Homework Paper

70 Chapter 4 • Designing Distribution Networks and Applications to Online Sales

• Customer experience • Time to market • Order visibility • Returnability

Response time is the amount of time it takes for a customer to receive an order. Product vari- ety is the number of different products/configurations that are offered by the distribution network. Product availability is the probability of having a product in stock when a customer order arrives. Customer experience includes the ease with which customers can place and receive orders and the extent to which this experience is customized. It also includes purely experiential aspects, such as the possibility of getting a cup of coffee and the value that the sales staff provides. Time to market is the time it takes to bring a new product to the market. Order visibility is the ability of customers to track their orders from placement to delivery. Returnability is the ease with which a customer can return unsatisfactory merchandise and the ability of the network to handle such returns.

It may seem at first that a customer always wants the highest level of performance along all these dimensions. In practice, however, this is not the case. Customers ordering a book at Amazon.com are willing to wait longer than those who drive to a nearby Barnes & Noble store to get the same book. In contrast, customers can find a much larger variety of books at Amazon compared to the Barnes & Noble store. Thus, Amazon customers trade off fast response times for high levels of variety.

Firms that target customers who can tolerate a long response time require only a few locations that may be far from the customer. These companies can focus on increasing the capacity of each location. In contrast, firms that target customers who value short response times need to locate facilities close to them. These firms must have many facilities, each with a low capacity. Thus, a decrease in the response time customers desire increases the number of facilities required in the network, as shown in Figure 4-1. For example, Barnes & Noble provides its customers with books on the same day but requires hundreds of stores to achieve this goal for most of the United States. Amazon, in contrast, takes a few days to deliver a book to its U.S. customers, but it uses about 20 locations to store its books.

Changing the distribution network design affects the following supply chain costs (notice that these are four of the six supply chain drivers we discussed earlier):

• Inventories • Transportation • Facilities and handling • Information

The other two drivers, sourcing and pricing, also affect the choice of the distribution system; the link will be discussed when relevant. As the number of facilities in a supply chain increases, the inventory and resulting inventory costs also increase (see Chapter 12), as shown in Figure 4-2.

Required Number of Facilities

Desired Response Time

FIGURE 4-1 Relationship Between Desired Response Time and Number of Facilities

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To decrease inventory costs, firms try to consolidate and limit the number of facilities in their supply chain network. For example, with fewer facilities, Amazon is able to turn its inventory about 10 times a year, whereas Barnes & Noble, with hundreds of facilities, achieves only about 3 turns per year.

Inbound transportation costs are the costs incurred in bringing material into a facility. Outbound transportation costs are the costs of sending material out of a facility. Outbound transportation costs per unit tend to be higher than inbound costs because inbound lot sizes are typically larger. For example, an Amazon warehouse receives full truckload shipments of books on the inbound side, but ships out small packages with only a few books per customer on the outbound side. Increasing the number of warehouse locations decreases the average outbound distance to the customer and makes outbound transportation distance a smaller fraction of the total distance traveled by the product. Thus, as long as inbound transportation economies of scale are maintained, increasing the number of facilities decreases total trans- portation cost, as shown in Figure 4-3. If the number of facilities is increased to a point where inbound lot sizes are also very small and result in a significant loss of economies of scale in inbound transportation, increasing the number of facilities increases total transportation cost, as shown in Figure 4-3.

Inventory Costs

Number of Facilities

FIGURE 4-2 Relationship Between Number of Facilities and Inventory Costs

Transportation Cost

Number of Facilities

FIGURE 4-3 Relationship Between Number of Facilities and Transportation Cost

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To decrease inventory costs, firms try to consolidate and limit the number of facilities in their supply chain network. For example, with fewer facilities, Amazon is able to turn its inventory about 10 times a year, whereas Barnes & Noble, with hundreds of facilities, achieves only about 3 turns per year.

Inbound transportation costs are the costs incurred in bringing material into a facility. Outbound transportation costs are the costs of sending material out of a facility. Outbound transportation costs per unit tend to be higher than inbound costs because inbound lot sizes are typically larger. For example, an Amazon warehouse receives full truckload shipments of books on the inbound side, but ships out small packages with only a few books per customer on the outbound side. Increasing the number of warehouse locations decreases the average outbound distance to the customer and makes outbound transportation distance a smaller fraction of the total distance traveled by the product. Thus, as long as inbound transportation economies of scale are maintained, increasing the number of facilities decreases total trans- portation cost, as shown in Figure 4-3. If the number of facilities is increased to a point where inbound lot sizes are also very small and result in a significant loss of economies of scale in inbound transportation, increasing the number of facilities increases total transportation cost, as shown in Figure 4-3.

Inventory Costs

Number of Facilities

FIGURE 4-2 Relationship Between Number of Facilities and Inventory Costs

Transportation Cost

Number of Facilities

FIGURE 4-3 Relationship Between Number of Facilities and Transportation Cost

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Facility Costs

Number of Facilities

FIGURE 4-4 Relationship Between Number of Facilities and Facility Costs

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Facility costs decrease as the number of facilities is reduced, as shown in Figure 4-4, because a consolidation of facilities allows a firm to exploit economies of scale. While Amazon achieved a property, plant, and equipment turnover (PPET) of 19 in 2009, Barnes & Noble had a PPET of just over 7.

Total logistics costs are the sum of inventory, transportation, and facility costs for a supply chain network. As the number of facilities increases, total logistics costs first decrease and then increase as shown in Figure 4-5. Each firm should have at least the number of facilities that minimizes total logistics costs. Amazon has more than one warehouse primarily to reduce its logistics costs (and improve response time). If a firm wants to reduce the response time to its customers further, it may have to increase the number of facilities beyond the point that minimizes logistics costs. A firm should add facilities beyond the cost-minimizing point only if managers are confident that the increase in revenues because of better responsiveness is greater than the increase in costs because of the additional facilities.

Response Time

Number of Facilities

Total Logistics Cost

FIGURE 4-5 Variation in Logistics Cost and Response Time with Number of Facilities

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Facility Costs

Number of Facilities

FIGURE 4-4 Relationship Between Number of Facilities and Facility Costs

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Facility costs decrease as the number of facilities is reduced, as shown in Figure 4-4, because a consolidation of facilities allows a firm to exploit economies of scale. While Amazon achieved a property, plant, and equipment turnover (PPET) of 19 in 2009, Barnes & Noble had a PPET of just over 7.

Total logistics costs are the sum of inventory, transportation, and facility costs for a supply chain network. As the number of facilities increases, total logistics costs first decrease and then increase as shown in Figure 4-5. Each firm should have at least the number of facilities that minimizes total logistics costs. Amazon has more than one warehouse primarily to reduce its logistics costs (and improve response time). If a firm wants to reduce the response time to its customers further, it may have to increase the number of facilities beyond the point that minimizes logistics costs. A firm should add facilities beyond the cost-minimizing point only if managers are confident that the increase in revenues because of better responsiveness is greater than the increase in costs because of the additional facilities.

Response Time

Number of Facilities

Total Logistics Cost

FIGURE 4-5 Variation in Logistics Cost and Response Time with Number of Facilities

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The customer service and cost components listed earlier are the primary measures used to evaluate different delivery network designs. In general, no distribution network will outperform others along all dimensions. Thus, it is important to ensure that the strengths of the distribution network fit with the strategic position of the firm.

In the next section, we discuss various distribution networks and their relative strengths and weaknesses.

4.3 DESIGN OPTIONS FOR A DISTRIBUTION NETWORK

In this section, we discuss distribution network choices from the manufacturer to the end consumer. When considering distribution between any other pair of stages, such as supplier to manufacturer or even a service company serving its customers through a distribution network, many of the same options still apply. Managers must make two key decisions when designing a distribution network:

1. Will product be delivered to the customer location or picked up from a prearranged site? 2. Will product flow through an intermediary (or intermediate location)?

Based on the firm’s industry and the answers to these two questions, one of six distinct distribution network designs may be used to move products from factory to customer. These designs are classified as follows:

1. Manufacturer storage with direct shipping 2. Manufacturer storage with direct shipping and in-transit merge 3. Distributor storage with carrier delivery 4. Distributor storage with last-mile delivery 5. Manufacturer/distributor storage with customer pickup 6. Retail storage with customer pickup

Manufacturer Storage with Direct Shipping

In this option, product is shipped directly from the manufacturer to the end customer, bypassing the retailer (who takes the order and initiates the delivery request). This option is also referred to as drop-shipping. The retailer carries no inventory. Information flows from the customer, via the retailer, to the manufacturer, and product is shipped directly from the manufacturer to customers as shown in Figure 4-6. Online retailers such as eBags and Nordstrom.com use drop-shipping to deliver goods to the end consumer. eBags holds few bags in inventory. Nordstrom carries some products in inventory and uses the drop-ship model for slow-moving footwear. W.W. Grainger also uses drop-shipping to deliver slow-moving items to customers.

The biggest advantage of drop-shipping is the ability to centralize inventories at the manufac- turer who can aggregate demand across all retailers that it supplies. As a result, the supply chain is

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Manufacturers

Customers

Retailer

Product Flow Information Flow

FIGURE 4-6 Manufacturer Storage with Direct Shipping

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Given its performance characteristics, manufacturer storage with direct shipping is best suited for a large variety of low-demand, high-value items for which customers are willing to wait for delivery and accept several partial shipments. Manufacturer storage is also suitable if it allows the manufacturer to postpone customization, thus reducing inventories. It is thus ideal for direct sellers that are able to build-to-order. For drop-shipping to be effective, there should be few sourcing locations per order.

Manufacturer Storage with Direct Shipping and In-Transit Merge

Unlike pure drop-shipping, under which each product in the order is sent directly from its manufacturer to the end customer, in-transit merge combines pieces of the order coming from different locations so that the customer gets a single delivery. Information and product flows for the in-transit merge network are shown in Figure 4-7. In-transit merge has been used by Dell and can be used by companies implementing drop-shipping. When a customer orders a PC from Dell along with a Sony monitor, the package carrier picks up the PC from the Dell factory and the monitor from the Sony factory; it then merges the two at a hub before making a single delivery to the customer.

As with drop-shipping, the ability to aggregate inventories and postpone product customization is a significant advantage of in-transit merge. In-transit merge allows Dell and Sony to hold all their inventories at the factory. This approach has the greatest benefits for products with high value whose demand is difficult to forecast, particularly if product customization can be postponed.

Although an increase in coordination is required, merge in transit decreases transportation costs relative to drop-shipping by aggregating the final delivery.

Facility and processing costs for the manufacturer and the retailer are similar to those for drop-shipping. The party performing the in-transit merge has higher facility costs because of the merge capability required. Receiving costs at the customer are lower because a single delivery is received. Overall supply chain facility and handling costs are somewhat higher than with drop-shipping.

A sophisticated information infrastructure is needed to allow in-transit merge. In addition to information, operations at the retailer, manufacturers, and the carrier must be coordinated. The investment in information infrastructure is higher than that for drop-shipping.

Response times, product variety, availability, and time to market are similar to drop- shipping. Response times may be marginally higher because of the need to perform the merge. Customer experience is likely to be better than with drop-shipping, because the customer receives only one delivery for an order instead of many partial shipments. Order visibility is an important requirement. Although the initial setup is difficult because it requires integration of manufacturer, carrier, and retailer, tracking itself becomes easier given the merge that occurs at the carrier hub.

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Factories

Customers

In-Transit Merge by CarrierRetailer

Product Flow Information Flow

FIGURE 4-7 In-Transit Merge Network

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inventory than a retail network. Amazon achieves about 10 turns of inventory annually using warehouse storage, whereas Barnes & Noble achieves about 3 turns using retail stores.

Transportation costs are somewhat lower for distributor storage compared to manufacturer storage because an economic mode of transportation (e.g., truckloads) can be employed for inbound shipments to the warehouse, which is closer to the customer. Unlike manufacturer storage, under which multiple shipments may need to go out for a single customer order with multiple items, distributor storage allows outbound orders to the customer to be bundled into a single shipment, further reducing transportation cost. Distributor storage provides savings on the transportation of faster moving items relative to manufacturer storage.

Compared to manufacturer storage, facility costs (of warehousing) are somewhat higher with distributor storage because of a loss of aggregation. Processing and handling costs are comparable to manufacturer storage unless the factory is able to ship to the end customer directly from the production line. In that case, distributor storage has higher processing costs. From a facility cost perspective, distributor storage is not appropriate for extremely slow-moving items.

The information infrastructure needed with distributor storage is significantly less complex than that needed with manufacturer storage. The distributor warehouse serves as a buffer between the customer and the manufacturer, decreasing the need to coordinate the two completely. Real-time visibility between customers and the warehouse is needed, whereas real-time visibility between the customer and the manufacturer is not. Visibility between the distributor warehouse and manufacturer can be achieved at a much lower cost than real-time visibility between the customer and manufacturer.

Response time under distributor storage is better than under manufacturer storage because distributor warehouses are, on average, closer to customers, and the entire order is aggregated at the warehouse before being shipped. Amazon, for example, processes most warehouse-stored items within a day and then it takes three to five business days using ground transportation for the order to reach the customer. W.W. Grainger processes customer orders on the same day and has enough warehouses to deliver most orders the next day using ground transport. Warehouse storage limits to some extent the variety of products that can be offered. W.W. Grainger does not store very low-demand items at its warehouse, relying on manufacturers to drop-ship those products to the customer. Customer convenience is high with distributor storage because a single shipment reaches the customer in response to an order. Time to market under distributor storage is somewhat higher than under manufacturer storage because of the need to stock another stage in the supply chain. Order visibility becomes easier than with manufacturer storage because there is a single shipment from the warehouse to the customer and only one stage of the supply chain is involved directly in filling the customer order. Returnability is better than with manufacturer storage because all returns can be processed at the warehouse itself. The customer also has to return only one package, even if the items are from several manufacturers.

The performance of distributor storage with carrier delivery is summarized in Table 4-3. Distributor storage with carrier delivery is well suited for slow- to fast-moving items.

Warehouse Storage by Distributor/ Retailer

Factories

Customers

Product Flow Information Flow

FIGURE 4-8 Distributor Storage with Carrier Delivery

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(including transportation and processing) can be more than $20 per home delivery in the grocery industry. Last-mile delivery may be somewhat less expensive in large, dense cities. Transportation costs may also be justifiable for bulky products for which the customer is willing to pay for home delivery. Home delivery of water and large bags of rice has proved quite successful in China, where the high population density has helped decrease delivery costs. Transportation costs of last-mile delivery are best justified in settings where the customer is purchasing in large quantities. This is rare for individual customers, but businesses such as auto dealerships purchase large quantities of spare parts on a daily basis and can thus justify daily delivery. Home delivery to individual customers can be justified for bulky items such as five-gallon jugs of water in the United States and large bags of rice in China. In each instance, last-mile delivery is cheaper and more convenient than customers picking up their own bottles or bags.

Using this option, facility costs are somewhat lower than for a network with retail stores but much higher than for either manufacturer storage or distributor storage with package carrier delivery. Processing costs, however, are much higher than for a network of retail stores because all customer participation is eliminated. A grocery store using last-mile delivery performs all the processing until the product is delivered to the customer’s home, unlike a supermarket, where the customer does a lot more work.

The information infrastructure with last-mile delivery is similar to that for distributor storage with package carrier delivery. However, it requires the additional capability of scheduling deliveries.

Response times are faster than using package carriers. Kozmo and Urbanfetch tried to provide same-day delivery, whereas online grocers typically provide next-day delivery. Product variety is generally lower than for distributor storage with carrier delivery. The cost of providing product availability is higher than for every option other than retail stores. The customer experience can be good using this option, particularly for bulky, hard-to-carry items. Time to market is even higher than for distributor storage with package carrier delivery because the new product has to penetrate deeper before it is available to the customer. Order visibility is less of an issue given that deliveries are made within 24 hours. The order-tracking feature does become important to handle exceptions in case of incomplete or undelivered orders. Of all the options discussed, returnability is best with last-mile delivery, because trucks making deliveries can also pick up returns from customers. Returns are still more expensive to handle than at a retail store, where a customer can bring the product back.

The performance characteristics of distributor storage with last-mile delivery are summarized in Table 4-4. In areas with high labor costs, it is hard to justify last-mile delivery to individual consumers on the basis of efficiency or improved margin. It can be justified only if there is a large enough customer segment willing to pay for this convenience. In that case, an effort should be made to couple last-mile delivery with an existing distribution network to exploit economies of scale and improve utilization. An example is Albertsons’ use of existing grocery

Distributor/Retailer Warehouse

Factories

Customers

Product Flow Information Flow

FIGURE 4-9 Distributor Storage with Last-Mile Delivery

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manufacturers is cross-docked and sent to retail outlets on a daily basis. An online retailer delivering an order through Seven-Eleven can be treated as one of the manufacturers, with deliveries cross-docked and sent to the appropriate Seven-Eleven outlet. Serving as an outlet for online orders allows Seven-Eleven to improve utilization of its existing logistical assets.

Inventory costs using this approach can be kept low, with either manufacturer or distributor storage to exploit aggregation. W.W. Grainger keeps its inventory of fast-moving items at pickup locations, whereas slow-moving items are stocked at a central warehouse or in some cases at the manufacturer.

Transportation cost is lower than for any solution using package carriers because significant aggregation is possible when delivering orders to a pickup site. This allows the use of truckload or less-than-truckload carriers to transport orders to the pickup site. For a company such as Seven-Eleven Japan, the marginal increase in transportation cost is small because trucks are already making deliveries to the stores, and their utilization can be improved by including online orders. As a result, Seven-Eleven Japan allows customers to pick up orders without a shipping fee.

Facility costs are high if new pickup sites have to be built. A solution using existing sites can lower the additional facility costs. This, for example, is the case with 7dream.com, Wal-Mart, and W.W. Grainger, for which the stores already exist. Processing costs at the manufacturer or the warehouse are comparable to those of other solutions. Processing costs at the pickup site are high because each order must be matched with a specific customer when he or she arrives. Creating this capability can increase processing costs significantly if appropriate storage and information systems are not provided. Increased processing cost and potential errors at the pickup site are the biggest hurdle to the success of this approach.

A significant information infrastructure is needed to provide visibility of the order until the customer picks it up. Good coordination is needed among the retailer, the storage location, and the pickup location.

In this case, a response time comparable to that using package carriers can be achieved. Variety and availability comparable to any manufacturer or distributor storage option can be provided. There is some loss of customer experience, because unlike the other options discussed, customers must pick up their own orders. On the other hand, customers who do not want to pay online can pay by cash using this option. In countries like Japan, where Seven-Eleven has more than 10,000 outlets, it can be argued that the loss of customer convenience is small, because most customers are close to a pickup site and can collect an order at their convenience. In some cases, this option is considered more convenient because it does

Cross-Dock DC

Factories

Pickup Sites

Customers

Retailer

Product Flow Information Flow

Customer Flow

FIGURE 4-10 Manufacturer or Distributor Warehouse Storage with Consumer Pickup

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Chapter 4 ◆ Designing Distribution Networks and Applications to Omni-Channel Retailing 85

Examples of companies that offer multiple options of order placement include Home Depot and Tesco. In either case, customers can walk into the store or order online. A B2B example is W.W. Grainger: Customers can order online, by phone, or in person and pick up their order at one of W.W. Grainger’s retail outlets.

Local storage increases inventory costs because of the lack of aggregation. For fast- to very-fast-moving items, however, there is little increase in inventory, even with local storage. Home Depot uses local storage for its fast-moving products while delivering a wider variety of products from a regional location for pickup at the store. Similarly, W.W. Grainger keeps its inventory of fast-moving items at pickup locations, whereas slow-moving items are stocked at a central warehouse.

Cost Factor Performance

Inventory Can match any other option, depending on the location of inventory.

Transportation Lower than the use of package carriers, especially if using an existing delivery network.

Facilities and handling Facility costs can be high if new facilities have to be built. Costs are lower if existing facilities are used. The increase in handling cost at the pickup site can be significant.

Information Significant investment in infrastructure is required.

Service Factor Performance

Response time Similar to package carrier delivery with manufacturer or distributor storage. Same-day pickup is possible for items stored at regional DC.

Product variety Similar to other manufacturer or distributor storage options.

Product availability Similar to other manufacturer or distributor storage options.

Customer experience Lower than other options because of the lack of home delivery. Experience is sensitive to capability of pickup location.

Time to market Similar to other manufacturer or distributor storage options.

Order visibility Difficult but essential.

Returnability Somewhat easier, given that pickup location can handle returns.

TABLE 4-5 Performance Characteristics of Network with Customer Pickup Sites

DC

Factories

Retail Stores

Customers

Product Flow Information Flow

Customer Flow

Figure 4-11 Retail Storage with Customer Pickup

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These showrooms facilitate a face-to-face information exchange but do not carry inventory for customers to purchase. If a customer decides to make a purchase, the product is ordered online from the Bonobos website (or at the store). When using a showroom, product can either be picked up at the store or delivered at home. The showrooms carry no inventory for sale, thus significantly reducing inventory and the size of the store required. Relative to traditional retail, this channel saves on inventory and facilities infrastructure but requires a greater investment in transportation and information infrastructure, especially with home delivery.

ONLINE INFORMATION + HOME DELIVERY Amazon is an excellent example of this channel where customers browse for products and order online to have the purchases then delivered at home. Aggregation of inventories in a few locations allows the online channel to have a much lower investment in facilities and inventory compared to traditional retail. Transportation cost, however, tends to be high for home delivery.

ONLINE INFORMATION + PICKUP The high cost of home delivery for the online channel has led several players to offer the option of a pickup location at a lower price. The presence of a pickup location significantly reduces the outbound transportation cost incurred by the online retailer. It does require the customer to travel to the pickup location. A suitable choice of pickup location can lower this travel cost if customers can combine order pickup with other activities they naturally perform at the location. For example, Walmart allows a “free instore pickup” option where people can shop online and pick up the order at the store. This option clearly reduces Walmart’s transportation cost because online orders can be shipped to the store along with other products being shipped there. Such an option may also not add much to the transporta- tion cost for a customer if he or she is planning to shop at the Walmart store in any case. In the grocery industry in U.K., pickup locations now dominate as the channel for online grocery shop- ping. Grocery retailers such as Tesco and ASDA offer a low cost “click & collect” service where customers place their orders online and collect them at a pickup location.

Performance of Channels in Terms of Customer Service

As with distribution networks considered earlier, we start by studying how the various channels perform in terms of customer service elements such as response time, product variety, availabil- ity, customer experience, time to market, visibility, and returnability.

Traditional Retail

Showrooms + Home Delivery /

Pickup

Online Information

+ Pickup

Online Information

+ Home Delivery

Pickup Home Delivery

Product

Face-to-face

Remote

Information

Figure 4-12 Alternatives in Omni-Channel Retail

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