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Lead Times, Incoterms and Vendor-Managed Inventories

The issue of lead time actually ties into the second VMI principle, the use of Incoterms. Sometimes treated as a footnote to international negotiations, the Incoterms actually drive the dynamics of the relationship between buyer and seller on two important points: risk of loss or damage to the goods and responsibility for transportation and related expenses. Independent of the business model, it must be noted that Incoterms do not consider transfer of title; they pertain only to the obligations of the seller in relation to delivery of the goods. [1] However, this point does not relieve the vendor of responsibility for the well-being of the merchandise or the cost of transportation to the production facility.

In a VMI model, the preceding points have two implications. First, because the vendor owns the merchandise up to the production process, it makes sense to adjust the Incoterms to shift responsibility to the vendor for risk of loss or damage and transportation expenses. Simply stated, if the vendor owns the merchandise, the vendor should be responsible for its well-being. In more traditional purchase-order-driven models, the vendor relinquished responsibility farther upstream in the supply chain, using Incoterms like ex works, free carrier or free on board. In order to align Incoterms with title transfer under VMI, responsibility moves to the vendor via Incoterms like delivered duty unpaid and delivered duty paid. In this scenario, should anything happen to the goods in the form of damage, loss or theft, it is technically the responsibility of the vendor.

Second, use of the delivered duty unpaid and delivered duty paid Incoterms should not be overlooked from a landed cost perspective. Under these terms, the sale price quoted to the customer includes not only unit price but also any transportation expense associated with getting the goods into the production facility. As discussed in previous chapters, this could include origin pickup, consolidation, international airfreight, documentation, customs clearance and local delivery. If a vendor moves from an Incoterm like ex works to delivered duty unpaid without accounting for those additional costs in the sale price, the vendor will lose money before the first unit is ever shipped.

Finally, because the vendor's responsibility is heightened under delivered duty unpaid and delivered duty paid, the level of logistics expertise required of the vendor increases commensurately. With ex works, for example, the vendor makes goods available to the customer at the vendor's facility and from that point forward washes its hands of any transportation-related liability. Although it makes sense for a supplier to monitor the flow of its shipments regardless of the Incoterm used, reality dictates that the buyer be more vigilant under this type of Incoterm. With a delivered duty paid Incoterm, the vendor is responsible for the goods and pays the freight and would therefore be wise to employ a third-party logistics company capable of handling that responsibility.

All of the operational requirements discussed thus far must be carried out with +99% accuracy in order for the VMI model to function effectively. Some may consider these levels too unrealistic for an international model, but it is actually these same demands that make the model successful. With so much at stake from both an operational and financial perspective, it would be foolish of both the vendor and customer to not work together to reduce lead time, inventory and production variances. This emphasis on details and constant collaboration extends well beyond an inventory management environment, all the way up the supply chain to its origins.

While all of the operational details inherent to a successful VMI operation can be articulated, the most important component of the program is more subtle. From the outset, the fortunes of a VMI model rely on the philosophy and attitude that both vendor and manufacturer apply to their relationship. In the past, many vendor/customer relationships have been characterized by a constant game of "one upmanship," with each entity seeking ways to take advantage of the other. If a manufacturer canceled shipment of raw materials well after an order was placed, that was the vendor's problem. Conversely, if a vendor loaded up a customer with more raw materials than production called for, it was not the vendor's concern. The VMI philosophy forces both vendor and manufacturer to realize that any supply chain disruption affects all involved, not just the party holding the inventory. Each is equally responsible for variance reductions in the areas of product quality, lead times and inventory management, with an understanding that all involved eventually share unnecessary supply chain costs.

As detailed in Table 7.2, the juxtaposition of the JIT and VMI philosophies creates some very interesting contrasts. Most notably, JIT pushes the model toward zero inventory, while VMI has inventory built into it. It is also of interest to note, however, that each school promotes continuous improvement, the elimination of waste and intense supplier management. Paradoxically, the JIT model works because there is no inventory being held, whereas the VMI model works because there is inventory being held. Which model functions best is a question of corporate culture, supply chain structure and industry-specific characteristics. As Thomas Jefferson said, "the price of freedom is constant vigilance." For both JIT and VMI, the cost of success is constant vigilance as well.

Table 7.2: JIT Versus VMI

INCOTERMS: CORNERSTONE OF THE BUYER-SELLER RELATIONSHIP

First established in 1936 by the International Chamber of Commerce in Paris, France, Incoterms (International Commercial Terms) form the operational foundation of any cross-border transaction. Since their inception, the goal of the Incoterms has been to provide a standard that addresses the responsibilities of the seller as they relate to the delivery of merchandise to an international buyer. As articulated in the Introduction of the 2000 edition of Incoterms, the scope of these 13 trade terms is limited to:

Matters relating to the rights and obligations of the parties to the contract of sale with respect to the delivery of the goods.

More specifically, Incoterms cover two critical clauses in any well-prepared contract for sale. First, use of a specific term clearly defines at what point in the logistics chain responsibility for loss or damage to the goods shifts from the seller to the buyer. Second, Incoterms also clarify at what point transportation and related expenses (local pickup, international airfreight, customs clearance, duties, etc.) shift between the parties. Given the critical nature of these two points to a successful business relationship, an understanding of the true ramifications of the Incoterms must be established well before shipments are effected.

Since the Incoterms deal in part with the burden of expense associated with the movement of goods, they have a considerable impact on landed costs. As a percentage of total cost of ownership, transportation and related expenses can represent up to 20% of the landed expense. Without clear definition of who pays for what, phantom costs will continuously surface, eroding the gross profit of both buyer and seller.

Prudent use of the Incoterms can also affect the transportation component of cumulative lead times. Issues that deal with mode of transport (air, ocean, rail, truck or multi-modal), the definition of "usual" shipping practices and the meaning of "delivery" are all meticulously covered in the publication. In a world where time to market and velocity are sources of competitive advantage, comprehensive knowledge of the Incoterms is vital to a company's success in global trade.

It is important to point out that the Incoterms per se do not carry the force of law. Incoterms are standards that are intended to be part of a sales contract, the intent of which is to define commonly used trade terms. If, however, reference is made to the Incoterms 2000 in a binding contract for sale, interpretation of the responsibilities relating to delivery of the goods will be pursuant to the Incoterms. For this and many other reasons, it is prudent to include reference to the Incoterms 2000 in any international sales contract. As an additional note on the enforceability of contracts using the Incoterms, the 2000 publication is consistent with and makes reference to the 1980 United Nations Convention on Contracts for the International Sales of Goods.

Although the Incoterms are very clear with regard to scope, their use continues to generate a great deal of confusion between buyer and seller. For this reason, it is equally important to articulate what the Incoterms do not cover. For example, the Incoterms explicitly state that their scope does not consider transfer of title (different from responsibility for loss or damage), property rights, financing or breach of contract. In this context, Incoterms only cover the two clauses previously mentioned, and the other important details of a binding sales contract are covered under separate clauses.

Tactical knowledge of the Incoterms is the cornerstone of any international operation. Regardless of the departments in which employees work, a lack of understanding of the Incoterms will eventually lead to waste, longer cycle times and extremely annoyed customers.

Source: Incoterms 2000

[1]Incoterms, International Chamber of Commerce, Paris, 2000.