2. Illustration of Linkages

The purpose of this section is to provide the reader with some specific examples of the things businesses do when they reorganize and restructure their logistics operations and the kinds of savings and other benefits that they realize. In the first part we give some sense of the evolution of business thinking about logistics over the last few decades; in the next part we offer three short case histories of logistics reorganization carried out by major corporations: Polaroid Camera, Dell Computer, and Ford Motor Company.

2.1 The Business World's View of Logistics: Trends and Developments

Since the end of World War II, American businesses have given ever closer attention to reducing costs and improving performance of their logistics operations. Freight carriage, inventories, warehouses, and related facilities and operations have come under intense scrutiny as managers have realized both the potential for savings and for improved service to customers.

In the 1960s, for example, air lines promoted air freight on the basis of savings that shippers of high-value merchandise could achieve through reductions in inventory, warehousing, and materials-handling costs by switching from ground modes to more expensive, but much faster, air transport. Many shippers found that, in fact, they could spend more on transportation but achieve a reduction in total logistics costs. Essentially, they found that the money spent for reduced transit time and increased reliability was returned to them in lower costs for the other elements of their logistics operations. Reduction in time costs also provided benefits for customers and expanded sales for businesses. Markets for perishables such as fresh fruits, vegetables, and cut flowers were hugely expanded as air transport extended the reach of producers and distributors of these goods.

Throughout the 1960s business managers and analysts spoke of "physical distribution" when referring to the logistics operations and facilities that supported the movement of finished goods along the chain from manufacturers to wholesalers to retailers. Inbound movement of materials and components was seen as a separate subject and was refereed to in the literature as "physical supply." This curious distinction vanished in the 1970s, and all of these activities and issues came under the single label of "logistics," presumably borrowed from military parlance.

Concern with finding the least-cost combination of logistics components has long since spread beyond the distribution of perishable and other very high-value merchandise to virtually all physical products that must be stored and shipped. The concept of trading expenditure for increased speed and reliability against expenditure for inventory levels, number and size of warehouses, and related costs has been well established for some time. Exploiting reductions in time cost to achieve lower total logistics costs and improved customer service is the essence of the business response to freight improvement that we need to examine in this study.

In general, freight transportation costs have been declining in real terms because of deregulation and the trucking-industry changes it spurred and because of technology and infrastructure improvements. At the same time, inventory and warehousing costs have been increasing. The distinct trend has been to spend more on transportation and realize offsetting reductions in other logistics costs. As transportation costs have decreased relative to inventory and warehousing costs it has become common place to substitute transportation for inventory and warehousing to reduce total logistics costs. One result has been a decline in logistics costs as a relative share of the total costs of business.

Businesses are particularly aware of highway improvements that reduce transit time and increase reliability. Among other things, increased reliability reduces the amount of inventory that must be maintained as a buffer against the risk of late or missed deliveries. Decreases in transit time allow for greater productivity of drivers and extend the reach of a factory or warehouse. The effective market reach of a warehouse, for example, is often defined by the round trip that can be completed in one day (in ten hours or less under current maximum hours of service rules). Decreases in transit time enable greater distances to be covered and/or more stops to be made, enlarging the market served by the warehouse. While we write here in terms of distinct effects of speed increases and reliability increases, there is some evidence that business managers view these in a combined way. A speed increase is of limited value, for example, if reliability is low.

In thinking about business reactions to freight improvements, it is important to bear in mind that there is a distinct element of "lumpiness" in the ways that firms can respond. Changing the number, size, and location of warehouses, for example, cannot be done in a gradual and continuous fashion. Such actions may require major investments; businesses' discretion in making changes may also be time constrained by factors such as the terms of leases. Thus, business responses may lag well behind freight improvements in time. It is also the case that there will be a minimum gain, or threshold, in terms of cost reduction and time improvement that managers must see before they make major responses to a freight improvement.

2.2 Case Histories of Logistics Reorganizations

2.2.1 Polaroid

In the late 1980s Polaroid decided to centralize its European inventories by substituting transportation for warehousing; a large number of warehouses were closed. Estimated annual gross savings were $6.9 million, broken down as follows:

1. warehousing personnel—$2.5 million;
2. inventory carrying costs—$2.2 million;
3. warehouse rental costs—$1.0 million;
4. facilities and offices—$0.6 million;
5. internal transportation between dealers and subsidiaries—$0.5 million; and
6. insurance premiums—$0.1 million.

Net annual savings were $6.3 million after subtracting $0.6 million per year for increased costs resulting from computer system maintenance and increased warehouse personnel at headquarters. A capital investment of $3.0 million for new computer equipment was required.

Besides these savings that Polaroid could quantify, there were other gains that were not measured. Prior to centralizing inventory, 69 percent of orders could not be filled at the location that received them, so that items were backordered until they could be filled from other locations. This required significant internal transportation among dealers and subsidiaries to reposition inventory. Polaroid also achieved unspecified freight cost savings based on volume discounts for consolidated (truckload) shipments to centralized warehouses as well as reduced freight rates that reflected truck cost savings from reduction of border crossing inefficiencies.

2.2.2 Dell Computer

In 1996 Dell Computer launched its "on-line" store. Customers were able to choose their own computer configurations and to receive 24-hour support on line. When an on-line order is received, the configuration of the desired computer is immediately transmitted to the manufacturing group. Using a specification sheet the order is broken down to individual components. Components are either ordered for just-in-time (JIT) delivery on very short notice or drawn from relatively small stocks that are replenished on a JIT basis. The computer is assembled by a production team and then shifted to software loading where it is tested for between four to eight hours. The entire process from receipt of order to shipping requires about 36 hours. Dell would not be able to achieve this combination of rapid response and low level of inventory without a very high level of freight service from United Parcel Service (UPS) under a comprehensive contract covering all inbound movements of parts, in addition to a sophisticated, computer-based communications system.

The on-line store concept was a revolutionary precedent for the computer industry that had been dominated by manufacturers with complex supply chains and relatively large inventories of parts and computers. By building to order and outsourcing most components, Dell gained a major cost advantage by greatly reducing parts inventories and virtually eliminating stocks of finished machines. Dell effectively became little more than an assembly and shipping company.

The JIT system for parts delivery allows Dell to reduce inventory of components from an industry norm of 75 to 100 days to 6.6 days. Suppliers are integrated into Dell's on-line ordering and procurement system resulting in a span of fifteen minutes for most suppliers between receipt of order and shipment to Dell's assembly plant. Shippers of monitors, for example, receive an e-mail giving the day a customer's order is to be shipped, and the monitor is delivered on that day. Dell estimates that they save $30 per monitor by virtually eliminating inventory.

Dell's build-to-order approach is of particular significance in an industry characterized by continuous innovation and introduction of new products. Since prices of components decline rapidly in response to continuous innovation, Dell derives a cost advantage from the fact that most components are not bought until an order is received.

The Dell JIT system of procurement and on-line ordering typifies the virtual substitution of transportation and communications for inventory. It would not be possible without the availability of very high-quality freight transportation services.

2.2.3 Ford Motor Company

Ford presents another example of using communication and transportation improvements to establish closer links to the customer and reduce inventory. The transportation-improvement stimulus came from cost and service gains realized from sharply increased use of rail service. Railroads went from moving very few new vehicles from assembly plants to a dominant share (over 80 percent) of this market. For example, in 1980 railroads handled 342,000 carloads of vehicles compared to 609,000 carloads in 1990. Since 1990 annual movements of finished vehicles have increased to nearly 900,000. This is a case in which a shipper reorganized its logistics to exploit fully the financial advantages of a low-cost mode while improving service to customers.

Several trends have favored increased use of rail movements of finished automobiles and light trucks in the U.S.

• Domestic vehicle production has grown largely as a result of foreign transplants and resulting decreases in imports with a more recent shift to exports.
• The mixture of new vehicles shipped has changed in the direction of more light trucks, which tends to favor rail for shipments from factories because the cubic-space requirements of light trucks and sport utility recreational vehicles are better met by rail cars.
• North American assembly plants, with the exception of recent rail served expansions in Mexico, have remained relatively concentrated in the Midwest and southern Ontario at rail-competitive distances from major coastal markets.

The Big Three did not respond to the service characteristics of rail shipment in any substantial way until 1997. Commencing in 1997 both Ford and GM announced sweeping changes in how new vehicles were to be distributed from assembly plants to domestic markets. Ford moved to implement a "regional mixing center" concept.

The stated reasons for the changes in distribution of finished automobiles were to reduce the costs of inventories and transportation and improve services and sales to dealers and customers. Ford was seeking to reduce order delivery time for new vehicles from 72 days to 30 days by 1997 and then to 15 days by 1999. Chrysler has announced similar objectives to deliver all orders within 28 days and sold orders within 16 days. GM has already established 24-hour delivery for its Cadillac line by creating ten regional distribution centers from which dealer orders can be filled in 24 hours.

Ford has created four national mixing centers at Chicago; Shelbyville, Kentucky; Kansas City, Missouri; and Fostoria, Ohio. Ford has an exclusive contract with Norfolk Southern Railway under which NS constructs and operates these sites. Each mixing center performs the function of a logistics distribution center by creating an assortment of vehicles that can be shipped to dealers in full rail cars or trucks to destination markets.

The mixing centers replace a push distribution system in which dealer orders for different lines of vehicles were accumulated at particular assembly plants until a sufficient quantity existed to fill an entire rail car (ten to twenty vehicles, depending on size) or truck (five to ten vehicles, depending on size) for shipment to the local market. Instead of waiting for sufficient dealer orders to fill rail cars and trucks, each assembly plant will make daily shipments to the mixing centers. The mixing centers will receive shipments from different assembly plants. Rail cars and trucks will be unloaded and reloaded with a unique assortment for destination markets, reflecting orders by local area dealers. Vehicles will normally be held at the mixing center only as long as necessary for transloading. It is estimated that vehicles will be received at the mixing centers, unloaded, reloaded and shipped within eight to 24 hours.

The properties acquired for the Ford mixing centers range in size from 300 to 700 acres. The actual property to be used for automobile distribution will vary from 125 to 180 acres, averaging about 150 acres. The remaining acreage will be held as a combination of buffer or for other developments. It is anticipated that other manufacturers will also use the mixing centers as one mechanism to lower throughput costs. In some instances the development costs have been substantial. For example, NS has purchased nearly 700 acres at Shelbyville, KY to develop a 125-acre mixing facility for Ford. Ideally, about 300 to 400 acres would have been acquired but several large parcels had to be acquired in their entirety, necessitating a total land acquisition expense of nearly $10 million. The Shelbyville center has parking spaces for nearly 3,000 vehicles and employs nearly 200 persons. The Ford distribution center concept has been adopted to achieve economies of transportation time by maximizing trainload and truckload movements of vehicles from all plants to the centers and from centers to local markets.

The four Ford mixing centers will handle over 3.2 million new vehicles a year. The mixing center concept also appears to have achieved substantial transportation cost savings for Ford. Exclusive rail access to each center was put out for competitive bid among three railroads. NS was the low bidder and serves all four sites. As a result NS can expect to handle almost all of Ford's business in these markets albeit at a substantial discount.

Through a major restructuring of its logistics operations and facilities, Ford was able both to reduce transportation costs and inventory costs while improving service to its customers.

2.3 Summary

Two of these cases, Polaroid and Dell, illustrate a point that is at the heart of our analytical framework—that businesses will increase expenditure on freight transportation, buy more freight service, and thereby achieve a reduction in total logistics costs because of savings in inventory and warehouses. And this is done in ways that improve customer service. Ford found savings in both freight costs and other logistics costs. The auto maker responded to the stimulus of improved rail service by switching to a lower-priced mode and using it more efficiently to cut inventory costs and reduce the time required to respond to customers' orders. Perhaps the central point is that real-world firms are alert for opportunities to improve theirs logistics systems and will act when they find the price and quality of transportation makes it feasible to do so.

In the following section, we see how this readiness to respond to better transportation can be expressed in formal economic logic and how the degree of business response becomes the keystone of our analytic framework.

previous | next