Inventory management – using consignment

Gal Merom

3 years ago

What is a consignment?

It’s a system where the supplier gets paid not when the client receives the goods but when the client sells or uses the goods (in an industrial setting, it’s when the material is consumed). How does it work? The supplier sends the goods to a warehouse that belongs to the client or is nearby. When the client uses the goods, then and only then does the act of selling occur.

Why is it advantageous to the client?

Zero inventory costs. The client doesn’t pay until he uses the inventory.
High availability of inventory close to the client. No lead time.

Why is it advantageous to the supplier?

When the client doesn’t experience shortages of goods, he might sell more.
It helps to fix problems with the supply chain:
1. Splitting orders – Customers usually want to break orders down as much as possible to reduce inventory costs. For example, instead of purchasing 6000 units every six months, they order six orders of 1000 units every month. Now look what happens:
  1. Supplier – When the supplier tries to fulfill the 1000 units, he has small batches that take more setup time and create more waste than producing one batch of 6000 units. Many suppliers will make the 6000 units in advance to avoid costly waste and setup time. Then they will send 1000 units every month. In the meanwhile, they hold the inventory in their warehouse. It is much easier to send all the goods to the client, and he will pay when he uses it. Of course, the supplier can produce 1000 units every month and send them to the client. Then he will pay extra delivery and waste costs, and of course, have extra setup time.
  2. Moving orders – The customer often can’t predict the exact number of goods he may use. He will ask to postpone some shipments or even rush them if he experiences shortages. That takes a lot of logistical attention on the part of the supplier. It can be avoided if the inventory is near the client.
  3. Bureaucracy – Fulfilling and shipping six orders requires a lot more bureaucracy than 1 order. The supplier will need much fewer people to deal with bureaucracy when he sells bigger orders.
2. Lead time – The world is moving towards less and less lead time. The usual problems of “We have a problem with the machine,” “The harbor is closed due to holidays/strike,” and so on were OK before, but in today’s world, the customer won’t care. The customer will look for another source if the first one has problems with the lead times. Putting the inventory in his backyard ensures the shortest lead times.
3. Competitive advantage – Having a zero-cost inventory in your backyard is a big plus for the customer. He will rather consume consignment goods than order from another supplier and deal with shortages and lead times.

How consignment works

The customer holds a lot of inventory in his warehouse or a warehouse near him.
When the supplier consumes (or sells) goods from the warehouse, he notifies the supplier (it can be a monthly report, it doesn’t have to be online).
When the inventory exceeds the order point, the supplier sends a replenish order and fills up the goods.
The safety stock in this kind of warehouse is usually higher than the usual level as the supplier doesn’t want to rush the order. The supplier wants to produce the goods according to his best optimal times.

How is the payment made?

It depends on what was agreed. Some clients pay every month/quarter/week on actual consumption, and others pay only for replenishment of new goods. For example, if you consume 5000 units in 5 months, you can pay for 1000 units each month when they are consumed or 5000 every five months when the client asks for replenishment.

What is the difference between the two methods?

The main difference is who manages the replenishment. If the customer gives clear notices on consumption from the warehouse, then the supplier can manage the inventory without the intervention of the client’s planners. In that case, the payment is usually made when the consumption happens (+credit terms). However, sometimes it is difficult for the customer to report on every consumption, so he orders a replenishment and pays for the previous order.

However, many other methods might be agreed upon between the supplier and the client.

What does it take to start working with consignment?

In a word, TRUST

The supplier takes all the risks. He sends goods to the client free of charge. The goods are sometimes stored in a warehouse that belongs to the client. He needs to be sure that it is insured so that he is compensated in case of fire or theft.

What do you need in consignment agreements?

A mutual understanding that this is a long-term relationship between supplier and client. That means that the client will use the supplier’s goods most of the time and not the competitor’s goods.
An agreement that contains the following:
1. Who insures the goods
2. What to do when a bad product is found. The product might be defective before or after it arrives at the warehouse. So make sure that you decide how to manage those conflicts.
Who owns the warehouse that will store the goods?
The supplier needs to follow the financial risks that the client faces. If the client becomes bankrupt, the goods might “disappear” by the client’s creditors.
Inventory levels and who is responsible for the replenishment
And, of course, all the other “regular” terms of the agreement, such as credit, bureaucracy, etc.

Summary

Consignment is always good for the client that pays for the goods only when he consumes them.

It is also good for the supplier since he can reduce the cost of the supply chain:

Fewer setups
Less splitting of shipments
Less bureaucracy by dealing with fewer orders
No shortages for the client = a big advantage to the supplier

When a client and a supplier agree on consignment, they agree to a long-term relationship important for both sides.