Purchasing inventory is one of the biggest risks a retailer takes. If they don’t sell everything, they end up with excess stock and valuable capital tied up in an unmovable product.
Inventory risk doesn’t just impact retailers though - it impacts suppliers, too. When retailers play it safe, they’re less likely to take a risk on new brands or even new products from familiar brands. They fear they’ll buy a new product in bulk only for the product to end up a flop with customers. So retailers order less, and suppliers see less-than-expected purchase orders.
Fortunately, there’s an arrangement that allows both parties to benefit by spreading the risk.
What Is Consignment Stock?
Consignment stock, also called “buying on consignment,” is an arrangement where a consignor (the supplier or wholesaler) sells his goods to a retailer (the consignee) who only pays when he sells the product to customers.
This is a popular model even in non-wholesale businesses like the jewelry industry. In a high-end market like jewelry, boutiques and luxury retailers don’t want to take a financial risk on new designers.
So, boutiques offer to showcase pieces without paying for them outright. If the jewelry sells, the boutique (the consignee) pays the designer (consignor). If it doesn’t sell, the designer takes their jewelry back and the boutique doesn’t lose any money.
What Are the Advantages of Consignment Inventory?
Advantages for Retailers (Consignees)
The most obvious advantage of a consignment model for retailers is the total elimination of inventory risk. When retailers, or even other upstream supply chain parties like manufacturers, purchase goods on consignment, they don’t have to worry about stock-outs, excessive inventory, or deadstock.
Avoiding stock-outs is in the best interest of everyone involved. For retailers, they cause lost sales and a diminished customer experience. For manufacturers, stock-outs lead to production delays, backorders, and, of course, unhappy customers.
Retailers, manufacturers, and warehouses have developed a number of ways to manage stock risk. One method uses historical data about customer demand and supplier lead times to calculate safety stock.
While data-driven inventory management methods lead to better estimates of safety stock levels and reorder points, they are still just estimates. That means that they’re susceptible to error, especially from supply chain fluctuations caused by unexpected events.
Consignment inventory goes a step further to provide manufacturers and retailers with peace of mind.
Advantages for Vendors (Consignors)
It may sound like there are no advantages of a consignment approach for vendors. But there are benefits for vendors in exposure and opportunity. Offering consignment goods gives suppliers an opportunity to:
- Boost their brand recognition by putting their goods on the shelves of big-name retailers
- Expand into new markets by offering new products that are different from their usual offerings
In both cases, retailers often don’t want the risk of buying products outright. They want to buy proven commercial products from well-known brands. But with a consignment arrangement, they may be more willing to offer some shelf space.
Take the jewelry industry for example again. A showcase in the right store can do wonders for an up-and-coming or lesser-known designer. As Jodi Kaplan, vice president of jewelry and watches at Bergdorf Goodman in New York, told the New York Times, “The amount of traffic and recognition they get here is like a stamp of approval. It catapults them to the next level.”
What Are the Disadvantages of Consignment Inventory?
Disadvantages for Retailers (Consignees)
In a consignment model, consignees assume minimal risk, but not zero risk. Remember that inventory carrying costs consist of more than just the cost of the goods themselves . There’s also the cost of storing the inventory, which comes in the form of warehouse space (represented by a percentage of the rent), heating or cooling, securing the inventory, and more.
Aside from the direct cost of storing inventory, there’s also the trade-off involved. Space dedicated to one product means space is taken away from another product.
Add to that the risk of damaging the inventory. Under most consignment agreements, if the consignee damages the goods, it has to buy them.
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Disadvantages for Supplier (Consignors)
Consignors generally assume a higher degree of risk in a consignment inventory model. If items don’t sell, they’re left with inventory that could have been supplied to a different retailer, perhaps with more success.
Depending on the product, they could wind up with spoiled goods. For example, consignment products are popular in grocery stores, where items like eggs and poultry are often sold on consignment. If an item doesn’t sell, the grocer simply sends it back to the supplier, often leaving the supplier with unsellable goods since the items are likely close to or past the sell-by date.
Moreover, consignment agreements with different supply chain entities introduce different kinds of risk. If a consignor offers consignment stock to a manufacturer, its cash flow is tied to the manufacturer’s production efficiency. If the manufacturer has delays in production, its usage of the consigned parts is pushed back and the supplier waits longer for payment.
Consignment Inventory Best Practices, Models, and Processes
While some companies still use spreadsheets and even pen-and-paper methods for consignment inventory management, manual tracking is extremely discouraged when entering into consignment inventory arrangements.
The retailer needs a digital inventory management system designed to accommodate retail consignment inventory accounting. That way, it can track the consigned inventory, determine what hasn’t been sold (and therefore needs to be returned to the consignor), and identify items that have sold, so payment can be sent.
While the exact method and terminology will vary based on each warehouse management system (WMS), generally, your warehouse inventory management software will allow you to manage your consigned inventory like this:
- When goods arrive from the supplier, the retailer can designate them in the consignment inventory management system as either “Owned” or “Consigned”
- Goods are putaway in the consignment inventory location and their location is recorded in the consignment inventory management system
- If a customer purchases the goods, the item goes through a few status changes in the consignment inventory management system (picked, packed, shipped)
- When the item is shipped, the item’s status is changed to “Sold”
- The consignment inventory management system creates an accounting entry and initiates a payment to the vendor
With a custom warehouse management tool, businesses can tailor consignment inventory management workflows based on their needs. Some consignment inventory management systems even provide wholesalers or suppliers with visibility over their stock being held at the retail locations.
Note that in the scenario outlined above, ownership transfers from the consignor to the consignee when the order is picked, packed, and shipped. In some industries, like the grocery industry, retailers practice what’s called scan-based trading. Ownership transfers from the consignor to the consignee once the product is scanned through the grocery store’s point-of-sale (POS) system.
Regardless of their industry or the details of their consignment arrangement, businesses may want to consider using electronic data interchange (EDI). For suppliers, EDI speeds up the process of receiving and acting on new purchase orders from retailers. For retailers, it helps speed up the creation of an accounting record when they sell consignment inventory.
How To Draft a Consignment Inventory Agreement
How does consignment work? Well, before entering into a consignment arrangement, you should have a consignment inventory agreement.
Since a consignment inventory model shares the risk, you want to be on the same page about what exactly that risk is. (A handshake agreement is not enough!)
While the final details of your agreement should be reviewed by your company’s lawyer, be sure to consider the following while negotiating your contract.
Carefully Consider Your Goals and Objectives
If you’re the supplier, think about what will make this arrangement worthwhile for you.
Do you have market research that indicates placing your product in a specific retail location will generate sales?
Have you crunched the numbers and found that storing your inventory with a retailer is cheaper than paying for warehouse storage?
It’s important to understand the economics of a consignment inventory arrangement for your business. This way, you’ll know what your deal-breakers are when drafting your consignment inventory agreement.
If you’re a retailer, you also need to consider your goals and objectives. Don’t simply view a consignment inventory arrangement as an easy win. It’s important to understand how working with a specific supplier will benefit your business. Specifically:
- Is this supplier’s product aligned with your store’s brand?
- Is the quality of this supplier’s product comparable to the quality your customers expect?
- Will storing this product take valuable shelf space away from proven products?
- Can you afford to secure and manage the additional inventory?
While the risk falls largely on the supplier, there’s still some financial risk on the part of the retailer. So, like the supplier, it’s important to understand just how much risk you are comfortable with, so you know your deal-breakers.
Determine How Long the Retailer Will Hold the Inventory
Every consignment inventory agreement should identify how long a retailer must hold the inventory. For instance, if a retailer only holds the inventory for a week (and it’s a non-perishable product) it may not be a worthwhile arrangement for the suppliers. On the other hand, if the supplier wants the retailer to hold the inventory for a year, it could take up a retailer’s warehouse space. You should try to negotiate a time period that helps you both meet your goals.
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Determine Where and How the Retailer Will Display the Products
For a consignment inventory arrangement to be successful, customers must buy the product. Technically, sales benefit both the supplier and the retailer, but the retailer feels less urgency than the supplier.
The retailer can make money off of the many other products they sell and, if they never get around to properly unpacking and displaying the consigned inventory, they can return it without losing any money.
On the other hand, the supplier needs to make sales in order for the arrangement to be worthwhile.
To protect themselves and promote sales, consignment suppliers should ensure that the contract includes a requirement to display a specific amount of the inventory for a specific duration of time within a specific number of days of receiving the shipment.
Proactively demonstrating the potential profits retailers can make off their products is also a good way to build a positive relationship with retailers.
Establish Liability For Theft or Damage To The Items
Liability is a tricky issue when it comes to consignment inventory arrangements. On the face of it, it makes sense for the retailer to pay for any items lost or damaged while in their care, but that kind of stipulation may prevent retailers from entering into consignment arrangements at all. As a result, a supplier may be tempted to take on some or all of the liability.
Generally speaking, consignors shouldn’t enter into a consignment inventory agreement unless the consignee is willing to take on the liability for lost or stolen goods. It isn’t good enough to assume this is understood - make sure it’s explicitly stated in your agreement.
Establish an Invoicing Arrangement
How often will the consignor get paid? Every week? Every two weeks? Every month? Like other elements of your agreement, it’s important not to make an assumption.
You may think you’ll get paid every two weeks while your consignee plans to pay every month. Agreeing on a billing period reduces the chance of unexpected delays with your money.
Why is it important to avoid delays in payment? Because it affects your cash flow. If your goods sell between March 1 and March 31, but you won’t be paid until April 30 (and you were expecting it sooner) your cash flow is affected. Generally, the sooner you get paid for your sales, the better. So it’s important not to back down on payment terms when negotiating.
Who Pays For Shipping?
Your consignment agreement should also detail who pays for shipping - including shipping of stock and shipment of unsold items. It should also detail who’s responsible for customer returns.
Consignment Inventory Requires Careful Management
A consignment inventory arrangement can offer benefits for both suppliers (consignors) and retailers (consignees). By offering inventory on consignment, suppliers get the opportunity to grow brand awareness and enter new markets. Retailers get to expand the product offering at their stores without assuming too much inventory risk.
Of course, a successful consignment arrangement requires a solid consignment inventory agreement. Every contract should detail who is liable for lost or damaged goods, how long goods are stocked for, who pays for shipping, and any other relevant factors.
No matter how much trust you have with your supplier, or how obvious an element of the arrangement is, be sure to include everything in a formal business contract.
Written by Ruthie Bowles
Ruthie is a content marketing consultant for Logiwa. Her specialties include small business development and inventory management.