Designing the Distribution Network in a Supply ChainSunil ChopraKellogg School of Management, Northwestern University2001 Sheridan Road, Evanston, IL 60208, U.S.ATel: 1-847-491-8169; Fax: 1-847-467-1220; is paper describes a framework for designing the distribution network in a supply chain. Variousfactors influencing the choice of distribution network are described. We then discuss different choicesof distribution networks and their relative strengths and weaknesses. The paper concludes byidentifying distribution networks that are best suited for a variety of customer and productcharacteristics.0. IntroductionDistribution refers to the steps taken to move and store a product from the supplier stage to a customerstage in the supply chain. Distribution is a key driver of the overall profitability of a firm because itdirectly impacts both the supply chain cost and the customer experience. Good distribution can beused to achieve a variety of supply chain objectives ranging from low cost to high responsiveness. Asa result, companies in the same industry often select very different distribution networks.Dell distributes its PCs directly to end consumers, while companies like Hewlett Packard and Compaqdistribute through resellers [3]. Dell customers wait several days to get a PC while customers can walkaway with an HP or Compaq PC from a reseller. Gateway opened Gateway Country stores wherecustomers could check out the products and have sales people help them configure a PC that suitedtheir needs. Gateway, however, chose to sell no products at the stores, with all PCs shipped directly1

from the factory to the customer. In 2001, Gateway closed several of these stores given their poorfinancial performance. Apple Computers is planning to open retail stores where computers will be sold[4]. These PC companies have chosen three different distribution models. How can we evaluate thiswide range of distribution choices? Which ones serve the companies and their customers better?W.W. Grainger, an MRO distributor, stocks about 100,000 skus that can be sent to customers within aday of the order being placed. The remaining slower moving products are not stocked but shippeddirectly from the manufacturer when a customer places an order. It takes several days for the customerto receive the product in this case. Are these distribution choices appropriate? How can they bejustified? When should a distribution network include an additional stage such as a distributor?Proponents of e-business had predicted the death of intermediaries like distributors. Why were theyproved wrong in many industries?In this paper we provide a framework and identify key dimensions along which to evaluate theperformance of any distribution network.1. Factors Influencing Distribution Network DesignAt the highest level, performance of a distribution network should be evaluated along two dimensions:1. Customer needs that are met2. Cost of meeting customer needsThe customer needs that are met influence the company's revenues, which along with cost decide theprofitability of the delivery network.2

While customer service consists of many components, we will focus on those measures that areinfluenced by the structure of the distribution network. These include: Response time Product variety Product availability Customer experience Order visibility ReturnabilityResponse time is the time between when a customer places an order and receives delivery. Productvariety is the number of different products / configurations that a customer desires from thedistribution network. Availability is the probability of having a product in stock when a customerorder arrives. Customer experience includes the ease with which the customer can place and receivetheir order. Order visibility is the ability of the customer to track their order from placement todelivery. Returnability is the ease with which a customer can return unsatisfactory merchandise andthe 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 thesedimensions. In practice, however, this is not always the case. Customers ordering a book are willing to wait longer than those that drive to a nearby Borders store to get the samebook. On the other hand, customers can find a far larger variety of books at Amazon compared to theBorders store.3

Firms that target customers who can tolerate a large response time require few locations that may befar from the customer and can focus on increasing the capacity of each location. On the other hand,firms that target customers who value short response times need to locate close to them. These firmsmust have many facilities, with each location having a low capacity. Thus, a decrease in the responsetime customers desire increases the number of facilities required in the network, as shown in Figure4.1. For example, Borders provides its customers with books on the same day but requires about 400stores to achieve this goal for most of the United States. Amazon, on the other hand, takes about aweek to deliver a book to its customers, but only uses about 5 locations to store its Insert Figure 4.1 hanging the distribution network design affects the following supply chain costs: Inventories Transportation Facilities and handling InformationAs the number of facilities in a supply chain increases, the inventory and resulting inventory costs alsoincrease as shown in Figure 4.2. For example, Amazon with fewer facilities is able to turn itsinventory about twelve times a year, while Borders with about 400 facilities achieves only about twoturns per year. As long as inbound transportation economies of scale are maintained, increasing thenumber of facilities decreases total transportation cost, as shown in Figure 4.2. If the number offacilities is increased to a point where there is a significant loss of economies of scale in inboundtransportation, increasing the number of facilities increases total transportation cost. A distribution4

network with more than one warehouse allows to reduce transportation cost relative to anetwork with a single warehouse. Facility costs decrease as the number of facilities is reduced asshown in Figure 4.2, because a consolidation of facilities allows a firm to exploit economies of Insert Figure 4.2 Total logistics costs are the sum of inventory, transportation, and facility costs for a supply chainnetwork. As the number of facilities is increased, total logistics costs first decrease and then increaseas shown in Figure 4.3. Each firm should have at least the number of facilities that minimize totallogistics costs. As a firm wants to further reduce the response time to its customers, it may have toincrease the number of facilities beyond the point that minimizes logistics costs. A firm should addfacilities beyond the cost- minimizing point only if managers are confident that the increase inrevenues because of better responsiveness is greater than the increase in costs because of the ---------------Insert Figure 4.3 2. Design Options for a Distribution NetworkWe will discuss distribution network choices in the context of distribution from the manufacturer tothe end consumer. When considering distribution between any other pair of stages, such as supplier to5

manufacturer, many of the same options still apply. There are two key decisions when designing adistribution network:1. Will product be delivered to the customer location or picked up from a preordained site?2. Will product flow through an intermediary (or intermediate location)?Based on the choices for the two decisions, there are six distinct distribution network designs that areclassified as follows:1. Manufacturer storage with direct shipping2. Manufacturer storage with direct shipping and in-transit merge3. Distributor storage with package carrier delivery4. Distributor storage with last mile delivery5. Manufacturer / distributor storage with costumer pickup6. Retail storage with customer pickupWe now describe each distribution option and discuss its strengths and weaknesses.2.1 Manufacturer Storage with Direct ShippingIn this option, product is shipped directly from the manufacturer to the end customer, bypassing theretailer (who takes the order and initiates the delivery request). This option is also referred to as dropshipping. All inventories are stored at the manufacturer. Information flows from the customer, via theretailer, to the manufacturer, while product is shipped directly from the manufacturer to customers asshown in Figure 4.4. In some instances like Dell, the manufacturer sells directly to the customer.Online retailers such as eBags and use drop shipping to deliver goods to the endconsumer. eBags does not hold any inventory of bags and has them drop shipped directly from themanufacturer to the customer. Nordstrom carries some products in inventory while using the drop-ship6

model for slow moving footwear. W.W. Grainger also uses drop shipping to deliver slow movingitems that are not carried in ----Insert Figure 4.4 The biggest advantage of drop shipping is the ability to centralize inventories at the manufacturer. Amanufacturer can aggregate demand and provide a high level of product availability with lower levelsof inventory than individual retailers. The benefits from centralization are highest for high value, lowvolume items with unpredictable demand. The decision of Nordstrom to drop-ship low volume shoessatisfies these criteria. Similarly, bags sold by eBags tend to have high value and low relativelyvolume per sku. The inventory benefits of aggregation are small for items with predictable demandand low value [1]. Thus, drop shipping would not offer a significant inventory advantage to an onlinegrocer selling a staple item like detergent.Drop shipping also offers the manufacturer the opportunity to further lower inventories by postponingcustomization until after the customer order has been placed. Build-to-order companies such as Dellhold inventories as common components and postpone product customization, thus lowering the levelof inventories carried.Transportation costs are high with drop shipping because the average outbound distance to the endconsumer is large and package carriers must be used to ship the product. Package carriers have highshipping costs per unit compared to truckload(TL) or less-than-truckload (LTL) carriers. With dropshipping, a customer order with items from several manufacturers will involve multiple shipments tothe customer. This loss in aggregation in outbound transportation further increases cost.7

Supply chains save on the fixed cost of storage facilities when using drop shipping because allinventories are centralized at the manufacturer. There can be some savings of handling costs as wellbecause the transfer from manufacturer to retailer no longer occurs. Handling costs can besignificantly reduced if the manufacturer has the capability to ship orders directly from the productionline.A good information infrastructure is needed so that the retailer can provide product availabilityinformation to the customer even though the inventory is located at the manufacturer. The customershould also have visibility into order processing at the manufacturer even though the order is placedwith the retailer. Drop shipping will generally require significant investment in the informationinfrastructure. The information infrastructure requirement is somewhat simpler for direct sellers likeDell because two stages (retailer and manufacturer) do not need to be integrated.Response times tend to be large when drop shipping is used because the order has to be transmittedfrom the retailer to the manufacturer and shipping distances are on average longer from themanufacturer's centralized site. eBags, for example, states that order processing may take from 1-5days and ground transportation after that may take from 3-11 business days. This implies thatcustomer response time at eBags is 4-16 days using ground transportation and drop shipping. Anotherissue is that the response time need not be identical for every manufacturer that is part of a customerorder. Given an order containing products from several sources, the customer will receive multiplepartial shipments over time making receiving more complicated for the customer.Manufacturer storage with drop shipping allows a high level of product variety to be made available tothe customer. W.W. Grainger is able to offer hundreds of thousands of slow moving items from8

thousands of manufacturers using drop shipping. This would be impossible if each product had to bestored by Grainger.Drop shipping provides a good customer experience in the form of delivery to the customer location.The experience, however, suffers when a single order containing products from several manufacturersis delivered in partial shipments.Order visibility is very important in the context of manufacturer storage because two stages in thesupply chain are involved in every customer order. Order tracking, however, becomes harder toimplement in a situation of drop shipping because it requires complete integration of informationsystems at both the retailer as well as the manufacturer. For direct sellers such as Dell, order visibilityis simpler to provide.A manufacturer storage network is likely to have difficulty handling returns, hurting customersatisfaction. The handling of returns is more expensive under drop shipping because each order mayinvolve shipments from more than one manufacturer. There are two ways that returns can be handled.One is for the customer to return the product directly to the manufacturer. The second approach is forthe retailer to set up a separate facility (across all manufacturers) to handle returns. The first approachincurs high transportation and coordination cost while the second approach requires investment in afacility to handle returns.The performance characteristics of drop shipping along various dimensions are summarized in Table4.1.9

--------------------------------------------Insert Table 4.1 Given its performance characteristics, manufacturer storage with direct shipping is best suited for alarge variety of low demand, high value items where customers are willing to wait for delivery andaccept several partial shipments. Manufacturer storage is also suitable if it allows the manufacturer topostpone customization, thus reducing inventories. For drop-shipping to be effective, there should befew sourcing locations per order. It is thus ideal for direct sellers that are able to build-to-order. Dropshipping is hard to implement if there are more than 20-30 sourcing locations that have to ship directlyto customers on a regular basis. For products with very low demand, however, drop shipping may bethe only option.2.2 Manufacturer Storage With Direct Shipping and In-Transit MergeUnlike pure drop shipping where each product in the order is sent directly from each manufacturer tothe end customer, in-transit merge combines pieces of the order coming from different locations sothat the customer gets a single delivery. Information and product flows for the in-transit mergenetwork are as shown in Figure 4.5. When a customer orders a PC from Dell along with a Sonymonitor, the package carrier picks up the PC at the Dell factory, the monitor at the Sony factory andmerges the two together at a hub before making a single delivery to the ---Insert Figure 4.5 10

As with drop shipping, the ability to aggregate inventories and postpone product customization is asignificant advantage of in-transit merge. In-transit merge allows Dell and Sony to aggregate all theirinventories at the factory. This approach will have the greatest benefits for products with high valuewhose demand is hard to forecast, in particular if product customization can be postponed.In most cases, transportation costs are lower than drop shipping because of the merge that takes placeat the carrier hub prior to delivery to the customer. An order with products from three manufacturersthus requires only one delivery to the customer compared to three that would be required with dropshipping. Fewer deliveries save transportation cost and simplify receiving.Facility and processing costs for the manufacturer and the retailer are as in drop shipping. The partyperforming 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 chainfacility and handling costs are somewhat higher than drop shipping.A very sophisticated information infrastructure is needed to allow the in-transit merge. Besidesinformation, operations at the retailer, manufacturers, and the carrier must be coordinated. Theinvestment in information infrastructure will be higher than for drop shipping.Response times, product variety, and availability are similar to drop shipping. Response times may bemarginally higher because of the need to perform the merge. Customer experience is likely to be betterthan drop shipping because the customer receives only one delivery for their order instead of manypartial shipments. Order visibility is a very important requirement. While the initial setup is difficultbecause it requires integration of manufacturer, carrier, and retailer, tracking itself becomes easiergiven the merge that occurs at the carrier hub. Up to the point of merge, the order from each11

manufacturer is tracked separately. After that the order can be tracked as a single unit. Returnability issimilar to drop shipping. Problems in handling returns are very likely and the reverse supply chain willcontinue to be expensive and difficult to implement as with drop shipping.The performance of factory storage with in-transit merge is compared with drop shipping in Table sert Table 4.2 The main advantage of in-transit merge over drop shipping is the somewhat lower transportation costand improved customer experience. The major disadvantage is the additional effort during the mergeitself. Given its performance characteristics, manufacturer storage with in-transit merge is best suitedfor low to medium demand, high value items where the retailer is sourcing from a limited number ofmanufacturers. Compared to drop shipping, in-transit merge requires a higher volume from eachmanufacturer to be effective. If there are too many sources, in-transit merge can be very difficult tocoordinate and implement. In-transit merge is best implemented if there are no more than four or fivesourcing locations and each customer order has products from multiple locations. The in-transit mergeof a Dell PC with a Sony monitor is appropriate because product variety is high but there are fewsourcing locations with relatively large total volume from each sourcing location.2.3 Distributor Storage with Carrier DeliveryUnder this option, inventory is not held by manufacturers at the factories but is held by distributors /retailers in intermediate warehouses and package carriers are used to transport products from the12

intermediate location to the final customer. as well as industrial distributors like W.W.Grainger use this approach combined with drop shipping from a manufacturer. Information andproduct flows when using distributor storage with delivery by a package carrier are shown in ----Insert Figure 4.6 Relative to manufacturer storage, distributor storage will require a higher level of inventory becausethe distributor / retailer warehouse aggregates demand uncertainty to a lower level than themanufacturer. From an inventory perspective, distributor storage makes sense for products withsomewhat higher demand. Both Amazon and Grainger only stock the medium to fast moving items attheir warehouse with slower moving items stocked further upstream. In some instances, postponementcan be implemented with distributor storage but it does require that the warehouse develop someassembly capability. Distributor storage, however, requires much less inventory than a retail network.Amazon achieves about 12 turns of inventory using warehouse storage while Borders achieves about 2turns using retail stores.Transportation costs are somewhat lower for distributor storage compared to manufacturer storagebecause an economic mode of transportation (e.g. truckload) can be employed for inbound shipmentsto the warehouse, which is closer to the customer. Unlike manufacturer storage where multipleshipments may need to go out for a single customer order with multiple items, distributor storageallows outbound orders to the customer to be bundled into a single shipment further reducingtransportation cost. Transportation savings from distributor storage relative to manufacturer storageincrease for faster moving items.13

Compared to manufacturer storage, facility costs are somewhat higher with distributor storage becauseof a loss of aggregation. Processing and handling costs are comparable to manufacturer storage unlessthe factory is able to ship to the end customer directly from the production line. In that case, distributorstorage will have higher processing costs. From a facility cost perspective, distributor storage is notappropriate for extremely slow moving items.The information infrastructure needed with distributor storage is significantly less complex than thatneeded with manufacturer storage. The distributor warehouse serves as a buffer between the customerand the manufacturer, decreasing the need to coordinate the two completely. Real time visibilitybetween customers and the warehouse is needed, whereas real time visibility between the customerand the manufacturer is not. Visibility between the distributor warehouse and manufacturer can beachieved at a much lower cost than real time visibility between the customer and manufacturer.Response time with distributor storage is better than with manufacturer storage because distributorwarehouses are, on average, closer to customers and the entire order is aggregated at the warehousewhen shipped. Amazon, for example, processes all warehouse-stored items within a day and it thentakes 3-7 business days using ground transportation for the order to reach the customer. Graingerprocesses customer orders on the same day and has enough warehouses to deliver most orders nextday using ground transport. Warehouse storage will limit to some extent the variety of products thatcan be offered. Grainger does not store very low volume items at its warehouse, relying onmanufacturers to drop ship those products to the customer. Customer convenience is high withdistributor storage because a single shipment reaches the customer in response to an order. Ordervisibility becomes easier than with manufacturer storage because there is a single shipment from thewarehouse to the customer and only one stage of the supply chain is directly involved in filling the14

customer order. Returnability is better than with manufacturer storage because all returns can beprocessed at the warehouse itself. The customer also has to return only one package even if the itemsare from several manufacturers.The performance of distributor storage with carrier delivery is summarized in Table sert Table 4.3 Distributor storage with carrier delivery is well suited for medium to fast moving items. Distributorstorage also makes sense when customers want delivery faster than offered by manufacturer storagebut do not need it immediately. Distributor storage can handle somewhat lower variety thanmanufacturer storage but can handle a much higher level of variety than a chain of retail stores.2.4 Distributor Storage with Last Mile DeliveryLast mile delivery refers to the distributor / retailer delivering the product to the customer's homeinstead of using a package carrier. Webvan, Peapod, and Alberston's have used last mile delivery inthe grocery industry. Unlike package carrier delivery, last mile delivery requires the distributorwarehouse to be much closer to the customer, increasing the number of warehouses required. Thewarehouse storage with last mile delivery network is as shown in Figure sert Figure 4.7 5

Distributor storage with last mile delivery requires higher levels of inventory than all options otherthan retail stores, because it has a lower level of aggregation. From an inventory perspective,warehouse storage with last mile delivery is suitable for relatively fast moving items wheredisaggregation does not lead to a significant increase of inventory. Staple items in the grocery industryfit this description.Transportation costs are highest using last mile delivery. This is because package carriers aggregatedelivery across many retailers and are able to obtain better economies of scale than available to adistributor / retailer attempting last mile delivery. Delivery costs (including picking and transportation)can be as high as 30- 40 per home delivery in the grocery industry. Last mile delivery may besomewhat cheaper in dense cities. Transportation costs may also be justifiable for bulky productswhere the customer is willing to pay for home delivery. Home delivery for water and large bags of ricehas proved quite successful in China, where the high population density has helped decrease deliverycosts.Facility and processing costs are very high using this option given the large number of facilitiesrequired. Facility costs are somewhat lower than a network with retail stores but much higher thaneither manufacturer storage or distributor storage with package carrier delivery. Processing costs,however, are much higher than a network of retail stores because all customer participation iseliminated. A grocery store doing last mile delivery, performs all the processing until the product isdelivered to the customer's home unlike a supermarket where there is much more customerparticipation.The information infrastructure with last mile delivery is similar to distributor storage with packagecarrier delivery. It requires, however, the additional capability of scheduling deliveries.16

Response times are faster than the use of package carriers. Product variety is generally lower thandistributor storage with carrier delivery. The cost of providing product availability is higher than everyoption other than retail stores. The customer experience is very good using this option, particularly forbulky, hard to carry items. Order visibility is less of an issue given that deliveries are made within 24hours. The order-tracking feature does become important to handle exceptions in case of incomplete orundelivered orders. Of all the options discussed, returnability is best with last mile delivery becausetrucks making deliveries can also pick up returns from customers. Returns are more expensive tohandle 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 ---Insert Table 4.4 In areas with high labor cost, it is very hard to justify distributor storage with last mile delivery on thebasis of efficiency or improved margin. It can only be justified if there is a large enough customersegment willing to pay for this convenience. In that case, an effort should be made to couple last miledelivery with an existing network to exploit economies of scale and improve utilization. An example isAlbertson's use of existing grocery store facilities and labor to provide home delivery. A portion of thegrocery store serves as a fulfillment center for online orders as well as a replenishment center for thegrocery store itself. This helps improve utilization and lower the cost of providing this service. Lastmile delivery may be justifiable if customer orders are large enough and customers are willing to pay17

for this service. All home delivery companies like Peapod now charge for this service even for verylarge order sizes.2.5 Manufacturer or Distributor Storage with Consumer PickupIn this approach, inventory is stored at the manufacturer or distributor warehouse but customers placetheir orders online or on the phone and then come to designate pickup points to collect their orders.Orders are shipped from the storage site to the pickup points as needed. Examples include 7dream.comoperated by 7 Eleven Japan, which allows customers to pick up online orders at a designated store [2].A B2B example is W. W. Grainger where customers can pick up their order at one of the Graingerretail outlets [1]. In the case of, the order is delivered from a manufacturer or distributorwarehouse to the pickup location. In the case of Grainger, some items are stored at the pickup locationwhile others may come from a central location. The information and

Dec 04, 2001 · identifying distribution networks that are best suited for a variety of customer and product characteristics. 0. Introduction Distribution refers to the steps taken to move and store a product from the supplier stage to a customer stage in the supply chain. Distribution is a key