Tuesday, February 14, 2012

Supplier Managed Inventory

In a number of procurement activities it has become more frequently for suppliers to stock items either at or close to the buyer’s location and operate under a form of pull replenishment ordering system. I decided it would be worth talking about how this needs to work from a contract perspective.

The driving force behind what needs to be included to address supplier-managed inventory is whether the materials are unique to the buyer. Items that are unique would be defined to include items that are not returnable, resalable, nor readily usable by either the buyer or the supplier. The reason for this is with unique materials if the buyer does not consume them by pulling them from the supplier managed inventory, the supplier doesn’t get paid and the supplier winds up with items that have no value. If an item isn’t unique, the potential risk to the supplier is far less as they can re-deploy any excess at much less of a cost. For non-unique items what is required contractually will be less than any unique items.

A second force is managing costs. Suppliers do not want to be carrying large inventories that aren’t being consumed. If the buyer has required quantities that are in excess of their demand a supplier may want the buyer to pay either an inventory carrying cost on aging inventory or pay the costs to re-deploy the items to where they may be sold. As buyers may have to pay for 1) any excess unique materials that are not consumed, 2) carrying costs on aging inventory and 3) costs to have the materials redeployed, buyers need to have terms that manage those costs by managing the inventory levels being held by the supplier.

Normal purchase terms like delivery and lead-time take on a new meaning when you have supplier-managed inventory. Delivery doesn’t mean taking delivery at the supplier manufacturing location, it’s taking delivery at the stocking hub where the items are pulled from. As you are doing pulls from inventory, there is not traditional lead-time as it should be available in stock for you to pull from. The lead-time you need to be concerned with is the replenishment lead-time. That is the period from when the product is pulled from the inventory until it’s replaced in the stocking hub. That is longer than a supplier’s normal lead-time for a product as that needs to include all the in-transit time until it is received at the stocking hub. If you will have both traditional purchasing and supplier managed inventory occur under an agreement, you’ll need to have a separate appendix that defines the terms you will use and establishes the parties responsibilities for the supplier-managed inventory.

With supplier managed inventory everything starts with the “planning schedule”, which means Buyer’s forecasts of projected quantities required over time. Before being able to establish a supplier managed inventory the parties need to establish a number of things in their agreement:
1.The initial quantity to be placed in inventory.
2.The responsibilities of the buyer to provide updated forecasts.
3.Responsibilities of the supplier to adjust the quantities based upon changes to the forecasts, actual demand, and any changes to their known lead-time for replenishment.
4.For unique items the liability horizon the buyer will have so they understand their maximum potential liability. This is because liability is based not just on inventory in stock but also work in process required to meet replenishment commitments. Buyers want to have the right of approval over anything that would increase the liability horizon.
See the not below for a further discussion on liability horizons.
5.Where the materials will be stocked. This could be a supplier location, a third party warehouse, or the buyer’s location. If they will be stocked at the Buyer site it will require additional provisions for how that will be managed, who insures the materials etc.
6.For unique items, what constitutes obsolete inventory that the Buyer must purchase.
7.For any excess or aging inventory of non-unique items, what the options are:
7a.If the Buyer wants the inventory held, how long the supplier must hold it, the carrying cost, and when the buyer must pull and pay for it, or
7b.What the buyer’s liability is if the item is re-deployed by the supplier.
8.The mechanism for pulls. How pulls are communicated, requirements for pull purchase orders to bill against, pull notifications of intent to pull, pull delivery obligations, and invoicing procedures for pulled product.
9.The agreed replenishment process and time for the supplier to replenish the pulled product with a new one in inventory at the stocking hub (the replenishment lead-time).
10.If the supplier will hold product in addition to the liability horizon for additional flexibility.
11.The obligations of the parties for the supplier managed Inventory in the event the contract is terminated or a purchase order is cancelled.
12.Adjustments the buyer or supplier can make to the quantities held in inventory that will impact the liability horizon.
13.Remedies buyer has if the supplier fails to meet their obligations to replenish the inventory within the agreed replenishment lead-time.

A note about “liability horizon”. Very few products start their production as a unique product. The uniqueness does not occur until the product has a manufacturing process performed that makes it unique to you. That is the point after which the item cannot be used for other purposes. In establishing liability horizons for unique product that are being manufactured to meet replenishment obligations, you only want to be liable for those products where the work in process (WIP) has been performed that makes the item unique to your use. If the work in process has not been performed, you want the supplier to use that work in process for other purposes. It’s a way of mitigating the potential cost and risk to you.

Here’s an example. A Semiconductor manufacturer’s total cycle time for production of a semiconductor product may be sixteen weeks. The sixteen weeks will include time for each of the processes that are serially performed in the manufacture of the wafer, the cutting of the finished wafer into die, having the die be packaged, and having the packaged chip tested. It may take another week to get the tested chip to the stocking location. So if you had a supplier-managed inventory for that semiconductor the replenishment lead-time would be seventeen weeks. Semiconductors are manufactured in a number of layers. For this example let’s say this semiconductor has 24 layers. Semiconductors are usually designed using standard building blocks. The first 20 layers of the chip may be the standard building blocks. The last four layers may be the processes that make the product unique to you. So if you were negotiating the liability horizon for that product under a supplier-managed inventory, you would determine the period of time that it takes from the completion of the 20th layer (where it is still not unique) until you would get delivery of the replenishment product at the stocking point. That duration should be your liability horizon. You don’t want to be liable for the full value of the product up to that WIP point as the Supplier can use it for other purposes. To get that you may have to agree to pay a carrying cost until they can use it elsewhere as they are helping you mitigate your cost. Once the product falls within the liability horizon window where any processes have been performed make that unique to you, the chip either needs to be scrapped or it needs to be completed. For unique products held in supplier managed inventory the supplier will want you to be liable for any items held in inventory that you haven’t pulled. They will also want you to be liable to either purchase the completed item or pay their costs in any volumes held in WIP that exists because of the requirement to replenish products. It’s not any different than having liability for cancellation of orders. The only difference is instead of your issuing purchase orders for that work, you have required replenishment by the supplier.


  1. Especially for companies operating in the fast-moving consumer goods sector, efficient management of inventory is crucial. In a way, it is a means to ensure that goods that are first in the inventory are sold first.

  2. Ethan, there are a lot of good reasons to manage inventory using fifo. If you have items where the cost is going down you want to sell the older ones first to reduce your inventory cost. It's important because products may change and older products may have less value. Most important is where a product has a shelf life where there can be a physical deterioration with age that makes the item worth less or not be something that can be sold or used.