Productivity -- Supply Chain -- Information

Consignment inventory

What is it and when does it make sense to use it?

by Dave Piasecki

Let’s start with a simple definition: Consignment inventory is inventory that is in the possession of the customer, but is still owned by the supplier.

In other words, the supplier places some of his inventory in his customer’s possession and allows them to sell or consume directly from his stock. The customer purchases the inventory only after he has resold or consumed it.

The key benefit to the customer should be obvious; he does not have to tie up his capital in inventory. This does not mean that there are no inventory carrying costs for the customer; he does still incur costs related to storing and managing the inventory.

So what’s in it for the supplier? This is where the benefits may not be so obvious or may not even exist. Let’s start with a classic consignment model that has significant benefits for the supplier.

Where consignment works best
Consignment works best when a supplier has a product or group of products he believes will sell if he can get them in front of end-users. The trick is getting them in front of end-users means getting them stocked in retail establishments.

Retailers are hesitant to stock the product because they do not have the same level of confidence in it as the supplier. Because the supplier realizes in-store exposure is critical to getting his products sold, he offers to stock his product in their stores.

This creates a condition of shared risk whereby the supplier risks the capital investment associated with the inventory while the customer risks dedicating retail space to the product.

This also creates a condition of shared benefit because neither the supplier nor the customer will benefit until the product is sold to an end-user. This shared-risk/shared-benefit condition will often be enough to convince a customer to stock the product.

It works well for:

• New and unproven products
• The introduction of existing product lines into new sales channels.
• Very expensive products where sales are questionable.

The key to all these examples is the combination of a high-degree of demand uncertainty from the customer’s point of view, and a high degree of confidence in the sales potential from the supplier’s point of view.

The consignment inventory model can also be effective with service parts for critical equipment where the customer would not stock certain service parts due to budget constraints or demand uncertainty.

In this situation, consignment inventory allows the supplier to provide a higher service level (by having the parts immediately available), save expedited freight costs, and ensure the customer does not procure a replacement part from a competitor.

Not so good
Where is consignment inventory less effective or even counterproductive? Don’t use consignment inventory as a localized cost-cutting tactic. This happens when a big customer decides he is going to pressure his suppliers into providing consignment inventory to eliminate his investment in inventory.

In these situations, the customer was probably already stocking the product and is simply using his leverage over the supplier to reduce his costs. While this may reduce the customer’s costs, it is actually just moving these costs from the customer to the supplier.

In addition, consignment inventory will almost always add costs to the supply chain because there are additional costs associated with managing the consignment process. So in the end, the supply chain has to absorb more costs without any meaningful benefits.

Many faces of consignment inventory
Below are some examples of the variety of approaches to consignment.

Consignment transfer of ownership models

• Pay as sold (real-time)
• Pay as sold during a pre-defined period
• Ownership changes after a pre-defined period
• Order to order consignment (when next consignment order is placed, previous is billed).

Various system tracking models (supplier)

• Transferred to consignment warehouse/facility
• Purely an accounting process (rather than moving dollars to payables, it transfers it to a consignment account)
• Sometimes overall quantities are tracked; sometimes quantities are tied to original consignment order

Various system tracking models (customer)

• Received into consignment warehouse/facility
• Purely an accounting process (create an offsetting consignment inventory account)
• Sometimes overall quantities are tracked, sometimes quantities are tied to original consignment order
• Transitioning can be a problem (how you deal with owned and consigned quantities of the same item)

Agreement issues
Both parties need to clearly understand the terms.

• Real-time sales or period-end sales.
• Time limit (must be purchased or returned within specified period)
• What is the freight policy?
• What is the return policy?
• Who holds responsibility for damage or loss while in customer’s possession?
• What are the insurance implications?
• Exactly how and when is data exchanged? What data is exchanged?
• How are miscellaneous transactions processed?

• Cycle count adjustments,
• Customer returns (does a return initiate a credit from the supplier?)
• Scrap

Most systems don’t handle consignment inventory very well
The nature of consignment inventory is that change of ownership is unrelated to the shipment/receipt processes. This is contrary to the basic design of most inventory/accounting system’s transactional processes.

Because of this, most inventory systems do not handle consignment inventory very well. This forces many businesses to manage consignment inventory with manual off-line processes. Not only is this time consuming, but it also creates many opportunities for errors because the additional transactions necessary for consignment inventory can get rather complicated and are highly dependant on accurate information sharing. If this process is not monitored closely, you can end up in a situation where reconciling your consignment inventory becomes a nightmare.

If consignment inventory is a significant part of your business, you need to look for software that focuses on consignment inventory or look into modifying your current system to add this functionality.

Dave Piasecki, CPIM, is owner/operator of Inventory Operations Consulting LLC, a consulting firm providing services related to inventory management, material handling, and warehouse operations to manufacturers and distributors in Southeast Wisconsin and Northeast Illinois. He has over 15 years experience in warehousing and inventory management and can be reached through his Web site, where he maintains additional relevant information and links.