A customer agrees to give you all of his business. All you have to do is maintain an adequate inventory of the products he uses at his facility. What a deal!!!! Large, frequent orders from a customer. No one “nickel and diming” you to death. Wouldn’t any distributor jump at the chance to get as much of this type of business as possible?
Many distributors have jumped at the chance to get these “vendor managed inventory” or VMI contracts… jumped right into a pool of problems and losses. I heard about one of these unfortunate companies last weekend. This is a true story. But like the old TV show Dragnet, all of the names have been changed. But this time, to protect the guilty.
Six months ago, the outside salesman for Smokey Supply was very excited. He had just finished negotiating a VMI contract with one of his largest customers, Ajax Chemical. In exchange for maintaining a completely stocked parts supply room, Smokey Supply would receive all of Ajax Chemical’s business for industrial supplies. The contract stated that Ajax would buy stock products at 16% above Smokey Supply’s actual cost.
“Sure these are low margins,” the salesman told management, “but think of the volume of business we’ll do with these folks.” Smokey’s management agreed that it made sense to give up the 25% gross margin they had previously made on sales to Ajax to capture all of their business.
Well, last week Ajax Chemical canceled the VMI contract stating that they couldn’t live with the problems which resulted from Smokey Supply’s management of their inventory. And, when Smokey’s management conducted an after-the-fact inquiry into what went wrong, they discovered that in addition to the service problems reported by the customer, they had lost money on the contract in each of the six months the contract was in effect! Let’s look at what happened and see how Smokey lost both money and customer goodwill on a deal that was supposed to be a sure-fire, unquestionable success. Hopefully you can avoid this distributor’s mistakes.
Problem #1: Ajax Chemical’s Existing Inventory
One of the last items discussed in the negotiations for the VMI contract was what to do with Ajax Chemical’s existing inventory. To expedite matters, Smokey’s salesman agreed to give the customer full credit on the return of their existing stock. Ajax had paid $2,000 for this material. Why was this a problem?
Smokey was in effect giving back the profit made on $2,000 worth of sales. Looking at it another way, Ajax was receiving a credit of $2,000, but Smokey was receiving back only $1,500 worth of material (the value at their cost). And the $1,500 didn’t include:
- The $400 (at Smokey’s cost) worth of discontinued items and the $200 worth of material Ajax had purchased from Smokey’s competitors. Though Smokey gave the customer credit for this material, it could not be resold.
- The eight hours necessary for a Smokey employee to physically count the stock in Ajax’s parts room. Using a conservative labor cost of $15 per hour, this process cost Smokey $120.
Instead of getting $1,500 of material for a $2,000 credit, Smokey actually received $780. In other words, this last-minute concession cost the distributor $1,220!
What Smokey Should Have Done: The disposition of a customer’s existing inventory should be one of the first topics discussed when negotiating a VMI contract. A distributor needs to know how much it will cost him (and it always costs him something), so that he can make sure that the gross profits earned under the new agreement will cover this expense and provide a return on investment. And Smokey should have separated the “good” stock from the “dead” stock, and given the customer full credit only on the material that could be resold.
Problem #2: The Cost of Maintaining Inventory
in Ajax Chemical’s Parts Room
Before entering into the vendor managed inventory agreement, Smokey Supply’s sales manager and upper management reviewed Ajax Chemical’s $44,200 worth of purchases (at cost) over the past 12 months. That’s an average of $850 per week. At a 16% mark up, Smokey’s projected revenues to be $986 per week, or $51,272 per year, and the annual gross profit would be $7,072.
But when dealing with maintenance, repairs, and operations, the customer’s engineers usually don’t know what they will need in advance. The parts room had to have an ample stock of parts, not only for routine maintenance, but also for emergencies that might occur. Smokey couldn’t just deliver $850 of material per week. They needed to maintain an inventory worth $1,600 in Ajax’s parts room. Because Smokey was not warehousing the material in their own facility, they felt that they didn’t have many of the inventory carrying costs normally experienced by distributors. Furthermore, that investment of $1,600 was reasonable considering the profit they would receive from the contract. After all, if you consider the cost of money to be about 10%, it cost about $160 to maintain the inventory in Ajax’s parts room. They saw that as “chicken feed” when they considered the total worth of the contract.
What Smokey failed to consider was the cost of labor necessary to maintain the inventory in the parts room. The distributor not only had to restock the shelves once a week, but also:
- Cycle count the inventory to be sure that the Ajax’s material requisitions reflected what was taken from the shelf.
- Provide emergency delivery service, at no additional charge, when Ajax experienced a stock out between normal deliveries.
In all, it took one Smokey employee an average of eight hours to service the Ajax contract each week. At $15 per hour, this was $120 per week, or $6,240 per year.
A bleak picture is painted if you consider all of Smokey’s costs:
| Projected Annual Gross Profit |
Cost of Inventory Return |
Cost of Money Tied Up in Inventory |
Labor Cost To Administer Contract |
Net Profit (End of 1st Year) |
| $7,072 | $1,020 | $160 | $6,240 | -$348 |
And these numbers don’t include the cost of billing the customer or commissions paid to the salesman.
What Smokey Should Have Done: It’s obvious that Smokey’s management didn’t have a good handle on their costs before they went into negotiations with Ajax. They probably didn’t fully consider the benefits that Ajax would derive from this relationship:
- Reduced labor cost in the stock room
- Reduced labor cost in the purchasing department
- Emergency delivery service, at no charge, when a needed part wasn’t on the shelf
Ajax saw a terrific opportunity. Smokey was willing to cut their prices, and provide “free” labor in exchange for an exclusive contract to deliver material. What customer wouldn’t be attracted by this kind of offer?
Smokey should have realized, before the contract was negotiated, that they were not going sell material to Ajax as much as they were going to operate a “mini-warehouse” in the customer’s manufacturing plant. They based their markup of 16% on the costs they normally incurred when filling stock orders out of their own warehouse. They needed to consider all of the costs associated with operating a remote branch location.
Problem #3: Despite a 97% Order Fill Rate,
Ajax Canceled the Contract Because They Were
Dissatisfied with the Service Provided by Smokey Supply
Each month, Smokey Supply’s salesman and management reviewed the number of backorders on requisitions from the Ajax parts room stock. They were very pleased that over a four-month time period, 782 out of 803 requests for material had been completed filled from parts room stock. Fifteen of the other 21 requests had been filled within four hours, and the remaining six requests had been delivered within 48 hours.
With what appeared to be outstanding performance, why was the customer upset? Well, two of the 21 requests that couldn’t be filled from shelf stock caused a manufacturing line to shut down. When management at Ajax asked for the reason for the shutdown, their engineers responded that the repair parts needed weren’t in the parts room – the parts room maintained by Smokey Supply. When two parts-related shutdowns occurred within six weeks, Ajax’s management decided to look for a more “reliable” supplier.
What Smokey Should Have Done: When Smokey’s salesman reviewed Ajax Chemical’s needs, he looked at what they had purchased in the past 12 months. He did not sit down with the customer’s engineering staff and determine what items should be considered “critical repair parts.” If Smokey had known what parts were crucial to keeping the manufacturing process going, they could have planned to maintain additional “safety allowance” inventory of these items.
The real problem was that Smokey’s management and Ajax Chemical’s management had two very different measurements for the success of the VMI agreement. Smokey was concerned with the percentage of requests that could be completely filled from shelf stock. If this percentage was high, they assumed that the customer was happy. Ajax viewed success in terms of keeping the production lines in their chemical plant operating. Whenever a critical part wasn’t available, they viewed the distributor’s performance as inadequate. During negotiations, they should both have agreed on a definition of “success” and made it part of the agreement.
Summary: What You Can Do
To Achieve Success in VMI Agreements
Learn from Smokey Supply’s mistakes. When negotiating a VMI contract with a customer, consider such things as:
- Your actual cost for buying back their existing stock
- The cost (especially the labor cost) of maintaining inventory at their location
- The fact that you need to know what parts are critical to their operation
There is nothing wrong with vendor managed inventory agreements. But, in order to ensure profitability and customer satisfaction, a distributor must realize that they are not merely selling supplies, but are operating a small branch for the exclusive use of a very demanding customer.