Physical distribution management by Geoff Lancaster©

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1 Introduction

An earlier resource pack described the decisions that must be taken when a company organises a channel or network of intermediaries who take responsibility for the management of goods as they move from the producer to the consumer. Each channel member must be carefully selected and the company must decide what type of relationship it seeks with each of its intermediate partners. Having established such a network, the organisation must next consider how these goods can be efficiently transferred, in the physical sense, from the place of manufacture to the place of consumption.

Physical distribution management (PDM) is concerned with ensuring the product is in the right place at the right time.

‘Place’ has always been thought of as being the least dynamic of the ‘4Ps’. Marketing practitioners and academics have tended to concentrate on the more conspicuous aspects of marketing. It is now recognised that PDM is a critical area of overall marketing management. Much of its expertise is ‘borrowed’ from military practice. During the Second World War and the Korean and Vietnam wars, supplies officers had to perform extraordinary feats of PDM, in terms of food, clothing, ammunition, weapons and a whole range of support equipment having to be transported across the world. The military skill that marketing has adopted and applied to PDM is that of logistics. Marketing management realised that distribution could be organised in a scientific way so the concept of business logistics developed, focusing attention on and increasing the importance of PDM.

As marketing analysis became increasingly sophisticated, managers became more aware of the costs of physical distribution. Whilst the military must win battles, the primary aim of business is to provide customer satisfaction in a manner that results in profit for the company. Business logistical techniques can be applied to PDM so that costs and customer satisfaction are optimised. There is little point in making large savings in the cost of distribution if, in the long run, sales are lost because of customer dissatisfaction. Similarly, it does not make economic sense to provide a level of service that is not really required by the customer and leads to an erosion of profits. This cost/service balance is a basic dilemma that faces physical distribution managers.

A final reason for the growing importance of PDM as a marketing function is the increasingly demanding nature of the business environment. In the past it was not uncommon for companies to hold large inventories of raw materials and components. Although industries and individual firms differ widely in their stockholding policies, nowadays, stock levels are kept to a minimum wherever possible. Holding stock is wasting working capital for it is not earning money for the company. A more financially analytical approach by management has combined to move the responsibility for carrying stock onto the supplier and away from the customer. Gilbert and Strebel (1989) pointed out that this has a ‘domino’ effect throughout the marketing channel, with each member putting pressure on the next to provide higher levels of service.

Logistical issues facing physical distribution managers today is the increasing application by customers of just-in-time management techniques or lean manufacturing. This topic was discussed in Chapter 4, but it is re-emphasised here. Hutchins (1988) stresses that companies who demand ‘JIT’ service from their suppliers carry only a few hours’ stock of material and components and rely totally on supplier service to keep their production running. This demanding distribution system is supported by company expediters whose task it is to ‘chase’ the progress of orders and deliveries, not only with immediate suppliers, but right along the chain of supply (called ‘supply chain integration’). Lean manufacturing has been widely adopted throughout the automotive industry where companies possess the necessary purchasing power to impose such delivery conditions on their suppliers. Their large purchasing power also necessitates stringent financial controls, and huge financial savings can be made in the reduction or even elimination of stockholding costs where this method of manufacturing is employed.

To think of the logistical process merely in terms of transportation is much too narrow a view. Physical distribution management (PDM) is concerned with the flow of goods from the receipt of an order until the goods are delivered to the customer. In addition to transportation, PDM involves close liaison with production planning, purchasing, order processing, material control and warehousing. All these areas must be managed so that they interact efficiently with each other to provide the level of service that the customer demands and at a cost that the company can afford.

2 Definitions

This material considers the four principal components of PDM:

  1. Order processing;
  2. Stock levels or inventory;
  3. Warehousing;
  4. Transportation.

PDM is concerned with ensuring that the individual efforts that go to make up the distributive function, are optimised so that a common objective is realised. This is called the ‘systems approach’ to distribution management and a major feature of PDM is that these functions be integrated.

Because PDM has a well-defined scientific basis, this chapter presents some of the analytical methods which management uses to assist in the development of an efficient logistics system. There are two central themes that should be taken into account:

  1. The success of an efficient distribution system relies on integration of effort. An overall service objective can be achieved, even though it may appear that some individual components of the system are not performing at maximum efficiency.
  2. It is never possible to provide maximum service at a minimum cost. The higher the level of service required by the customer, the higher the cost. Having decided on the necessary level of service, a company must then consider ways of minimising costs, which should never be at the expense of, or result in, a reduction of the predetermined service level.

3 The distribution process

The distribution process begins when a supplier receives an order from a customer. The customer is not too concerned with the design of the supplier’s distributive system, nor in any supply problems. In practical terms, the customer is only concerned with the efficiency of the supplier’s distribution. That is, the likelihood of receiving goods at the time requested. Lead-time is the period of time that elapses between the placing of an order and receipt of the goods. This can vary according to the type of product and the type of market and industry being considered. Lead-time in the shipbuilding industry can be measured in fractions or multiples of years, whilst in the retail sector, days and hours are common measures. Customers make production plans based on the lead-time agreed when the order was placed. Customers now expect that the quotation will be adhered to and a late delivery is no longer acceptable in most purchasing situations.

3.1 Order processing

Order processing is the first of the four stages in the logistical process. The efficiency of order processing has a direct effect on lead times. Orders are received from the sales team through the sales department. Many companies establish regular supply routes that remain relatively stable over a period of time providing that the supplier performs satisfactorily. Very often contracts are drawn up and repeat orders (forming part of the initial contract) are made at regular intervals during the contract period. Taken to its logical conclusion this effectively does away with ordering and leads to what is called ‘partnership sourcing’. This is an agreement between the buyer and seller to supply a particular product or commodity as an when required without the necessity of negotiating a new contract every time an order is placed.

Order-processing systems should function quickly and accurately. Other departments in the company need to know as quickly as possible that an order has been placed and the customer must have rapid confirmation of the order’s receipt and the precise delivery time. Even before products are manufactured and sold the level of office efficiency is a major contributor to a company’s image. Incorrect ‘paperwork’ and slow reactions by the sales office are often an unrecognised source of ill-will between buyers and sellers. When buyers review their suppliers, efficiency of order processing is an important factor in their evaluation.

A good computer system for order processing allows stock levels and delivery schedules to be automatically updated so management can rapidly obtain an accurate view of the sales position. Accuracy is an important objective of order processing as are procedures that are designed to shorten the order processing cycle.

3.2 Inventory

Inventory, or stock management, is a critical area of PDM because stock levels have a direct effect on levels of service and customer satisfaction. The optimum stock level is a function of the type of market in which the company operates. Few companies can say that they never run out of stock, but if stock-outs happen regularly then market share will be lost to more efficient competitors. Techniques for determining optimum stock levels are illustrated later in this chapter. The key lies in ascertaining the re-order point. Carrying stock at levels below the re-order point might ultimately mean a stock-out, whereas too high stock levels are unnecessary and expensive to maintain. The stock/cost dilemma is clearly illustrated by the systems approach to PDM that is dealt with later.

Stocks represent opportunity costs that occur because of constant competition for the company’s limited resources. If the company’s marketing strategy requires that high stock levels be maintained, this should be justified by a profit contribution that will exceed the extra stock carrying costs. Sometimes a company may be obliged to support high stock levels because the lead-times prevalent in a given market are particularly short. In such a case, the company must seek to reduce costs in other areas of the PDM ‘mix’.

3.3 Warehousing

American marketing texts tend to pay more attention to warehousing than do British texts. This is mainly because of the relatively longer distances involved in distributing in the USA, where it can sometimes take days to reach customers by the most efficient road or rail routes. The logistics of warehousing can, therefore, be correspondingly more complicated in the USA than in the UK. However, the principles remain the same, and indeed the European Union should be viewed as a large ‘home market’. Currently, many companies function adequately with their own on-site warehouses from where goods are despatched direct to customers. When a firm markets goods that are ordered regularly, but in small quantities, it becomes more logical to locate warehouses strategically around the country. Transportation can be carried out in bulk from the place of manufacture to respective warehouses where stocks wait ready for further distribution to the customers. This system is used by large retail chains, except that the warehouses and transportation are owned and operated for them by logistics experts (e.g. BOC Distribution, Excel Logistics and Rowntree Distribution). Levels of service will of course increase when numbers of warehouse locations increase, but cost will increase accordingly. Again, an optimum strategy must be established that reflects the desired level of service.

To summarise, factors that must be considered in the warehouse equation are:

  • Location of customers;
  • Size of orders;
  • Frequency of deliveries;
  • Lead times.

3.4 Transportation

Transportation usually represents the greatest distribution cost. It is usually easy to calculate because it can be related directly to weight or numbers of units. Costs must be carefully controlled through the mode of transport selected amongst alternatives, and these must be constantly reviewed. During the past 50 years, road transport has become the dominant transportation mode in the UK. It has the advantage of speed coupled with door-to-door delivery.

The patterns of retailing that have developed, and the pressure caused by low stock holding and short lead times, have made road transport indispensable. When the volume of goods being transported reaches a certain level some companies purchase their own vehicles, rather than use the services of haulage contractors. However, some large retail chains like Marks and Spencer, Tesco and Sainsbury’s have now entrusted all their warehousing and transport to specialist logistics companies as mentioned earlier.

For some types of goods, transport by rail still has advantages. When lead-time is a less critical element of marketing effort, or when lowering transport costs is a major objective, this mode of transport becomes viable. Similarly, when goods are hazardous or bulky in relation to value, and produced in large volumes then rail transport is advantageous. Rail transport is also suitable for light goods that require speedy delivery (e.g. letter and parcel post).

Except where goods are highly perishable or valuable in relation to their weight, air transport is not usually an attractive transport alternative for distribution within the UK where distances are relatively short in aviation terms. For long-distance overseas routes it is popular. Here, it has the advantage of quick delivery compared to sea transport, and without the cost of bulky and expensive packaging needed for sea transportation, as well as higher insurance costs.

Exporting poses particular transportation problems and challenges. The need for the exporter’s services needs to be such that the customer is scarcely aware that the goods purchased have been imported. Therefore, above all, export transportation must be reliable.

The development of roll-on roll-off (RORO) cargo ferries has greatly assisted UK exporters who distinguish between European and Near-European markets that can usually be served by road, once the North Sea has been crossed. ‘Deep sea markets’, such as the Far East, Australasia and America, are still served by traditional ocean-going freighters, and the widespread introduction of containerisation in the 1970s made this medium more efficient.

The chosen transportation mode should adequately protect goods from damage in transit (a factor just mentioned makes air freight popular over longer routes as less packaging is needed than for long sea voyages). Not only do damaged goods erode profits, but frequent claims increase insurance premiums and inconvenience customers, endangering future business.

4 The systems or ‘total’ approach to PDM

One of the central themes of this text has been to highlight the need to integrate marketing activities so they combine into a single marketing effort. Because PDM has been neglected in the past, this function has been late in adopting an integrated approach towards it activities. Managers have now become more conscious of the potential of PDM, and recognise that logistical systems should be designed with the total function in mind. A fragmented or disjointed approach to PDM is a principal cause of failure to provide satisfactory service, and causes excessive costs.

Within any PDM structure there is potential for conflict. Individual managers striving to achieve their personal goals can frustrate overall PDM objectives. Sales and marketing management will favour high stock levels, special products and short production runs coupled with frequent deliveries. Against this, the transport manager attempts to reduce costs by selecting more economical, but slower transportation methods, or by waiting until a load is full before making a delivery. Financial management will exercise pressure to reduce inventory wherever possible and discourage extended warehousing networks. Production managers will favour long production runs and standard products. It is possible for all these management areas to ‘appear’ efficient if they succeed in realising their individual objectives, but this might well be at the cost of the chosen marketing strategy not being implemented effectively.

Burbridge (1987) has provided guidelines to how levels of service to customers can be provided at optimal cost. Senior management must communicate overall distribution objectives to all company management and ensure that they are understood. Ideally, the systems approach to PDM should encompass production and production planning, purchasing and sales forecasting. Included in the systems approach is the concept of total cost, because individual costs are less important than the total cost. The cost of holding high stocks may appear unreasonable, but if high stocks provide a service that leads to higher sales and profits, then the total cost of all the PDM activities will have been effective. Costs are a reflection of distribution strategy, and maximum service cannot be provided at minimum cost.

PDM as a cost centre is worth extensive analysis as this function is now recognised as a valuable marketing tool in its own right. In homogeneous product markets, where differences in competitive prices may be negligible, service is often the major competitive weapon. Indeed, many buyers pay a premium for products that are consistently delivered on time. Similarly, the salesperson whose company provides a comprehensive spare parts and service facility, has a valuable negotiating tool when discussing prices.

Distribution is not, therefore, an adjunct to marketing; it has a full place in the marketing mix and can be an essential component of marketing strategy. In terms of marketing planning, a well-organised business logistics system can help to identify opportunities as well as supplying quantitative data that can be used to optimise the marketing mix as a whole.

5 Monitoring and control of PDM

The objective of PDM is: Getting the right goods to the right place at the right time for the least cost’.

The objective seems reasonable, although it gives little guidance on specific measures of operational effectiveness. Management needs objectives or criteria that, in turn, allow meaningful evaluation of performance. This is the basis of monitoring and control.

5.1 Basic output of physical distribution systems

The output from any system of physical distribution is the level of customer service. This is a key competitive benefit that companies can offer existing and potential customers to retain or attract business. From a policy point of view, the desired level of service should be at least equivalent to that of major competitors.

The level of service is often viewed as the time it takes to deliver an order to a customer or the percentage of orders that can be met from stock. Other service elements include technical assistance, training and after-sales services. The two most important service elements to the majority of firms are:

  1. Delivery - reliability and frequency;
  2. Stock availability - the ability to meet orders quickly.

To use a simple example, a company’s service policy may be to deliver 40 per cent of all orders within seven days from receipt of order. This is an operationally useful and specific service objective that provides a strict criterion for evaluation. A simple delivery delay analysis (see Figure 1) will inform management whether such objectives are being achieved or whether corrective action is necessary to alter the actual service level in line with stated objectives. Such an analysis can be updated on receipt of a copy of the despatch note. Management can be provided with a summary, in the form of a management report, from which they can judge whether corrective action is necessary. There can, of course, be over-provision of service, as well as under provision.

Delivery date Number of orders Percentage of total orders
     
As promised 186 37.2
Days late    
1 71 14.2
2 49 9.8
3 35 7.0
4 38 7.6
5 28 5.6
6 14 2.8
7 13 2.6
8 10 2.0
9 8 1.6
10-14 17 3.4
15-21 15 3.0
22-28 10 2.0
<28+ 6 1.2
  500 100.0

Figure 1 An example of a simple delivery delay analysis

5.2 Service elasticity

Provision of customer service is not free and its cost can be calculated in terms of time and money. This applies particularly in industrial markets, where potential customers often consider service more important than price when deciding to source supplies from a particular company. Service levels are of course a competitive marketing tool for companies supplying the automotive industry which applies lean manufacturing techniques.

The concept of diminishing returns, for marketing companies wishing to raise their service levels, is illustrated in the following example:

Suppose it costs a marketing firm £x to provide 75 per cent of all orders from stock, with 60 per cent of all orders delivered within seven days of receipt of purchase order.

To increase either of these targets by, say, 10 per cent may well increase the cost of service provision by 20 or 30 per cent. To be able to meet 85 per cent of orders out of stock, stockholding on all inventory items would have to increase. Similarly, to deliver 70 per cent of orders within the specified time may necessitate the purchase of extra transport which might be under-utilised for a large part of the time. Alternatively, the company might use outside haulage contractors to cope with the extra deliveries, which would add to costs.

The illustration in Figure 2 further illustrates this point. In this example, 80 per cent of the total possible service can be provided for approximately 40 per cent of the cost of 100 per cent service provision. To increase general service levels by 10 per cent brings about a cost increase of approximately 18 per cent. 100 per cent service provision means covering every possible eventuality, which is extremely expensive.

100  
90
80
70
60
50
40
30
20
10
0 10 20 30 40 50 60 70 80 90 100
Service level (%)

Figure 2 Illustration of possible diminishing returns to service level provision

In reality, maximum consumer satisfaction and minimum distribution costs are mutually exclusive, and there has to be some kind of trade-off. The degree of trade-off will often depend on the degree of service sensitivity or service elasticity in the market or market segments. Two industries may use the same product and may purchase that product from the same supplier, but their criteria for choosing a supplier may be very different. For example, both the sugar-processing and oil exploration industries use large high pressure ‘on-line’ valves: a sugar processing company to control the flow of its sugar beet pulp in the sugar-making process; an oil exploration company to control the flow of drilling fluids and crude oil on the exploration platform. The oil industry is highly service sensitive (or elastic), and when dealing with suppliers, price is relatively unimportant, but service levels are critical. Because of the very high costs of operations, and the potential cost of breakdown, every effort is made to cover every contingency. On the other hand, the sugar-processing industry is more price sensitive. Sugar processing is seasonal, with much of the processing work being carried out within two months, so as long as these critical two months are not disrupted, service provision can take a relatively low priority for the remainder of the year.

In theory, service levels should be increased up to the point where the marginal marketing expense equals the marginal marketing response. This follows the economist’s profit maximisation criterion of marginal cost being equal to marginal revenue. Figure 3 illustrates this point and it can be seen that the marginal expense (MME) of level of service provision x1 is Y and the marginal revenue (MMR) is Z. It would pay the firm to increase service levels, since the extra revenue generated by the increased services (MMR) is greater than the cost (MME). At service level x2, however, the marginal expense (Z) is higher than the marginal revenue (X), so service provision is too high. Clearly, the theoretical point of service optimisation is where marginal marketing expense and marginal marketing response are equal, service level xe.

        MME
         
Z        
         
Y       MMR
         
0 x1 xe x2  
Service level

Figure 3 Service level versus cost/revenue

5.3 Inventory management

Inventory (or stockholding) can be described as ‘the accumulation of an assortment of items today for the purpose of providing protection against what may occur tomorrow’. An inventory is maintained to increase profitability through manufacturing and marketing support. Manufacturing support is provided through two types of inventory system:

  • An inventory of the materials for production;
  • An inventory of spare and repair parts for maintaining production equipment.

Similarly, marketing support is provided through:

  • Inventories of the finished product;
  • Spare and repair parts that support the product.

If supply and demand could be perfectly coordinated, there would be no need for companies to hold stock. However, future demand is uncertain, as is reliability of supply. Hence inventories are accumulated to ensure availability of raw materials, spare parts and finished goods. Generally speaking, inventories are kept by companies because they:

  • Act as a ‘hedge’ against contingencies (e.g. unexpected demand, machinery breakdown);
  • Act as a ‘hedge’ against inflation, price or exchange rate fluctuations;
  • Assist purchasing economies;
  • Assist transportation economies
  • Assist production economies;
  • Improve the level of customer service by providing greater stock availability.

Inventory planning is largely a matter of balancing various types of cost. The cost of holding stock and procurement has to be weighed against the cost of ‘stock-out’ in terms of production shut-downs and loss of business and goodwill that would undoubtedly arise. These various costs conflict with each other.

Larger inventories mean more money is tied up in stock and more warehousing is needed. However, quantity discounts are usually available for large orders (e.g. of materials for production) and if fewer orders have to be placed, then purchasing administrative costs are reduced. Larger inventories also reduce the risks and costs of stock-outs.

When the conflicting costs just described are added together, they form a total cost that can be plotted as a ‘U-shaped’ curve. Part of management’s task is to find a procedure of ordering, resulting in an inventory level that minimises total costs. This ‘minimum total cost procurement concept’ is illustrated in Figure 4.

  Total costs (A + B + C)    
      Inventory carrying costs (A)
       
    Procurement costs (B)  
  Out-of-stock costs (C) Minimum cost re-order quantity  
 0 Stock replenishment quantity

Figure 4 Cost trade-off model

The economic order quantity (EOQ) is based on the assumption that total inventory costs are minimised at some definable purchase quantity. The EOQ method simply assumes that inventory costs are a function of the number of orders that are processed per unit of time, and the costs of maintaining an inventory over and above the cost of items included in the inventory (e.g. warehousing). The EOQ concept is simplistic in that it ignores transportation costs (which may significantly increase for smaller shipments) and the effects of quantity discounts. Because of these limitations, the EOQ concept decreased in significance in the management of inventory, but the widespread adoption of business computing has allowed the use of more sophisticated versions of EOQ. An example of the traditional EOQ method is provided to give a general understanding of the principles. The economic order quantity can be calculated using the following formula:

  EOQ = 2AS
      I
       
where: A = annual usage (units)
 

S

= ordering costs (£)
  I = inventory carrying cost as a percentage of inventory value
       
e.g. For:   Annual usage = 6,000 units
      Ordering costs = £13
      Inventory carrying cost = 17% (= 0.17)
      Unit cost = £1.30
       
  EOQ = 2 x 6,000 x £1.30 x £13
      0.17
       
    = 202,800
      0.17
       
    = 1,192,941.18
       
    = 1,092.22, or 840 units at £1.30 per unit

The EOQ concept and its variations basically seek to define the most economical lot size when considering the placement of an order. The order point method can be used to determine the ideal timing for placing an order. The calculation uses the following equation:

  OP = DLt + SS
       
where: OP   is the order point
  D   is the demand
  Lt   is the lead time
  SS   is the safety stock
e.g. For:   Demand = 150 units per week
      Lead time = 6 weeks
      Safety stock = 300 units
       
  OP = (150 x 6) + 300
    = 900 + 300
    = 1,200 units

i.e. A replenishment order should be placed when inventory levels decrease to 1,200 units. The actual size of the order placed when stock reaches this level can be calculated using the EOQ formula.

As with EOQ, the order point method incorporates certain assumptions. The order point assumes that lead times are fixed and can be accurately evaluated, which is rarely the case. However, despite the limitations of both the EOQ and order point models, the basic principles are valid and form the basis of more realistic and useful computer-based inventory models.

6 Summary

Discussion of PDM usually takes place from the viewpoint of the supplier. Understanding of physical distribution is, however, just as important to the purchaser. In addition to understanding the distribution tasks that face the supplier, the purchasing department must also appreciate logistical techniques for inventory control and the order cycle. There is consequently a close link between PDM and purchasing.

Work study-techniques and operations management can also be linked with PDM because management is concerned with efficiency and accuracy throughout the distributive function. Whilst a logistical system should not be inflexible, if routines can be established for certain functions they will assist the distribution process.

As a function of the marketing mix, PDM is linked to all other marketing sub-functions and is an important element that plays a large part in achieving the goal of customer satisfaction.