On a recent factory tour of a local division of a Fortune 500 industrial electrical equipment manufacturer, college students in my operations management class observed a number of contemporary inventory management techniques in practice. These shop floor practices included work cells, small lot production, kanban cards, flow storage, and more. However, our tour guide, the supply chain manager, seemed to be most proud that he achieved the greatest inventory reduction through a consignment agreement with one of his division’s suppliers.

This stood out to my students and me because there were many units of a component inside a fence on the factory floor. The supply chain manager said, “See that pile of inventory? It’s not really here.” He went on to explain his comment by stating the supplier technically still owns this inventory because it had agreed to consign until the inventory is actually consumed in the manufacturing process. Under the consignment agreement the supplier retains inventory ownership even though it was on this company’s factory floor. Therefore, the value of this inventory is not on this company’s books, and it is one less raw material for the supply chain manager to financially supervise.

During the next class, students asked very pertinent questions that perfectly frame the debate for and against consignment inventory as an effective inventory management practice. Their first question: Does consignment inventory really solve anything in regard to real inventory reduction? The students pointed out that, regardless of the consignment agreement, the inventory was still in the supply chain; and the total inventory carrying cost for this inventory remains the same, even though some of the cost elements have shifted between the two companies. We had spent much of the semester talking about inventory as the “root of all evil” and the need for effective management practices that continuously focus on inventory reduction. Consignment inventory, in the students’ views, didn’t fit into lean or Just-in-Time (JIT). Because the supplier now had to tie up more of its capital to finance this inventory, the students asked, wouldn’t it simply pass on this cost? Finally, the students asked if the companies could enhance their combined competitive position if they worked together via collaborative planning, forecasting, and replenishment (CPFR) to mutually share the benefits of total inventory reduction in the supply chain.

The real story
Let’s address these questions by examining the facts surrounding consignment inventory. According to the Institute of Management and Administration’s 2004 Inventory Management Report Survey, 37.3 percent of respondents shift inventory ownership to suppliers via consignment agreements. Although consignment inventory historically has been a top 10 best practice, it was tied for third place in 2004, up from fifth place in 2003 and tenth place in 2002. Obviously this trend indicates supply chain managers believe consignment inventory actually reduces inventory to provide a better return on assets. For every dollar of consignment inventory there is dollar reduction in the raw material inventory account, which reduces the demand for working capital and ultimately enhances the bottom line. This is an indisputable fact. Or is it?

Consignment inventory can be very seductive because, on the surface, it looks like the best of both worlds. A supply chain manager can easily perceive this as a “have-your-cake-and-eat-it-too” situation. Nothing could be further from the truth. For every benefit there is a cost. This is the first concept an economics student learns. Shifting inventory ownership back to suppliers via consignment agreements is not free and includes hidden costs and other important considerations that often are ignored in the justification rationale.

The universal incentive behind inventory reduction always has been to cut carrying costs, particularly the money needed to manage the inventory. Under a consignment agreement, the cost definitely goes down, but a company will, at best, realize one-half the benefit of reducing inventory by other means. Not all of the carrying costs shift back to the supplier. In fact, the majority of inventory carrying costs remain, such as handling, storage, insurance, obsolescence, and more. One could argue saving 50 cents instead of a dollar is still better than saving nothing, but this would ignore the administrative cost of the consignment agreement itself.

All too often supply chain managers overlook the costs associated with managing the consignment process, and these costs can absorb the benefit achieved by reducing a portion of the carrying cost. The truth of the matter is most enterprise resources planning systems don’t handle consignment inventory very well. This necessitates manual off-line processing that can be time consuming and error prone. Consignment inventory systems also add complexity to the replenishment process. Both of these factors can drive up inventory management and ordering costs.

Questionable savings
All things being equal, is it realistic to expect your supplier to absorb the cost of holding inventory in your facility? It sounds like a win-lose situation and not the basis for a long-range partnership. Eventually, your supplier will find a way to recoup the capital cost of financing this consigned inventory. Therefore, the tangible benefits from consignment inventory should be considered shaky at best. (See Table 1.) Unfortunately, many supply chain managers look for quick fixes and fail to see the big picture.

Table 1: Cost impact of a consignment inventory agreement

Any form of inventory by lean or JIT definition?consigned or not?represents waste. All inventory hides problems and makes the job of quality and productivity improvement more difficult. Because consignment agreements are relatively quick and easy to implement, they often serve to take the pressure off real inventory reduction initiatives. Shifting inventory ownership back to the supplier may have some small, upfront cost benefit, but no meaningful or lasting improvement in the supply chain. It is na?ve to think your suppliers, because they now own the inventory, are going to be any better at managing it than you were.

Factual solutions
In the long run, it is better to avoid consignment inventory agreements and to work with suppliers collaboratively to reduce inventory throughout the supply chain. This effort can lead to a long-term, mutually beneficial partnership. Sharing benefits is the key to providing incentives and laying the groundwork for trust between companies. Let’s face it: Inventory is there for a reason (excessive lead times, inflexible processes, quality problems, and more), but the most common reason is to hedge against uncertainty in demand forecasts.

CPFR methodology provides a more effective means to manage inventory reduction through the synchronization of forecasts, prod-uction, and replenishment plans throughout the supply chain. The ultimate goal of CPFR is to reduce or eliminate the inventory that is held as a hedge against forecast and replenishment order uncertainty by linking the demand and supply planning activities between supply chain partners. The following actions can help you get started with the CPFR process.

* Establish a front-end partnership agreement. The single largest hurdle to overcome in CPFR implementation is the lack of trust over complete information sharing between supply chain partners. A written supply agreement that includes objectives and metrics (such as inventory reduction amounts); the resource requirements (human and technologically based) necessary for collaboration; and, finally, the expectations regarding confidentially will help establish the prerequisite trust needed for CPFR to work.
* Implement joint-business-planning processes. A joint-planning calendar that identifies the sequence and frequency of supply and demand planning activities between partners must be established. Once you have a calendar of events, the goal is to provide a more reliable and longer-term view of future demand in the supply chain. Joint business planning brings the supply chain partners closer together with more forward visibility from information sharing.
* Manage the CPFR process as a change initiative. As with any new corporate initiative, there will be skepticism and resistance to change. Therefore, it is important to establish the necessary collaboration and support processes. Creating motivation and political support for CPFR is only the first step in managing a change process. Management also must be prepared to handle the transition phase, which includes developing an activity plan that articulates the timing, priorities, and goals of the program.

The CPFR process needs to receive sustained support and reinforcement in order to carry it through the momentum-sustaining phase. The initial excitement and activity of change dissipates in the face of the practical problems of learning new ways of working. Without the necessary resources and support systems in place it will not be completed.

Source: APICS, Jim Mullen

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Jim Mullen, CPIM, CPM, is an assistant professor of management at Elmira College. Before joining the faculty, he spent 22 years working in the materials management field. Most recently, he was vice president of materials management at Toshiba Display Devices Inc. He may be contacted at (607) 735-1986 or jmullen@elmira.edu.

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