Chapter 2: Designing Distribution
Networks
1. Key factors in designing a distribution network
2. Distribution Network Configurations
3. Selecting a Distribution Network Design
¨ Comparable performance over six network designs
¨ Network options for product/ customer characteristics
¨ Centralized vs. decentralized network design – game
theory approach
1. Key Factors
The Role of Distribution
in the Supply Chain
¨ Distribution – the steps taken to and a
product from the supplier stage to the customer
stage in a supply chain
¨ Drives profitability by directly affecting supply
chain cost and the customer experience
¨ Choice of distribution network can achieve
supply chain objectives from to high
Factors Influencing
Distribution Network Design
• Distribution network performance evaluated
along two dimensions
1. Customer needs (volume, quality)
2. of meeting customer needs
• Evaluate the impact on customer service and
cost for different distribution network options
• Profitability of the delivery network
determined by revenue from met customer
needs and network costs
Factors Influencing
Distribution Network Design
¨ Elements of customer service influenced
by network structure:
¨ Response time
¨ Product variety
¨ Product availability
¨ Customer experience
¨ Order visibility
¨ Returnability
Factors Influencing
Distribution Network Design
¨ Supply chain costs affected by network
structure:
¨ Inventories
¨ Transportation
¨ Facilities and handling
¨ Information
Desired Response Time and Number of
Facilities
Inventory Costs and Number
of Facilities
Transportation Costs and
Number of Facilities
Facility Costs and Number
of Facilities
Logistics Cost, Response Time, and
Number of Facilities
2. Design Options for a
Distribution Network
¨ Distribution network choices from the
manufacturer to the end consumer
¨ Two key decisions
1. Will product be delivered to the or
picked up from a prearranged ?
2. Will product flow through an (or
intermediate location)?
Design Options for a
Distribution Network
¨ One of six designs may be used
1. Manufacturer storage with direct shipping
2. Manufacturer storage with direct shipping and in-
transit merge
3. Distributor storage with carrier delivery
4. Distributor storage with last-mile delivery
5. Manufacturer/distributor storage with customer
pickup
6. Retail storage with customer pickup
2.1. Manufacturer Storage with
Direct Shipping (Drop-shipping)
¨ Advantage: Centralize inventories aggregate demand product availability ↑
with low inventory.
¨ Issue: Ownership structure of the inventory at the manufacturer
¨ Application:
¨ High-value, low and unpredictable demand.
¨ Postponement
Manufacturer Storage with Direct
Shipping Network
Cost Factor Performance
Inventory Lower costs because of aggregation. Benefits of aggregation
are highest for low-demand, high-value items. Benefits are
large if product customization can be postponed at the
manufacturer.
Transportation Higher transportation costs because of increased distance
and disaggregate shipping.
Facilities and handling Lower facility costs because of aggregation. Some saving on
handling costs if manufacturer can manage small shipments
or ship from production line.
Information Significant investment in information infrastructure to
integrate manufacturer and retailer.
Manufacturer Storage with Direct
Shipping Network
Service Factor Performance
Response time Long response time of one to two weeks because of increased
distance and two stages for order processing. Response time may
vary by product, thus complicating receiving.
Product variety Easy to provide a high level of variety.
Product availability Easy to provide a high level of product availability because of aggregation
at manufacturer.
Customer experience Good in terms of home delivery but can suffer if order from several
manufacturers is sent as partial shipments.
Time to market Fast, with the product available as soon as the first unit is produced.
Order visibility More difficult but also more important from a customer service perspective.
Returnability Expensive and difficult to implement.
2.2. In-Transit Merge Network
¨ Advantages: aggregate inventories and postpone product
customization similar to drop-shipping
¨ Increase in is required
In-Transit Merge
Cost Factor Performance
Inventory Similar to drop-shipping.
Transportation Somewhat lower transportation costs than drop-
shipping.
Facilities and handling Handling costs higher than drop-shipping at carrier;
receiving costs lower at customer.
Information Investment is somewhat higher than for drop-
shipping.
In-Transit Merge
Service Factor Performance
Response time Similar to drop-shipping; may be marginally higher.
Product variety Similar to drop-shipping.
Product availability Similar to drop-shipping.
Customer experience Better than drop-shipping because only a single delivery has
to be received.
Time to market Similar to drop-shipping.
Order visibility Similar to drop-shipping.
Returnability Similar to drop-shipping.
2.3. Distributor Storage with
Carrier Delivery
¨ Inventories are held by distributors/retailers in intermediate warehouses
¨ Package carriers are used to transport products from the intermediate location to
the final customer
¨ Relative to manufacturer storage, distributor storage requires a higher level of
inventory because of a loss of aggregation
¨ In some instances, postponement can be implemented and no need assembly
capability
Distributor Storage with
Carrier Delivery
Cost Factor Performance
Inventory Higher than manufacturer storage. Difference is not
large for faster moving items but can be large for very
slow-moving items.
Transportation Lower than manufacturer storage. Reduction is
highest for faster moving items.
Facilities and handling Somewhat higher than manufacturer storage. The
difference can be large for very slow-moving items.
Information Simpler infrastructure compared to manufacturer
storage.
Distributor Storage with
Carrier Delivery
Service Factor Performance
Response time Faster than manufacturer storage.
Product variety Lower than manufacturer storage.
Product availability Higher cost to provide the same level of availability as
manufacturer storage.
Customer experience Better than manufacturer storage with drop-shipping.
Time to market Higher than manufacturer storage.
Order visibility Easier than manufacturer storage.
Returnability Easier than manufacturer storage.
2.4. Distributor Storage with
Last Mile Delivery
¨ Distributor warehouse is to customer and delivery to
customer’s home instead of using a package carrier
¨ Distributor storage requires higher level of inventory than the
other options (except for retail stores) because it has a lower level
of aggregation.
Distributor Storage with
Last Mile Delivery
Cost Factor Performance
Inventory Higher than distributor storage with package carrier
delivery.
Transportation Very high cost given minimal scale economies.
Higher than any other distribution option.
Facilities and handling Facility costs higher than manufacturer storage or
distributor storage with package carrier delivery, but
lower than a chain of retail stores.
Information Similar to distributor storage with package carrier
delivery.
Distributor Storage with
Last Mile Delivery
Service Factor Performance
Response time Very quick. Same day to next-day delivery.
Product variety Somewhat less than distributor storage with package carrier
delivery but larger than retail stores.
Product availability More expensive to provide availability than any other option
except retail stores.
Customer experience Very good, particularly for bulky items. Slightly higher than
distributor storage with package carrier delivery.
Time to market Less of an issue and easier to implement than manufacturer
storage or distributor storage with package carrier delivery.
Order visibility Easier to implement than other previous options.
Returnability Harder and more expensive than a retail network.
2.5. Manufacturer or Distributor
Storage with Customer Pickup
¨ Inventory is stored at the manufacturer or distributor. Customers
order online or by phone and pick up at specified points.
Manufacturer or Distributor Storage with
Customer Pickup
Cost Factor Performance
Inventory Can match any other option, depending on the
location of inventory.
Transportation Lower than the use of package carriers, especially if
using an existing delivery network.
Facilities and handling Facility costs can be high if new facilities have to be
built. Costs are lower if existing facilities are used.
The increase in handling cost at the pickup site can
be significant.
Information Significant investment in infrastructure required.
Manufacturer or Distributor
Storage with Customer Pickup
Service Factor Performance
Response time Similar to package carrier delivery with manufacturer or
distributor storage. Same-day delivery possible for items
stored locally at pickup site.
Product variety Similar to other manufacturer or distributor storage options.
Product availability Similar to other manufacturer or distributor storage options.
Customer experience Lower than other options because of the lack of home
delivery. Experience is sensitive to capability of pickup
location.
Time to market Similar to manufacturer storage options.
Order visibility Difficult but essential.
Returnability Somewhat easier given that pickup location can handle
returns.
2.6. Retail Storage with Customer
Pickup
¨ Inventory is stored locally at retail stores
Cost Factor Performance
Inventory Higher than all other options.
Transportation Lower than all other options.
Facilities and handling Higher than other options. The increase in handling
cost at the pickup site can be significant for online
and phone orders.
Information Some investment in infrastructure required for online
and phone orders.
Retail Storage with Customer Pickup
Service Factor Performance
Response time Same-day (immediate) pickup possible for items stored
locally at pickup site.
Product variety Lower than all other options.
Product availability More expensive to provide than all other options.
Customer experience Related to whether shopping is viewed as a positive or
negative experience by customer.
Time to market Highest among distribution options.
Order visibility Trivial for in-store orders. Difficult, but essential, for online
and phone orders.
Returnability Easier than other options because retail store can provide a
substitute.
3. Selecting a Distribution Network Design
3.1. Comparative performance of Delivery Network Designs
3.2. Characteristics of Design Options
¨ Most companies are best served by a combination of delivery networks
¨ Performance of Delivery Networks in various situations
3.3. Centralized vs. decentralized network designs (1 of 4)
What factors are affected with the decision over centralized or
decentralized management of the distribution network?
• Example:
Consider 2 identical retailers, with the same costs and characteristics, facing
random demand for a single product. We compare the two system, the
decentralized and centralized one. In the centralized pooled system, the retailers
together operate a joint inventory facility and take items out of the pooled
inventory to meet demand. In the decentralized system, each retailer individually
orders from the manufacturer to meet demand.
We consider a single period of random demand. The probabilistic forecast of
demand faced by each retailer is depicted in the following table. The wholesale
price is $80 per unit, the selling price of $125 per unit, salvage value of $20 per
unit, and production cost of $35 per unit. If the order quantity must be multiples
of 1,000 units. What’s each retailer’s best order quantity in a period in each
system? What is retailer’s expected profit? Manufacturer’s profit in each system?
Example 1
Manufacturer Demand Probabilistic
8,000 11%
10,000 11%
DC (owned 12,000 28%
by 14,000 22%
retailers) 16,000 18%
18,000 10%
Retailers
Customer demand
Centralized system Decentralized system
Example 1 (cont.)
Strategy Each retailer Manufacturer System
Centralized $500,268 $1,170,000 $2,170,536
Decentralized $470,700 $1,080,000 $2,021,400
Since both each retailer and manufacturer earns more profits in the
centralized system, both prefer the centralized system over
decentralized one.
Centralized vs. decentralized network designs (2 of 4)
• The previous example makes an important assumption that does not
hold in practice: if a customer arrives when a retailer does not have
inventory, the customer disappears, and this unit of demand is lost.
• What if the customer search within the system for alternatives? Can the
retailers take advantage of the search process? Does it affect the
preference over centralized/ decentralized system?
• This question can be only addressed using concepts from game
theory, and in particular Nash equilibria.
Impacts on the decentralized system
• What if a retailer knows that his competitors don’t keep enough
inventory, what should he do?
- Raise the inventory to satisfy: his own demand, and the demand of
customers who initially approach other retailers with limited
inventory.
• What if a retailer knows that his competitors keep significant inventory?
- Reduce the inventory level, since it’s unlikely to see customers who
switch.
• A retailer’s strategy depends on his competitor’s strategy. The two
retailers reach a Nash equilibrium if they both make decisions on the
amount to order that:
- Neither can improve their expected profits by changing the order
quant. if the other doesn’t change his.
Example 2
Let’s return to our example. We let represent the percentage of customers
that search the system. In the other words, the percentage of customers
who check the other retailer if their demand is not met at the first retailer.
Using this information, each retailer can determine what its effective
demand will be (that is, what its initial demand and the searched demand
will total) if the other retailer order a specific amount. Based on this
information, they can calculate how much they should order given any
order by their competitors. This is known as their best response.
The following graph depicts the retailers’ best response given , so that 90%
of the customers whose demand is not met at a retailer checks to see if the
item is in stock at the other retailer.
Example 2
• As retailer 1 would increases its inventory (pink curve), retailer 2’s
inventory decreases, up to a certain amount
Example 2
• The two retailers has no incentive to modify its strategy is when they
order the amount of 13,900 each, associated with the intersection of
the two curves. This is the unique Nash equilibrium for this system.
Strategy Each retailer Manufacturer System
Centralized $504,696 $1,170,000 $2,179,392
Decentralized $489,460 $1,251,000 $2,229,920
The centralized system doesn’t strictly dominate the decentralized one.
While the retailer prefers the centralized system, the manufacturer
prefers the decentralized one.
Centralized vs. decentralized network designs (3 of 4)
Amount ordered by retailers as a function of the search level
Centralized vs. decentralized network designs (4 of 4)
As increases
• Each retailer’s order quantity and profit increases.
• Retailers’ total expected profit will be higher in the centralized pooling
system than in the decentralized system Retailers prefer a
centralized system
• In the decentralized system, the retailers tend to order more than in a
centralized one, increasing the manufacturer’s profit the manufacturer
will prefer a decentralized system.
• Critical search level: When customer search is below that level, the
manufacturer prefers the centralized system, and otherwise, the
manufacturer prefers the decentralized one.
