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AbhishekLohia
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AWA Essay: Relocation of inventory

by AbhishekLohia Fri Dec 18, 2015 3:03 am

The following memo was circulated by the management team of a retail company:

"We are very pleased to announce the relocation of our inventory, which had been located in four different warehouses throughout the country, to a single new warehouse near Company headquarters in Boston. This consolidated location will cut the company’s expenses for warehouse rent in half. As a result we expect our monthly profitability to go up by this amount

Response:

The memo circulated by the management team states that the management expects to cut its expenses on warehouse rent in half, and consequently increase its profits by the same amount (i.e. the amount of rent saved by it) by relocating inventory from its four warehouses, all located in different parts of the country to one single warehouse near the company headquarters. The argument though, in first reading appears appealing, upon closer scrutiny, it falls apart on various grounds. The assumptions on which the conclusion is based are pure leaps of faith and the argument, upon drawing its conclusion, does not consider a number of factors that may lead to decrease in profits instead.

The biggest assumption by the argument in drawing the conclusion that the company can reduce its rent expenses and increase its profits by the same amount is that the strategy to shut down the warehouses will not have any other negative consequences, either by decreasing the revenues or by increasing other costs such as costs of delivery, logistics, customer service etc. In moving all its inventory from warehouses spread throughout the country into a single warehouse, the company may be moving away from the location of its end customers. If the company's customers or retail stores are spread throughout the country, each of those stores will now need to be services from the single warehouse and this will not only increase the costs of logistics and delivery but also the lead times in inventory management at these retail stores. In other words, a distributed warehousing network could each service the retail stores and customers that fall within its zone or cluster in a faster and more efficient way than the single warehouse could service all those stores from one location. The possible disadvantages of this could be as follows:

a) the company's retail stores could frequently run out of inventory because of lead times and delays in delivery if the warehouse near the headquarters is located very far from some of the retail stores.
b) the customers could face delays in delivery of products or in after sales servicing, eg. spare parts etc. which could lead to customer dissatisfaction and damage the company's reputation
c) the costs of delivery and logistics may increase if all the customers/stores are serviced from a single warehouse - the company will need to hire more delivery staffs and arrange infrastructure at the mother location, travel longer distances from the central location
d) the company may need to hire additional warehousing space in Boston if that warehouse is not able to house all the inventory in the future, and this may further increase the costs of rent.

Any of the above consequence would lead to either increase in costs or decrease in the revenue or both, and hence, the profits of the company may not increase by the same amount by which it saves on the warehouse rent. Infact, the profits may actually decrease. Thus, the conclusion of the management rests on very shaky assumptions without basis and without proof.

Furthermore, in the real world, it is quite common for retail companies to follow a hub-and-spoke distribution model, i.e. setting up a distributed system of warehousing, where each warehouse acts as a hub and services the customers or retail units close to it ("the spoke"). This model is followed by highly successful retail companies such as Amazon, Netflix, McDonalds etc. The management of the company under question is motivated by a short-term view of profits and fails to see the wider picture. In focusing only on monthly profits, it may be overlooking the damage the strategy may do to its longer-term sustainability.

The argument could have been strengthened if the management could demonstrate that there would be no additional costs as a result of following this strategy and that the customers could be serviced just as efficiently as they were being serviced in the past. Perhaps, all the customers and retail stores are located near the headquarters in which case the strategy may make more sense. Also, the management could discuss in its memo the cost-benefit-analysis it has performed to come to their conclusion and whether the same is sustainable in the longer term. In the absence of any information regarding these though, one cannot conclude that the management's strategy will lead to saving of costs and increase in profits.