June 27, 2016

By Chris Creyts and Nora Weisskopf, SCM class of 2016.  In response to the growth of their e-commerce businesses, many retailers are looking for ways to reduce the supply chain costs associated with internet orders. Some retailers are starting to look upstream in their supply chains, and are requesting that manufacturers fulfill orders via drop shipping. The change in delivery practices creates a number of key issues, including the potential for impacting per-unit distribution costs for manufacturers.

The MIT CTL researchers developed a framework that manufacturers can use to understand how switching to drop shipping for select product categories will affect important areas of their operations. The research also showed how manufacturers can gain visibility into retailer inventories.
The methods for assessing drop shipping were tested with a large CPG manufacturer and one of their large retail customers.

A potential revenue opportunity?

The CPG manufacturer currently operates several large distribution facilities that ship products to retailers’ networks. Retailers then fulfill customer orders from their own inventory. The manufacturer also operates a small direct-to-consumer operation for some of its private label brands.

The researchers explored product flows from the manufacturer’s DC to the retailer’s mixing center, and to the retailer’s e-commerce DC where product is shipped to the final customer. This long supply chain forces the retailer to hold large inventory volumes. In addition, high-value products tend to tie up large amounts of capital. However, the drop ship option enables the retailer to free up capital and carry much less inventory.

Drop shipping requires the manufacturer to take on the additional cost of product distribution, including picking and packing, and invest significantly more in working capital than previously. Also, the manufacturer involved in the project was unsure whether drop shipping high-value products does indeed deliver benefits.

For example, does the retailer understock these SKUs during peak demand periods, causing the manufacturer to lose out on sales? Without information on the availability of inventory at the retailer, it is difficult for the manufacturer to tell whether there are additional opportunities to generate revenue by avoiding stock outs.

Mixed bag

Using Activity-Based Costing, the researchers built a model of the current supply chain so that the manufacturer can determine the distribution cost per unit under the drop shipping model.

To provide information on inventory levels at the retailer, the researchers used a Web Extraction Service to gather public data from the retailer’s website, and paired these details with daily POS data and outbound shipment data to the retailer. By combining these three data sources, it was possible to gauge the retailer’s inventory levels and the availability of stored product.

Using the framework to analyze the high-value product supply chain, the researchers found that overall channel supply chain costs (retailer/manufacturer) were only slightly higher in the drop shipping scenario. Notably, the drop shipping process freed up large amounts of capital previously tied up in inventory at the retailer. Moreover, drop shipping significantly reduced the total amount of working capital and inventory in the system. The Web Extraction System showed that stock outs at the retailer did not present the manufacturer with important revenue-earning opportunities in the product categories analyzed.

For more information on MIT CTL’s Supply Chain Master’s program and the student theses visit http://scm.mit.edu/program or contact SCM program Executive Director Dr. Bruce Arntzen at: barntzen@mit.edu.