All companies assume dual roles. They are customers to their vendors and vendors to their customers. When companies think of consignment inventory, they often view it from these two viewpoints. As a customer, having a vendor willing to provide consignment inventory is an ideal way to reduce inventory costs. As a vendor, providing consignment inventory to customers can often be costly and difficult to manage, but an ideal way to secure long-term business. When looking at the pros and cons of consignment inventory, it really amounts to your company’s viewpoint. Are you asking your vendors for consignment inventory or are your customers asking you to provide consignment inventory? Have you defined your liabilities? More importantly, what are the pros and cons of consignment inventory for customers and vendors?
Consignment Inventory is vendor supplied inventory at the customer’s facility that is entirely owned by the vendor. The inventory remains owned by the vendor up to that point where the customer uses a portion of the inventory. Once this happens, the customer is only invoiced for the quantities they've used. Ultimately, it's about properly reconciling inventory by tracking what's been used relative to what remains. Without the ability to track usage, companies are unable to guarantee their inventory is being invoiced at the right time and in the right quantities. This means that both customer and vendor must be forthright with each other and come to an agreement about how inventory usage will be reported.
Even though the inventory is in the customer’s possession, the customer doesn’t own it outright, as they have neither been invoiced nor have been asked to pay for the consigned inventory. The customer is only invoiced for those units they use in the month they use it. The table below is an example of how consignment inventory would work.
Explanation of above table:
Customer Pros & Cons of Consignment Inventory
Customer Pros of Consignment inventory: In our above example, the customer is only invoiced for those quantities they use in the month they use them. The benefit to the customer is that they don’t own this inventory, but are able to draw upon it when needed. This improves their overall inventory cost of ownership by lowering their month to month holding costs. Additional savings include not paying for expedited freight on urgent parts from vendors, and saving a tremendous amount of money on the initial freight costs to get the entire consignment inventory delivered. A large portion of inventory costs are made up of the freight costs to get parts in and out of warehouses. Reduce these costs and you’ve successfully reduced a key cost of your inventory. The customer also likely benefits from a lower average price. In some instances, the customer may be able to secure the higher volume pricing (1000 widgets) while only using a portion of the inventory (100 widgets) each month.
- Lower month to month inventory holding costs
- Lower freight costs per unit
- Less incidence of urgent freight to get parts from vendors
- Better volume pricing
Customer Cons of Consignment Inventory:While it certainly seems like the perfect situation for the customer, there are some hidden costs to managing consignment inventory. While the customer doesn’t own the inventory, they still have to physically store, make space available and warehouse these parts. There is a cost to doing this, as most companies can attest to.
Holding this inventory opens the customer up to potential damage to inventory. The longer it’s held, the more likely the incidence of damage. Will the customer be responsible for the damage or will the vendor? Who will determine which party caused the damage? If the vendor inspected their own shipment, then they’ve likely got a strong argument against being liable for any damage. Also, if there is damage, what will the customer do with inventory they can’t use and without any additional inventory to draw upon? What happens if the inventory becomes obsolete and can no longer be used?
The above questions imply that the customer must be willing to consider the drawbacks of consignment inventory.
- Potential of damage and obsolescence
- Costs to physically store, warehouse & move parts
- Uncertainties about liabilities of damaged inventory
- Potential for “stock-outs”
Vendor Pros and Cons of Consignment Inventory
Looking at the above example, one can’t help but come away feeling that the entire situation is one-sided, and in favor of the customer. After all, the customer doesn’t own the inventory and is only invoiced for what they use. The vendor retains ownership of all consigned inventory until it’s used and invoiced. In this case, the vendor is actually financing the customer’s inventory as the vendor must incur additional holding costs. So, the costs have merely been transferred from the customer over to the vendor. Does this mean it’s all “win” for the customer and “lose” for the vendor? Well, not really. There are a couple of inherent benefits to the vendor when they pursue consignment inventory.
Vendor Pros of Consignment Inventory: From the vendor’s point of view, they are able to secure business with the customer and protect their interests against competitors. They have entered into an agreement whereby their customer solely intends to use the inventory and is pretty much guaranteed to remain the vendor’s customer for the duration of the agreement. In addition, the customer is likely extremely pleased with the agreement itself, which may allow the vendor to up-sell different product lines. The customer has lowered their inventory costs and can better manage usage. This has some value to both the customer and the vendor.
In some instances, vendors may actively pursue consignment agreements themselves. In the case of retail, a vendor may want to get their product out and in front of consumers. The retail outlet may not be convinced of the vendor’s product, or may be unwilling to commit to the costs of holding that inventory. So, to resolve the problem, the vendor provides their products on consignment so that the retailer’s customers can see the product in person. In this case, a consignment inventory agreement can aid the vendor in getting their products in front of consumers where they may be more inclined to purchase them.
- Benefit of securing long-term business
- Protection against competition
- Possibility of up-selling different product lines
- Stronger cohesion between customer and vendor
- Potential for increased sales of newer product lines
Vendor Cons of Consignment Inventory:There are costs to the vendor when it comes to consignment. First, the inventory is still owned by the vendor. As such, they must count this inventory in their assessment of their costs. In this case, standard inventory rules apply for the vendor. The longer they hold the inventory, or the longer the customer doesn’t use it, the more expensive that inventory becomes. This affects the vendor’s gross profit on the sale of the widgets as they incur costs to finance the inventory at the customer’s facility. In a sense, it’s no different than if the inventory were still in the vendor’s possession.
One of the impacts on the vendor’s gross profit is the impact of the daily cost of money. Most companies use business loans and credit lines to finance their inventory. Because of this, these loans have a yearly interest rate that can be applied to a daily interest rate. It’s this daily interest rate that erodes gross profit for the vendor every day the consignment inventory isn’t used by the customer.
The same drawbacks for the customer can also be drawbacks for the vendor. Which party is ultimately responsible for inventory damage and obsolescence? When are the parts invoiced – at the end of the month, or at the beginning of the following month? Can the vendor trust the customer to be honest about usage? Is there a time frame on how many parts must be used per month?
- Potential of damage and obsolescence
- Impact of daily cost of money on gross profit
- High inventory holding costs
- Difficulty in accuracy of reporting
- Discrepancies in customer usage
To summarize the pros and cons of consignment inventory, one must understand the role assumed by both parties. If your company is that vendor who is being asked to provide consigned inventory, make sure to do your homework. If possible, try to negotiate periodic inspection of the inventory at the customer’s facility and at the very least, make sure your contractual agreement stipulates liability for damaged and obsolete inventory. This is paramount to success.
Your company must account for this when negotiating with your customer. Also, be sure to determine when the consigned inventory is invoiced – same day or end of month? In the end, negotiating whether there should be a minimum monthly or quarterly invoice amount will help your company avoid the high costs associated with storing your inventory at your customer's location.
The above video explains the importance of defending your company's position in the face of customer threats in negotiation. To read more, please go to: Sales Negotiation: Defend Price, Customer Scare Tactics and Managing Concessions
Comments