Vendor Managed Inventory (VMI) : Definition, Risks and Best Practices

Inventory management involves the process of ordering, storing, using, and selling a business’s inventory. It can include the management of raw materials and finished goods as well as how these are processed. 

There are several methods for managing inventory. These methods can vary, depending on the industry sector, whether you run a brick-and-mortar or e-commerce business, and importantly, the unique characteristics of your business. 

Here, we take a deeper look at vendor-managed inventory (VMI), examining:

• What VMI is
• How VMI works
• Examples of VMI
• The industries that typically use VMI
• Comparison of VMI with third-party fulfilment (3PL)
• VMI metrics
• Advantages of VMI for vendors and businesses
• Disadvantages of VMI for vendors and businesses
• When a business should transition to VMI
• Best practices for VMI
• How QuickBooks can help you streamline your VMI
• FAQs

Let’s begin.

What is vendor-managed inventory (VMI)?

Vendor-managed inventory (VMI) involves a partnership between a vendor and a buyer whereby the former controls the latter’s inventory. This means that through access and control of the buyer’s inventory management system, the vendor manages and makes decisions about inventory, instead of the buyer. 

How does vendor-managed inventory (VMI) work?

A business selling products typically needs to store inventory. Depending on the quantities involved, inventory may be stored at the place of business (sometimes even in the home for a startup) or in a storage unit. In most cases, a business would lease a warehouse for storage purposes. 

As the quantities of inventory increase due to a higher volume of orders, or a broader range of product offerings, a robust system is required to manage that inventory. A business needs an easy, consistent and clear way to store, manage, identify, track and reorder inventory. 

There are several inventory management systems available, but VMI employs a unique approach.

The most critical distinction with VMI is that the vendor controls and manages inventory. This is achieved by firstly, accessing vital information in the inventory management system, and secondly, making decisions about new orders, restocking, quantities and timeframes. Needless to say, strong and open lines of communication are crucial for VMI success. 

Both parties must agree on multiple issues, including:

• the level of access the vendor will have to the buyer’s inventory system
• how stock performance will be tracked
• costs that will be incurred by both parties and how these will be apportioned or addressed
• minimum and maximum levels of stock for each product line
• key metrics
• how risks will be mitigated and much more

Example of vendor-managed inventory

But first, let’s take a look at VMI inventory in action.

Acme is a supplier of mechanical fasteners, such as screws, nuts, bolts and rivets. Acme uses VMI to manage all inventory because they want to ensure everything about their business is optimised. Their goal is to ensure that customers, such as BJ Hardware, do not carry too much inventory but also avoid stockouts (run out of stock).

Acme sends technicians to BJ Hardware’s stockrooms to monitor the inventory levels and conduct cycle counts (an inventory auditing procedure) to determine the replenishment levels. Armed with this information, the technicians report back to Acme to move to the next stage of fulfilment, ensuring that their next trip out is to deliver the necessary stock to BJ Hardware.

With VMI, Acme is responsible for ensuring the right amount of inventory for BJ Hardware to meet their customer demand. In this way, BJ Hardware does not have too much stock on hand, avoids labour costs associated with counting inventory, and can rest assured they always have ready stock.

Which industries use VMI inventory management?

Many industries use VMI, including fast-moving consumer goods companies, aviation, pharmaceuticals, oil and gas, retailers and e-commerce companies. 

Proctor & Gamble, Shell, Lockheed Martin Aeronautics and Walmart are good examples. Most people would be familiar with big-box stores (or megastores) such as Amazon, which deal with millions of SKUs (stock-keeping units) and collaborate with multiple third-party sellers.

VMI vs third party fulfilment (3PL)

Third-Party Fulfilment or Logistics (otherwise known as 3PL) is an outsourced fulfilment solution. Fulfilment in this sense involves more than just warehousing – it includes order processing, product selection, packing, and shipment to the customer. 

The extent of services provided depends on whether a selection of services is chosen or a full-service offering is taken. The latter typically includes: 

• inbounding (receiving and processing inbound shipments)
• storage
• selecting and packing of products
• outbound shipping

While there appear to be similarities between the two, the difference between VMI and 3PL lies in who manages the system. With 3PL, tasks are outsourced and managed by a third party. In contrast, with VMI, there is a close relationship between the vendor and buyer, with the vendor taking responsibility for managing inventory.

3PL can be considered an alternative to VMI when you’re not keen to manage inventory yourself and would like to leverage a 3PL network of fulfilment centres.

Metrics to determine VMI success

There are several metrics used to determine VMI success:

• Inventory turnover rate: the rate at which an item of inventory is sold or consumed within a specific timeframe. It may also be called stock turnover or inventory turn. QuickBooks offers an easy-to-use inventory turnover calculator to assist with calculations
• Stock to sales ratio: this measures the amount of inventory carried compared to the number of sales orders fulfilled
• Sell-through rate: this measures the amount of inventory sold set against the amount of stock received within a specified period
• Backorder rate: this measures the percentage of orders that cannot be delivered by the original date
• Supplier quality index (SQI): this evaluates how well a supplier meets expectations and requirements

Advantages of vendor-management inventory

VMI offers several key advantages over other methods of inventory management.

Benefits of VMI for vendors

• provides the vendor with more predictable and streamlined scheduling
• allows for more accurate forecasting based on historical performance, leading to more consistent and timely stock updates and orders
• enhanced visibility enables the identification of both slow-moving and sizzling products, and may also highlight emerging trends
• a better relationship with the buyer can lead to increased opportunities for collaboration and partnership

Benefits of VMI for buyers (businesses)

• helps save money across multiple areas in supply chain management
• optimises the supply chain by reducing time spent checking and managing stock levels, reducing over-ordering or insufficient inventory, and limiting unnecessary ordering and excess storage
• a better relationship with the vendor can lead to increased opportunities for collaboration and partnership
• improves team efficiency as a result of fewer inventory-related tasks
• reduces errors in inventory management

Disadvantages and risks of VMI

Despite the advantages that VMI offers, there are disadvantages to note. Understanding how implementation may play out can help you better manage the risks and respond well when issues arise.

Drawbacks of VMI for vendors

• lack of proficiency with the buyer’s inventory management system and sales data can lead to a breakdown of the entire operation
• lack of clear communication about changes to the system or additions to the product line can result in disruption, errors and unnecessary costs if the impact is not fully understood or prepared for
• unexpected demand spikes can interfere with the forecasts vendors use to determine restocks

Drawbacks of VMI for buyers

• including slow-moving stock in the system can lead to payment for any overstock
• buyers may be unable to deal with demand spikes because of an inflexible vendor
• relinquishing control to the vendor means less control for the buyer, necessitating a greater degree of trust and communication between the parties
• growing reliance on the vendor can also create a sense of dependence and the feeling that there are fewer options available for changes or partnerships
• less control of vital real-time inventory data can leave the buyer feeling vulnerable to risks or harm to the business

When should a business transition to VMI?

If a business believes that its circumstances warrant a transition to VMI, there are several questions it should ask before transitioning to VMI:

• Are you selling high-value commodity items? Luxury items or jewellery, for example, have different requirements such as higher levels of security, which make VMI unsuitable 
• Can you afford sufficient warehouse space? Given that warehouse space can be incredibly expensive, a better option may be to use a third-party logistics company instead
• Does your industry sector face rapid changes? Certain industries, and in particular, direct to consumer (DTC) markets, require an agile approach, making VMI unsuitable
• Do you require a high level of control over your business? Handing over control of certain aspects of your business to a vendor without a clear understanding of the nature of the partnership and risk mitigation in place can result in disastrous consequences
• How much do you trust your vendors? With VMI, the buyer exchanges vital inventory data with the vendor, thereby increasing their vulnerability. This is a system that works best when mutual trust between the parties exist

Best practices for VMI

Once you’ve decided to introduce VMI to your business, ensure that you apply the following practices.

Build strong relationships with your vendors

This cannot be overstated. VMI success begins with strong trust between the parties as critical business information is shared. A win-win relationship is key as is an understanding that both parties play equally important roles.

Set up a comprehensive VMI agreement

The devil in the details. Without a comprehensive understanding of the role and responsibilities of each party, and clear plans around risk and change management, the early euphoria around a new partnership can wane, leaving a mess in its wake.

Set goals and KPIs to measure success

Every business is unique even when products on offer look similar. Every business will have unique goals and metrics to measure success. The parties should ideally discuss these ideas and have a clear plan as to individual and joint goals and the corresponding KPIs so that both parties can arrive at a mutually agreed definition of success.

Maintain clear communication

VMI is not a set-it-and-forget-it business model. There should be clear channels of communication agreed on as well as systems and processes established for how records or exchanges are managed.

Inventory management software such as QuickBooks can generate custom reports that enable the parties to gain insights into inventory performance, thus supporting informed decision-making.

Use VMI software

So here’s where we are. You understand what VMI is, and how it works, and you believe in the advantages it brings. After reviewing the pros and cons, you’re now ready to move ahead. This is the point to consider whether technology can play a useful role in supporting your move.

QuickBooks Online can help streamline VMI through its inventory management feature.

How QuickBooks can help you streamline vendor-managed inventory

With its inventory management feature, QuickBooks supports customers interested in applying VMI in their business through the following:

• generate customised inventory reports
• integrate with e-commerce platforms and other inventory management apps
• sync inventory data, orders and payments on a single dashboard
• communicate with ease and in real time with vendors
• store vendor information in a centralised location (making reordering easy!) 
• centralise and sync inventory from online stores, so you can view and share real-time digital inventory data

QuickBooks Online Plus offers a one-stop robust e-commerce solution with an inbuilt inventory management feature. Keep your finger on the pulse for all your business inventory needs.

Stay stocked for continued success with a free 30-day trial today.

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