How does consignment inventory work?

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Consignment inventory is a useful arrangement that allows a supplier and a retailer to create a “win-win” scenario through the sharing of risk. Consignment inventory can be both a useful tool and a recipe for disaster depending on the circumstances in which it is employed. Below is a brief summary of what consignment inventory is, when it’s best used, and some key issues to bear in mind when using it.

What is consignment inventory?

Consignment inventory is a tweak to the regular structure of a supply arrangement. Usually when a supplier sells goods to a customer, the legal title to the goods passes to the customer once they receive them in exchange for payment (whether in cash or as a credit sale). With consignment inventory, there is no payment and the legal title stays with the supplier. The customer will receive and stock the items, but the supplier will retain ownership until they are finally sold to the customer’s customer (often a consumer). When the goods are sold, the customer buys the goods from the supplier, and they both ultimately receive money from the end sale.

The reason this arrangement works is because of the shared risk and the shared incentive of both the supplier and customer. The supplier’s risk is that they are giving away control of their inventory without payment, unless it is sold. The customer’s risk is that they must pay holding costs and use part of their retail space to stock the product. Both want the stock to be sold, as neither will profit until it does.

To use or not to use?

Consignment inventory works well when the shared risk/shared benefit scenario exists. For example, a new watch manufacturer attempting to enter the market may try to stock their watches with an established jeweler by consignment inventory. The manufacturer benefits, as the watch market is competitive and it would otherwise be difficult to get their product in front of customers in a meaningful way. The jeweler benefits as they don’t have to tie up their capital in this stock, and instead have an extra product for consumers while having funds to purchase stock from more established brands. The situation is therefore a “win-win” for both the manufacturer and jeweler.

A contrasting scenario could be where the jeweler is attempting to negotiate with a manufacturer of a more established watch brand so that they will provide stock through consignment inventory. Whether they will be able to achieve this will depend on the bargaining strength of the parties – few established manufacturers are likely to agree to this. But even if this were possible, there are better ways to make use of bargaining strength, such as simply paying a lower price, or longer payment terms. This is because consignment inventory can create inventory management issues (see below), which makes consignment inventory not worth it there is no shared benefit.

Recording difficulty

One major problem with consignment inventory is the difficulty in recording it when it comes to inventory management. The core concept of consignment – that change of ownership doesn’t occur until the goods are sold (rather than shipped), is contrary to the basic design of most inventory/accounting systems’ transactional processes. Many inventory management systems don’t handle this well. This leads some businesses to manage consignment inventory with time and resource-consuming manual processes, however there are inventory management software programs that can accommodate this. These programs are not only faster, but they are also far less error-prone.

Keep your staff in the loop

A final consideration is that consignment inventory will be invisible to most workers because the inventory is still produced and shipped to the customer like normal goods. It is important that those employees who need to appreciate the difference (i.e. the stock is not actually sold) are aware of this. This might range from staff responsible for order processing to high-level decision makers who aren’t familiar with inventory processes. Keeping all these people informed with help consignment inventory to run smoothly, if you decide that it is right for your business.

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Melanie - Unleashed Software

Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.

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