POV - What is an Optimal Distribution Network Strategy

What Is An Optimal Network Strategy?

A Point of View

By Tom Tiede and Kay Ree Lee


A Point of View 1 By Tom Tiede and Kay Ree Lee

Introduction

The questions “How many distribution centers should we have?” and “Where should the distribution centers be?” are undoubtedly some of the more complex business problems that corporations face, especially when confronted with the need to reduce costs while maintaining or increasing service levels to end customers. In addition to a cost vs. service tradeoff analysis often performed in answering these questions, logistics managers must also consider a number of other factors that may play an equally important role in the final network design. Infrequently is a network strategy derived from a mathematical equation. Instead, traditional optimization analysis serves as only the beginning of a series of compromise decisions that must be made to ultimately determine the “optimal” network strategy for an organization. This article will attempt to identify a short list of traditional and other decision variables corporations should address in designing a flexible, cost-effective, and implementable distribution network strategy. Cost

The need to evaluate all costs incurred as a result of redesigning a distribution network is in itself a challenge. However, without proper identification of all associated costs, it will be difficult to identify provable savings. Some common, traditional cost factors include:

• Distribution center – size, equipment, lease vs. own, lease termination • Transportation - mode, service level, distance, load factors • Inventory - cycle stock, safety stock, in-transit, ramp-up

• Moving costs - material and equipment transfer • People – labor rates, severance pay, relocation costs • Systems – warehouse management, transportation management, interfaces

Accurately identifying all costs is important in forming a solid baseline from which to compare alternative network scenarios. But, it is by no means an end in itself. The final design will be derived through as much art as science by evaluating alternatives and reaching consensus among stakeholders on a number of tradeoff decisions, both quantitative and qualitative in nature. Nonetheless, building an effective network strategy begins with a thorough understanding and evaluation of costs. Tax

In addition to traditional cost factors, corporations should consider tax implications in the network design. For corporation’s that ship products from one state to another, income must be allocated to the state to which to the product is shipped (i.e. the destination rule). On occasion, the destination state does not levy an income tax because that state does not have a corporate income tax or the corporation does not have a sufficient level of payroll or assets in that state (also known as nexus). This results in “nowhere income” – sales that are not taxable in destination states. This does not necessarily mean that this income goes untaxed – it’s not that simple! Many states have a throwback rule that results in “nowhere income” being passed back to the state of origin for tax purposes. So, how does this tax scenario play into distribution network design? The following is an example. Acme Corporation has 3 distribution centers located in CA, GA and IL. These are the only states in which Acme has nexus. All centers ship products to other states around the country as illustrated by the map below. In addition, all 3 states have a corporate income tax, and CA and IL both



employ the throwback rule. What would happen if Acme decides to close facilities in IL and CA and open a facility in NV, which does not have a corporate income tax?

In the example, demand fulfilled from facilities in GA and NV will lower the overall tax burden for Acme Corporation. Throwback rules on “nowhere income” are avoided. And, the NV facility avoids all corporate income tax on product distribution. But, is this the optimal strategy? Perhaps not; other factors, such as the impact on service, certainly need to be evaluated. Here are a few questions to consider in designing a tax efficient distribution network:

• In what states do you have nexus?

• Can you effectively move payroll and assets elsewhere to change nexus status? • In what states are you the most vulnerable to taxation? • What are the service requirements to customers in these states? • Distribution from what other states could service these requirements? • What are the tax laws in each of these alternative states of distribution? • In these states, what bills are being considered that may alter current tax laws? • Can you shift distribution of higher profit products to a facility in a lower tax state? • Does the benefit of relocating to a less tax-burdensome state outweigh the associated costs

and impact on service?

Service Level

Generally, there is a cost-service tradeoff between providing exceptional service to customers and the costs associated with that service. But, improving service does not always mean increasing costs. For example, opening an additional distribution center to improve service in a particular region of the country may yield freight, tax or other savings that offset or surpass the additional cost for warehousing. Service requirements can be met from an array of alternative network designs. The illustrative example matrix below is an effective way of visualizing the cost-service tradeoff associated with different what-if scenarios. It depicts the sum of costs of each alternative vs. the service level provided by the overall network.

WA

OR

MT ND

MN

WI

NV

IDSD

UT

AZ

NM

TX

OK

CO

WY

MI

LA FL

AR

MS

IA

IN

AL

SC

NC

NE

KS MO

TN

KY

OH

WV

ME

MARICT

VTNH

NY

NJPADE

VA

MDDCCA

GA

IL

WA

OR

MT ND

MN

WI

CA

IDSD

UT

AZ

NM

TX

OK

CO

WY

MI

LA FL

AR

MS

IL

IA

IN

AL

SC

NC

NE

KS MO

TN

KY

OH

WV

ME

MARICT

VTNH

NY

NJPADE

VA

MDDCNV

GA



An optimal network design requires a clear definition of service expectations. Once defined, they become a “stake in the ground” from which further analysis can be performed and decisions made. Using the example, both “2 Facility” alternatives may be quickly eliminated from further consideration if service expectations require a capability on the left side of the matrix.

Other Decision Variables

In addition to cost, taxes, and service level, other, less quantifiable decision variables play an equally important role in the design of a network strategy. Among them include:

• Growth Plans • Acquisition Plans • Local Government Incentives

• Availability of Warehousing • Local Labor Pool • Access to Carriers • Proximity to Strategic Customers • Bandwidth for Change • Executive Preference

Growth Plans – Are you designing for the past or the future? How far into the future? Traditional network modeling is dependent on historical data - primarily sales order history and freight history. After much effort to collect, cleanse, organize, and analyze historical data, a skilled modeler with a capable optimization tool can design the ideal network for yesterday’s needs. But, how well does the past represent the future? The optimal network strategy must focus on future needs, not the past. The network design must support planned growth, generally for the next 5 to 7 years. In simple terms, distribution facilities must be positioned to accommodate new customers and new service requirements in each geographic market, and each facility must have the flexibility to accommodate this growth. This may require locating facilities in areas other than what might be suggested by a centroid analysis and sizing them such that increased storage and throughout volume can be accommodated via expansion or other means. This may also mean equipping facilities with far less steel and automation than ideal for past needs. Acquisition Plans – Acquisitions are often a major part of an organization’s growth strategy. Rarely does an acquisition fail to create a need to re-align the distribution network. Redundant geographic

High

Low

High

LowCustomer Servicee

To

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ax

es

LegendA: Atlanta, GAC: Chicago, ILO: Oakland, CAS: Sparks, NVR: Richmond, VA

A, S

A, C, O

R, S

R, C, S

R, C, O

A, C, S

3 Facility Alternatives


Cost vs. Service Tradeoff Matrix (Illustrative)

High

Low

High

LowCustomer Servicee

To

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LegendA: Atlanta, GAC: Chicago, ILO: Oakland, CAS: Sparks, NVR: Richmond, VA

A, S

A, C, O

R, S

R, C, S

R, C, O

A, C, S



Cost vs. Service Tradeoff Matrix (Illustrative)



coverage, undersized facilities, and unrealized transportation synergies are a few reasons why. Further, the facility network of the acquired company may provide a better foundation for the combined distribution needs of the merged companies, essentially antiquating your existing network. Therefore, long term financial commitments in buildings and equipment should be considered carefully to limit risk. With an uncertain future, flexibility is key. Shorter term facility leases, contract warehousing, transferable equipment, expansion rights, etc. are a few means of creating flexibility and mitigating risk in the design and implementation of a distribution network. Local Government Incentives – Facilities are expensive. And, it’s just not the space. Local property and payroll taxes, for example, can make up a sizeable proportion of year-end costs. Incentives on both a state and local level can easily sway the decision on where to locate a facility. More often than not, engaging a state agency responsible for business development and local Chambers of Commerce in the facility search is worth the time. Alternatively, a knowledgeable broker can save time and is generally worth the incremental investment necessary to identify facilities in areas with the most advantageous incentives. Availability of Warehousing – Your network optimization model may suggest facility location within a 100 mile radius. Your best customer may suggest facility location within a 10 minute drive. Both may be excellent suggestions. But, if facilities are unavailable, don’t meet your specific needs, or are simply too costly to build or lease within the “suggested” area, a trade-off decision must be made between cost and service distance. This may mean choosing to distribute from a less costly, available facility in a good but not ideal area from which to serve your customers. Local Labor Pool – A great deal on a great building has little value without skilled, dedicated people to work in it. Stability, skill, dedication, and motivation form the foundation for distribution excellence. Struggling to find, recruit, and retain quality individuals with these attributes form the foundation for distribution mediocrity. With a poor foundation, customer goodwill will erode over time, costing an organization far more in lost profit than the savings differential of a facility in labor-poor market. Unless you plan a “lights out” facility, a compromise may be needed to locate in a market with a stronger labor pool. Access to Carriers – It’s 5 p.m., and you just received 10 new orders to 6 destinations that will fill 3 trucks. This is in addition to the 12 trucks you’ve already planned, and all of your orders need to be delivered tomorrow. It’s typical day, only each destination is different than yesterday’s orders The only way to get it done is to rely on a small pool of “go-to” carriers willing to take your loads; or better yet, have a dedicated carrier with the flexibility to take all of them. Accessibility to such carriers is a more detailed layer of analysis not typically encompassed within network optimization modeling. But, it’s a hugely important consideration for businesses with tight turnaround times between order cut-off and order delivery. Proximity to Strategic Customers – Let’s face it; some customers are more important than others. They need a higher degree of service. Often, this means locating a facility within close distance to a customer for next day or same day service. Traditional optimization analysis has difficulty weighing customer importance when modeling a network. Judgment, rather than math, is generally a better barometer in aligning the distribution network to serve strategic customers. Bandwidth for Change – A “green field” network optimization study can be very enlightening, often suggesting large savings from a distribution network design far different than the one in existence. But, can the organization handle monumental change? Implementing a network redesign can be a



“bet the business” proposition - the bigger the change, the higher the bet. To be successful in a complete redesign requires a bit of a “gambler’s streak” among executive leadership for authorization and a full commitment of dedicated resources who will tightly control implementation. This is a rare combination. More often than not, compromises are made to control risk and manage resource constraints. Compromise, resulting in incremental changes over time rather than a complete one-time overhaul, may indeed be the more optimal strategy for an organization. Executive Preference – After due diligence in overlaying judgment on top of the math in designing a network strategy, final decisions may reside higher up within the organization. And, these decisions almost always reflect the preferences of the individuals making them. “Bet the business” decisions can also be “bet the career” decisions. Therefore, they tend to bias toward changes that offer lower overall risk to the business. What is Optimal?

Designing an optimal network strategy is a delicate combination of science, art, and compromise. There are numerous factors to consider in approaching the problem. The process is usually focused on evaluating the tradeoff between total logistics cost and service level capabilities offered among alternative network scenarios. Of course, this limited focus is short-sighted. Tax considerations, as an example, are often neglected. Yet, potential tax savings for many organizations may easily exceed logistics costs. But even if taxes are included within the analysis, there is still a lot more work to do in designing the “optimal” network. A number of non-trivial, less quantifiable factors must be considered. Among them include: planned growth and acquisitions; availability of labor, warehousing, and carriers; and, organizational appetite for change and risk. The optimal design will result from careful evaluation of these and other variables tightly linked to the overall business strategy of the organization. As mentioned, redesigning a distribution network can be a “bet the business” endeavor due to its critical link to your customers and the vast investment required, both financially and in the time commitment of your most qualified individuals. It’s certainly non-trivial nor inexpensive. Yet, it cannot be ignored. Periodic redesign of the network strategy is vital to the ongoing success of almost every business that distributes products. So, what is “optimal?” Ultimately, it’s a commitment among key stakeholders to move forward with a network strategy that balances the broad and future needs of the business. It goes beyond cost vs. service. It goes beyond algorithmic analysis. Ideally, it’s a cost-effective, service-friendly, and implementable plan that minimizes tax burden, accommodates growth, allows flexibility, and mitigates risk. Of course, an “ideal” plan is an elusive target. Service and business requirements will continue to change over time, making it nearly impossible to implement the “ideal” plan. Therefore, “optimal” may never be “ideal.” But, “optimal” is certainly forward looking, broad in view, practical, balanced, and implementable. And, “optimal” has the steadfast commitment across a broad array of stakeholders to an agreed strategy. It may not be mathematical. It may not be easy. But, that is an “optimal” network strategy.

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POV - What is an Optimal Distribution Network Strategy