:
Q B* 
2 AB q
hB
TC B Q  
*
B 2 AB hB q

If the Supplier orders according to her EOQ then her profit level is given by:
 S  w  s q  TCS QS*   w  s q  2 AS hS q
If the Retailer also orders according to her EOQ then her profit level is given by:
 B  pq   ( w  c)q  TC B QB*   pq   ( w  c)q  2 AB hB q
Total Profit of the Supply Chain is:  S   B  pq   s  c q   2A h q 
S S 2 AB hB q 
 Case 2: Decentralized Supply Chain
[VMI Agreement between Supplier & Retailer]

Supplier Buyer Final Goods Market

(Produces WIP) w (Produces FG) Market Demand: q = a – p

Supplier’s per unit Buyer’s per unit Retail Price: p = a – q

production cost: s production cost: c = p(q)

1. The Retailer enters into VMI agreement with the supplier. Therefore the supplier maintains
inventory at the Retailer’s end.
2. All the inventory related costs (of the retailer) are carried by the supplier.
3. As the incurred cost level increases, the supplier charges the buyer by a different per unit
wholesale price level
wVMI : Supplier’s per unit wholesale price under VMI agreement
Therefore, assuming supplier & retailer order according to their EOQ, we can calculate
 S VMI  wVMI  s q  2 AS  AB hS  hB q
their profit level(s) as follows:

 B VMI  pq   wVMI  c q

Observe:
1. The Retailer’s profit level does not incorporate inventory cost at all
2. The supplier is carrying the entire inventory cost, as well as the associated risk
3. Such an agreement can be enforced if and only if Retailer holds high bargaining power
 Comparison between VMI & Non-VMI Supply Chains

Now, we compare the overall supply chain profits of VMI and non-VMI supply chain.
In order to get into comparable terms we assume that the supplier follows the EOQ of the
*
Retailer, i.e. (QB )
 S VMI   B VMI    S   B     
2 AB hB q  TCS QS  QB*  2 AS  AB hS  hB q

   q   hS  *   
  2 AB hB q   AS  *    QB    2 AS  AB hS  hB q

   QB   2    
AB hB q  AS hS   A  h 
     2 AB hB q 1  S 1  S 
2  AB hB   AB  hB 
2
 1 1

1   AS  2  hS  2
 0
 2 AB hB q 1    1  
2   AB   hB  
 
Thus algebraic simplification yields:
 S VMI   B VMI    S   B 
Observe: We have arrived at this conclusion without optimizing either supplier’s profit or
retailer’s profit
Example Problem
A supply chain consists of a supplier and a retailer. The details about ordering costs and
holding costs of these firms, marginal costs of production, annual demand, wholesale
prices are as follows:
AS  45; AB  3; hS  8; hB  1; q  60,000; p  50; s  10; c  5; w  15, wVMI  20
Assume that, without VMI agreement, the supplier follows retailer’s EOQ decision.
Calculate, the increase in profit level by implementing VMI
Comment whether the aforementioned wholesale price (with VMI) is a correct price point.
If we implement VMI, the supply chain profit increases by:
2
1  A h 
2 AB hB q  1  S  1  S  = 300
2  AB hB 

Without VMI
Supplier’s profit: (15 – 10)x60,000 – [45x(60,000/600)+(8/2)x600] = 2,93,100 (as EOQ of
retailer = 600)
Retailer’s profit: {50 – (15+5)}x60,000 – sqrt. (2x3x1x60,000) = 17,99,400
With VMI
Supplier’s profit: (20 – 10)x60,000 – sqrt. [2x(45+3)x(8+1)x60,000] = 5,92,800 (!!!)
Retailer’s profit: {50 – (20+5)}x60,000 = 15,00,000 (!!!)
Now calculate using w(VMI) = 15.005
Supplier’s profit: 2,93,100
Retailer’s profit: 17,99,700 (retailer captures that extra 300!)
Points to remember about VMI

1. VMI will reduce the total inventory-related cost of the whole system (Retailer and
Supplier together).

2. VMI will increase the supplier’s inventory-related costs.

3. In the short-term, the buyer’s profit level will always be increased after VMI. The
supplier’s profit could be decreased. Supplier’s profit level can increase only if she
can enforce a suitable contractual agreement.

4. The purchase quantity of the Retailer with VMI agreement is higher than that
without VMI agreement.
 How to copy the Wal-Mart model?

Although Wal-Mart’s methodologies are well known to other logistics providers, just a handful
of retailers have achieved them.
Copying the model is not easy because of the high initial costs, huge inventory levels involved,
and assurance of high sales.
Simply, no other chain can attain this scale.
Rank Store 2013 U.S. Sales Sales Growth
(000)
(’13 vs. ’12)
1 Wal-Mart $334,302,000 1.7%
2 Kroger $93,598,000 1.6%
3 Costco $74,740,000 5.2%
4 Target $71,279,000 – 0.9%
5 The Home Depot $69,951,000 6.6% Data Source(s): Forbes, IBT
 How is this relevant in Indian Retail scenario?

 Marico's organizational goal of ‘constant innovation’ led it to focus on the introduction of a

large number of newer brands in its supply chain.
 The company also anticipated that each of these new products might not get adequate
attention from dealers because of (initial) smaller volumes and uncertain demand.
 Marico solved this problem by introducing Vendor Managed Inventory (VMI) system
whose primary objective was to provide greater support to newer brands at the dealer end
and not solely reduce inventory.
 Attempts to replicate this across several sectors like retail, electronics components, textiles
and automobile manufacturing in India have taken place over the last 10 years with Marico
Industries Limited, Shoppers Stop, Future Group, Nokia India, Maruti Udyog Limited,
Mahindra & Mahindra