To plan a cost-effective distribution network solution, it is necessary to be aware of the individual logistics cost elements of distribution, how these will interact as the network alternates (different number, size, type and location of depots) as well as how the total logistics cost builds up and what this will be in different scenarios. Without this information it is impossible to measure the efficiency of the current network or gain the necessary insight into the distribution operations to allow for successful logistics planning and management. (Rushton et al. 2010, pp. 120)
According to Rushton et al. (2010, pp. 120-125) the typical logistics cost elements of a distribution network are transportation costs, inventory holding costs, system and administration costs and storage costs. These along with their shares form the generic cost structure of a distribution network as shown in Figure 9. Inevitably, the cost element shares will vary from one company to another, but here a typical situation in global scene is delineated.
(Rushton et al. 2010, pp. 10, 120-125)
Figure 9. Delineation of distribution networks’ cost structure and typical cost element shares in global scene
Based on their characteristics, the costs are categorized for modeling purposes either as variable (costs that are dependent on the number of units that pass through a facility) and fixed (costs that are a one-time charge independent of the volume). In network design context, this allotment is, though, often a somewhat trivial and there is no correct answer what cost is “variable” and what is “fixed” due to various reasons (for example increasing use of 3PL services in global
Total logistics cost
supply chains). Therefore, the key is to understand how these costs work and affect the whole to determine how to use them in one’s network design study. (Watson et al. 2013, pp. 127-128) Next, each cost element, their related characteristics and how these eventually form the total logistics cost in a distribution network will be discussed more closely.
The first and often the most critical cost element in distribution is transportation costs, which consist of two components that are the line-haul transportation cost and the delivery transportation cost. As was previously stated, the line-haul transporting refers to shipping products in bulk to DCs from the point of source or production, while the delivery transporting concerns delivering orders from DCs to local sites or directly to customers. Transportation costs are essentially dependent on the distance that is to be travelled and the number of different lines within the system. Due to this line-haul costs tend to increase (because the greater the number of lines the shipping volume is distributed) whereas delivery costs usually reduce (because the less the stem of distance) the greater the number of depots. Because the delivery cost component mainly dominates the cost entity, the overall effect of combining these two components is that total transportation costs will reduce, the greater the number of depots in the network. (Rushton et al. 2010, pp. 121-122)
Another important cost element considering distribution networks is the cost of holding inventories. This includes expenses incurred because of the volume of inventory is carried, and divides into three main components which are:
• Capital cost – the financing charge of money invested in the stock. To reflect this, companies usually apply their prevalent cost of capital or an opportunity cost of tying up capital that might otherwise be producing a return if invested elsewhere.
• Storage cost – the cost of space, equipment and workforce needed to store and handle goods in the inventory.
• Risk cost – the cost of risks involved in carrying an inventory, which may occur through damage, pilferage, stock obsolescence or possible deterioration of stocked items among other things.
As can be supposed, the costs of holding inventories increase as physical inventory increases.
Due to this, networks’ inventory holding costs increase the greater the number of depots.
Inventory holding costs are usually defined as a percentage of the monetary value of inventory per unit of time (principally year) and they vary heavily depending on the company and industry in question. Usually, the percentage is, though, around 20%-40% of the monetary value of inventory. (Arnold et al. 2011, pp. 201-202; Rushton et al. 2010, pp. 123-124)
The third cost element to be considered in distribution networks is system and administration costs or briefer system costs. These costs represent a variety of information, communication and management requirements ranging from order processing and invoicing to producing load assembly lists. The processes may still be manually operated but are more likely to be automatized using technology (at least in some degree). The system costs like all the previous ones tend to increase the greater the number of depots. (Rushton et al. 2010, pp. 124)
The final cost element in the listing is storage costs, which include all the depot related fixed costs. Here the major breakdown goes between building, building service, labor, equipment and management costs. Storage costs vary based on different business-related factors such as industry, regional location, product type, annual volume throughput and building characteristics. With respect to other parts of the distribution system, the storage costs are mainly dependent on the size and the number of depots within the distribution network. The effect of size can be illustrated by the economies of scale experienced with larger depots and the effect of repetition by the increased cost burden as the number of depots in a distribution network increases. (Rushton et al. 2010, pp. 120-121)
When it comes to the total logistics cost of the distribution network, the functional cost elements described above can be built together to get the overall cost incurring. This so-called total cost approach along with the high-level impacts of a different number of depots on distribution costs is illustrated in Figure 10 below. Considering distribution network designing, the overall cost effects of using a different number of depots can be demonstrated by a such graph. Here the top line shows the total logistics cost, which is obtained by adding up the individual cost curves of the functional cost elements.
(adapted from Rushton et al. 2010, pp. 125)
Figure 10. Relationship between total and functional logistics costs as the number of depots change in a distribution network
In the example presented in this figure, it can be seen from the graphs that the least expensive option measured by total logistics costs occurs around 5-to-6 depots. In practice, however, these results will depend on numerous factors such as industry, product type, business requirements, the required service level and the geographic distribution of demand among other things. Hence, the process of network planning is not just a question of costs, but other issues have to be taken into account as well. (Rushton et al. 2010, pp. 125-126)
An essential feature of this total cost approach in terms of network design and operations planning is also the concept of trade-off analysis delineated in Figure 11 below, which can be used to collate cost structures and underlying changes in the major cost elements between alternative network configurations. In the figure, the outcomes of a fictional network rationalization project are delineated where a reduction in number of depots has yield to significant declination in overall logistics costs. As can be seen from the trade-off analysis although there is quite some increase in delivery transportation costs, savings in other cost elements have produced overall cost benefits. (Rushton et al. 2010, pp. 126)
(Rushton et al. 2010, pp. 126)
Figure 11. Trade-off analysis delineating changes in total logistics costs and related cost structure as the network configuration is altered
As can be concluded, the number of facilities along with their sizes and locations tend to be a crucial factor in the success of a distribution network. In fact, some experts suggest that 80%
of the costs of the supply chain are locked in with the network design when determining the locations of these facilities and optimal flows of material between them. The most successful companies recognize this and place significant emphasis on the process of strategic network design and analysis, which is covered in more detail in the following chapters. (Watson et al.
2013, pp. 1)