A model for evaluating supplier-owned inventory strategy

Transcription

1 Int. J. Production Economics 8 82 (2003) A model for evaluating supplier-owned inventory strategy Rajesh Piplani a, S. Viswanathan b, * a Center for Engineering & Technology Management, School of Mechanical & Production Engineering, Nanyang Technological University, Singapore b Nanyang Business School, Nanyang Technological University, Nanyang Avenue, Singapore , Singapore Abstract Supplier-owned inventory (SOI) is an arrangement where the vendor is responsible for maintaining and controlling the inventory at the buyer s premises. The buyer draws the required quantity of the item from this SOI as and when required as if it were its own component store. In return, the vendor is provided with the latest demand information to control its inventory costs. In this paper, we develop a model to analyze and evaluate the SOI strategy. We conduct a numerical study to understand how the various model parameters affect the total costs under the SOI arrangement. The numerical study reveals that the total supply chain costs will never be higher under the SOI arrangement. In general, the benefits of the SOI arrangement to the supply chain are higher when the buyer that adopts SOI accounts for a larger percentage of the supplier s total demand. r 2002 Elsevier Science B.V. All rights reserved. Keywords: Supplier-owned inventory; Mathematical models of inventories; Inventory management. Introduction As businesses turn global, competition intensifies, and customers become more demanding, companies need to find more ingenious ways for improving the cycle time of their products and reducing the cost. This challenge of meeting customers demand faster and continuously reducing the cost of meeting that demand will determine tomorrow s winners. Companies are also beginning to realize that further improvements in cost and cycle time will come from not just within, but outside the company walls. And they are beginning to collaborate with their *Corresponding author. Tel.: ; fax: address: asviswa@ntu.edu.sg (S. Viswanathan). suppliers and distributors, in order to reduce costs and drive inefficiencies out of the entire supply chain. Optimizing supply chain performance requires close cooperation of all the players involved. One of the biggest inefficiencies in the supply chain is the inventories scattered across the various echelons of the supply chain. Reduction of these inventories without compromising the service level is a major challenge, as it represents significant amount of locked-up working capital. To achieve this, the participants in the supply chain should share information so that the inventory (whether raw material, WIP or finished goods) moves to the next echelon (downstream) only when it is needed. This reduction in inventory levels can then lead to savings for everyone involved. One strategy adopted by industrial /02/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved. PII: S (02)

2 566 R. Piplani, S. Viswanathan / Int. J. Production Economics 8 82 (2003) buyers to reduce their inventories is what is known as supplier-owned inventory (SOI). SOI (Yap, 999) is a new way of managing inventory where the customer receives and pays for only what is needed and when it is needed. SOI pushes the inventory management and replenishment responsibilities to the supplier, while insulating the customer from the pitfalls of having any but immediate inventory. Under the SOI arrangement, the supplier maintains inventory at the buyer s premises for the product he supplies. The buyer can draw the required quantities in small lots on acontinuous basis from this inventory. The process flow depicting asoi implementation is shown in Fig.. In this implementation, the inventory is kept in the raw material/component store at the buyer s premises. The process begins with the customer providing a blanket purchase order to the supplier (). The customer can draw the required amount of material by placing a pull request (2) with the component store. The supplier is notified of the pull request as well as the new inventory level (3). The supplier replenishes the inventory either based on a reorder point logic or based on a periodic review system (4) and bills the customer (5). SOI is a strategy by which the buyers can adopt the practice of just-in-time (JIT) procurement without incurring high replenishment costs. In JIT procurement (Ramasesh, 990), the buyer gets the supplier to deliver in smaller quantities, but more frequently, say once every day. More frequent and smaller deliveries result in lower inventory levels, but would lead to higher ordering or shipping costs. SOI effectively overcomes this problem from the buyer s perspective, since they can draw material from the SOI available in their premises without incurring any shipping costs. Clearly SOI would be beneficial to the buyers, as long as they can continue to pay the same price to the suppliers. However, its impact on the suppliers is not clear. In the context of JIT procurement, Waters-Fuller (996) found that the supplier s inventory level actually went up. The objective of this paper is to evaluate the impact of SOI on the whole supply chain. While anecdotal evidence as well as reports from industry case studies (see for example Business Week report on Dell Computer Corporation, April, 7, 997) indicate that SOI is beneficial to the buyer, to our knowledge, there has been little research on how SOI impacts different entities in the supply chain. Papers by Ramasesh (990), Ha and Kim (997), Joshi and Campbell (99), Ansari and Heckel (987), Jordan (988), and Pan and Liao (989) and several others have modeled and studied the impact of JIT procurement. Similarly there have been several papers (e.g. Cetinkaya and Lee, 2000) as well as case studies (Hammond, 994; Clark and McKenney, 995) that have analyzed or developed 3 Supplier updated on inventory levels Raw Material/ Component Store at Buyer's premises 2 Draw material from store with pull request. Vendor Replenish stock. Maintain the inventory level 4 Buyer Invoice 5 Blanket PO & Forecast Fig.. SOI process flow.

3 R. Piplani, S. Viswanathan / Int. J. Production Economics 8 82 (2003) models and systems for implementing a related strategy known as vendor-managed inventory (VMI). VMI, which is practiced in retailing and distribution of food and other fast moving consumer goods, is astrategy where the vendor is responsible for decisions concerning replenishment of inventory at the buyer s premises. However, the buyer still holds the inventory and incurs the related cost. Under the SOI arrangement, the supplier owns and manages the inventory at the buyer s premises and therefore incurs the related cost. The rest of the paper is organized as follows. In the next section, we develop astylized model to study SOI strategy. In Section 3, the model is then used in a numerical study to evaluate the cost of SOI strategy for the supplier as well the entire supply chain. Finally, a few concluding remarks are provided in Section SOI model In order to clearly analyze the impact of adopting SOI, it is assumed that the supplier has the SOI arrangement with only one buyer out of the several customers that he may have. For the rest of the paper, we refer to the buyer adopting SOI as the SOI-buyer and the remaining customers as non-soi-buyers. Under the SOI arrangement, the supplier has the responsibility to maintain inventory of the item at the raw material/ component store at the buyer s premises. The model developed in this section considers only the cost incurred by the supplier and SOI-buyer. The cost incurred by the non-soi-buyers does not change after the adoption of the SOI strategy. Hence they are not relevant to the model. Prior to adoption of the SOI arrangement, it is assumed that both the supplier and the SOI-buyer use acontinuous review inventory policy. The inventory position is monitored continuously and an order for a fixed quantity placed when the inventory position reaches the reorder level. To keep the model simple, we assume that the policy parameters are calculated using the standard heuristic policy discussed in production/inventory control textbooks (such as Silver et al., 998). The demand faced by the supplier as well as the SOIbuyer is assumed to be normally distributed. The notation used is summarized below. #X: random variable representing the total demand for the supplier from all the non-soibuyers; #XBNðD 0 ; #s 0 Þ: L 0 : production lead time for supplier (mainly to switch over production). (Note: For simplicity we assume that the production rate is large enough and that the effect of finite production rate on inventory level can be ignored. The model can be easily modified if this assumption is relaxed.) K 0 : setup cost for the supplier. h 0 : inventory holding cost rate for the supplier. z 0 : standard normal value corresponding to desired service level (probability of stockout) for supplier. X : random variable representing the demand faced by the SOI-buyer, where X BNðD ; s Þ: L : lead time for replenishment of order from supplier to SOI-buyer. K : ordering cost for the SOI-buyer. h : inventory holding cost rate for the SOI-buyer. z : standard normal value corresponding to desired service level (probability of stockout) for SOI-buyer. Under the (heuristic) continuous review policy, the order quantity is equal to the economic order quantity (EOQ) corresponding to the expected demand, and the reorder point is the inventory position required to ensure the desired probability of stock-out during the lead time. p For the SOIbuyer, the order quantity Q ¼ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi p ffiffiffiffiffi 2K D =h and the reorder point r ¼ z s L : Therefore, the cost to the SOI-buyer before implementation of SOI is C B ¼ p ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 2K D h p ffiffiffiffiffi þ h z s L : ðþ For the supplier, the total demand X is the sum of the demand from the non-soi-buyers and the demand from the SOI-buyer. That is X ¼ #X þ #X ; where #X is the demand from the SOI-buyer. As the buying pattern of the SOI-buyer is different from that of its customer, the variance of demand

4 568 R. Piplani, S. Viswanathan / Int. J. Production Economics 8 82 (2003) from SOI-buyer faced by the supplier is higher than that faced by the SOI-buyer. It can be shown that the expected total demand for the supplier EðXÞ ¼D ¼ D þ D 0 and that the variance of the total demand X during the lead time L 0 is VðX L Þ¼L 0 #s 2 0 þ L 0s 2 þ Q2 =6 (the derivation may be obtained from the authors). Note that X is the sum of the demand from several buyers; therefore, it is reasonable to approximate X asa normal distribution. The cost to the supplier before implementation of SOI is therefore C0 B ¼ p ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 2K 0 Dh 0 þ h 0 z 0 VðX L Þ: ð2þ After implementation of SOI, the supplier is responsible for managing the inventory at the buyer s premises. As the buyer withdraws the item as and when required, it is assumed that he does not incur any inventory costs. It is also assumed that the holding cost rate incurred by the supplier for the inventory at the SOI-buyer is the same as what the SOI-buyer incurred before (i.e. h ). Further, it is assumed that the lead time L and ordering cost K for transportation/delivery of the item to the buyer s premises (now incurred by the supplier) is the same as before. Therefore, under the SOI scenario, the supplier will incur all the costs and the SOI buyer s cost is zero. The supplier who has to maintain inventory at the SOI-buyer s premises as well as at his own warehouse (to meet the other buyer s demand) has two options for determining the inventory policy, namely: (i) Manage the inventory at the two locations independently using continuous review policy where the inventory at the SOI-buyer s premises caters to the demand of the SOI-buyer, and that at the supplier s premises to all demand including replenishment demand for the inventory at the SOI-buyer. (ii) Coordinate replenishments to both the inventory locations by adopting a periodic review policy. In this case the demand for replenishment for either inventory (supplier s premises or SOI-buyer s premises) is met by producing alot. Therefore, the inventory at the supplier s premises needs to cater only to demand from non-soi-buyers. A third option is to have a periodic review policy, by replenishing the inventory at the SOIbuyer s premises from the inventory at the supplier s premises, rather than by producing a lot. As this would be inferior to the continuous review policy under option (i), we do not consider this option in the paper. As the SOI-buyer withdraws the item only on a unit by unit basis, as and when demand occurs, the variance of demand from SOI-buyer as observed by the supplier would be equal to the true variance s under the SOI scenario. If the supplier uses option (i) and manages the two inventories independently using continuous review policy, then the cost to the supplier C Q ¼ C B þ CB 0 : ð3þ If supplier uses acoordinated, periodic review policy, then both the inventories are replenished by producing a lot. This means that for replenishing the SOI at the buyer s premises, the supplier has to incur both ordering cost K as well as the production setup cost K 0 : Therefore, whenever the SOI at the buyer s premises is replenished, it makes sense to replenish the inventory at the supplier s premises as well (as no additional setup cost is incurred). Hence, the replenishment interval or review period for the SOI will be an integer multiple of the review period for the inventory at the supplier s premises. Let the review period for the inventory at the supplier s premises be T 0 ; and that for the SOI at the buyer s premises be n T 0 : Then the cost to the supplier is C P ¼ K 0 =T 0 þð=2þh 0 D 0 T 0 pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi þ h 0 z 0 #s 0 L 0 þ T 0 þ K =ðn T 0 Þ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi þð=2þh D n T 0 þ h z s L 0 þ L þ n T 0 : ð4þ The supplier s cost in (4) above can be minimized by searching for the best value of T 0 and n : For a given T 0 ; the optimal n can be determined, and therefore C P ðt 0 Þ can be evaluated. In practice, only review periods that make practical sense such as day, 2 days, week, 2 weeks, month, etc. are used. Therefore, the optimal T 0 can be determined by an exhaustive search among the possible values of T 0 : In the numerical study, 730 possible review

5 R. Piplani, S. Viswanathan / Int. J. Production Economics 8 82 (2003) periods (in integer multiples of days) ranging from day to 2 years are considered. Among the two policy options, the supplier would choose the one with lower cost. 3. Numerical study A numerical study was carried out to evaluate how the SOI strategy affects the cost of the supplier as well as the entire supply chain. The numerical study was carried out for a large number of different values of the various model parameters. The detailed results of the numerical study are available from the authors. In this section, we summarize some of the more salient findings of the study. These findings are reported in Figs. 2 5; and they are based on a total of 44 problem sets. In these problem sets, following parameters were kept fixed at values given below (Table ). Values of problem parameters that were varied in the numerical study are given Table 2. For all the problems, the relevant cost before and after the adoption of the SOI strategy for both the supplier as well as the whole supply chain was evaluated. For all the problems in the numerical study, total cost for the supply chain as a whole under the SOI arrangement was less than or equal to the cost before adoption of SOI. Hence, the SOI strategy is beneficial to the supply chain as a whole. However, the supplier does not necessarily benefit always Total Cost under SOI (as ratio to cost before SOI) SOI-Cost Analysis-Impact of buyer holding cost Demand from SOI Buyer (% of total demand) h = 0.5 h = 0.20 h = 0.25 h = 0.40 Fig. 2. Impact of buyer s holding cost rate on total supply chain costs under SOI (the value of K was fixed at 50 for this analysis). Supplier's Cost under SOI (as ratio to cost before SOI) SOI-Cost Analysis-Impact of buyer holding cost 0.8 Demand from SOI Buyer (% of total demand) h = 0.5 h = 0.20 h = 0.25 h = 0.40 Fig. 3. Impact of buyer s holding cost rate on vendor s costs under SOI (the value of K was fixed at 50 for this analysis).

6 570 R. Piplani, S. Viswanathan / Int. J. Production Economics 8 82 (2003) Total Cost under SOI ( as ratio to cost before SOI) SOI-Cost Analysis-Impact of buyer ordering cost 0.6 Demand from SOI Buyer (% of total demand) K0/K=200 K0/K=20 K0/K=2 K0/K=0.5 Fig. 4. Impact of buyer s ordering cost on total supply chain costs under SOI (the value of h was fixed at 0.25 for this analysis). Supplier's Cost under SOI (as ratio to cost before SOI) SOI-Cost Analysis-Impact of buyer ordering cost Demand from SOI buyer (% of total demand) K0/K=200 K0/K=20 K0/K=2 K0/K=0.5 Fig. 5. Impact of buyer s ordering cost on vendor s costs under SOI (the value of h was fixed at 0.25 for this analysis). Table Values of problem parameters that were kept fixed in the numerical study D 0 =,000,000 #s 2 0 =20D 0 K 0 =0,000 h 0 ¼ 0:2 s 2 =0.50D L 0 ¼ L ¼ week z ¼ z 0 ¼ 2:33 Table 2 Values of problem parameters that were varied in the numerical study h : Four different values ( 0.5; 0.20; 0.25; 0.40) K : Four different values (50; 500; 5000; 20,000) D : Nine values (0.D; 0.2D; 0.3D; 0.4D; 0.5D; 0.6D; 0.7D; 0.8D; 0.9D) from the SOI strategy. Also, the extent of cost reduction from adopting SOI strategy would depend on specific problem parameters. Figs. 2 and 3 show the effect of buyer s holding cost on the SOI strategy (for the problems whose results are reported in these two figures, the value of K was fixed at 50). The figures reveal that for a fixed value of the supplier s holding cost rate h 0 ; the benefit to the whole supply chain increases as the holding cost rate for the inventory at the buyer s premises decreases. Furthermore, the benefit of SOI strategy to the whole supply chain increases with the increase in share of total demand (in percentage) from the SOI-buyer. However, beyond a threshold value of the holding cost rate h at the SOI-buyer s premises, the SOI arrangement does not bring any reduction in the total supply chain costs. The impact of the buyer s holding cost rate h on the supplier s cost (Fig. 3) is slightly different. The supplier also benefits more when the holding

7 R. Piplani, S. Viswanathan / Int. J. Production Economics 8 82 (2003) cost rate for the buyer h decreases. For h below a certain threshold value, the supplier s cost under SOI (as a ratio to the pre-soi cost) decreases as the percentage of demand accounted for the SOIbuyer increases. For a particular value of the buyer s holding cost rate h below the threshold value, the supplier actually incurs lower cost under the SOI strategy when percentage share of the total demand from the SOI-buyer is above a certain threshold. However, beyond the threshold value of h, the supplier s cost (as ratio to pre-soi cost) increases with the increase in demand percentage of the SOI-buyer. This is understandable, since beyond the threshold value of h ; the supply chain as a whole does not gain from SOI arrangement, and since the buyer s cost always decreases under SOI, the supplier s cost would naturally increase. Figs. 4 and 5 plot the cost under SOI (as ratio to pre-soi cost) for various values of the buyer s ordering cost (for this analysis, the value of h was fixed at 0.25). Fig. 4 reveals that the benefit to the supply chain as whole from SOI increases as the ratio of the supplier s setup cost to the buyer s ordering cost decreases. The benefit to the supply chain is higher when the percentage of demand accounted for by the SOI-buyer is higher. Fig. 5 reveals that generally, the supplier s cost (as ratio to pre-soi cost) decreases as the percentage of demand from SOI buyer is higher. However, the supplier seems to benefit significantly from SOI only for a particular value of the buyer s ordering cost. For ordering cost values K that are higher or lower than this value, the supplier incurs higher cost under SOI. 4. Summary and conclusion In this paper, we have modeled and performed a numerical study on the effect of supplier-owned inventory strategy on the costs for the whole supply chain. The SOI arrangement is always beneficial for the supply chain as a whole. The costs under SOI decrease as the percentage share of total demand from the SOI-buyer increases. The supplier also can benefit from SOI with lower costs especially when the holding cost for the inventory at the buyer s premises is lower. However, the benefit to the supplier from SOI is dependent on the problem parameters. For many problem parameters, supplier would incur higher costs under SOI. References Ansari, A., Heckel, J., 987. JIT purchasing: Impact of freight and inventory costs. International Journal of Purchasing and Materials Management (Summer), Business Week, 997. Whirlwind on the Web: Computer maker Dell is showing the world how to run abusiness in the Cyber Age. April 7, McGraw-Hill, New York. Cetinkaya, S., Lee, C.Y., Stock replenishment and shipment scheduling for vendor-managed inventory systems. Management Science 46, Clark, T.H., McKenney, J.L., 995. Proctor & Gamble: Improving consumer value through process redesign. Harvard Business School Case No Ha, D., Kim, S.L., 997. Implementation of JIT purchasing: An integrated approach. Production Planning and Control 8, Hammond, J.H., 994. Barilla SpA (A). Harvard Business School Case No Jordan, H.H., 988. Inventory management in the JIT age. Production and Inventory Management Journal 29, Joshi, K., Campbell, J.F., 99. Managing inventories in a JIT environment. International Journal of Purchasing and Materials Management (Spring), Pan, A.C., Liao, C.J., 989. A inventory model under just-intime purchasing agreements. Production and Inventory Management Journal 30, Ramasesh, R.V., 990. Recasting the traditional inventory model to implement just-in-time purchasing. Production and Inventory Management Journal 30 (), Silver, E.A., Pyke, D.F., Peterson, R., 998. Inventory Management and Production Planning and Scheduling, 3rd Edition.. Wiley, New York. Waters-Fuller, N., 996. The benefits and costs of JIT sourcing: A study of Scottish suppliers. International Journal of Physical Distribution and Logistics Management 26, Yap, R., 999. Holding the Aces in Manufacturing Logistics. Manufacturing Logistics for the 2st Century, Organized by EDB and MOM of Singapore Government, October