Midterm Exam in Logistics - Case No. 6

Case #6
Michigan Liquor Control Commission


I. Case Background:

On a Friday afternoon in October 2000, Joseph Duncan, a third-year distribution systems analyst for the Michigan Department of Commerce, was sitting at his office desk reading through some background material on distilled liquor distribution in Michigan. Prior to his current position, Joseph had worked as a distribution analyst in private industry for several years after graduating from a large midwestern university with a degree in materials and logistics management. His direct supervisor, Donna Mills, had given Joseph his next assignment earlier that day. “Be prepared to head up a project team and prepare a proposal on distilled liquor distribution,” Donna said, “We’ll meet Wednesday afternoon at 2:00 P.M. to lay out an initial plan.” This was Joseph’s first “lead” project assignment, and although he was unfamiliar with the topic, he was excited about the opportunity to demonstrate his ability. He placed the background material in his briefcase and decided to reexamine it at home over the upcoming weekend.
History of Michigan Liquor Distribution System
In the early 1900s, brewers in Detroit were the dominant force in the state due to efficiencies of size, new bottling technology, and local “option laws,” which restricted or outlawed in-county production. This created a sharp division between outstate and Detroit brewers and prevented the formation of a strong state liquor association. Prohibition forces also benefited from this divisiveness; by the year 1917, Michigan had 45 dry counties. Michigan enacted a statewide prohibition on liquor in May 1918, approximately 18 months prior to passage of federal Prohibition (the 18th Amendment). By the late 1920s and early 1930s, significant pressure existed throughout the country to repeal Prohibition. In early 1933, Congress passed a bill authorizing 3.2 percent beer. In the same year, a similar bill was considered in Michigan and along with it, the introduction of a state board which came to be known as the Michigan Liquor Control Commission (MLCC). In April 1933, Michigan became the first state to ratify the repeal of federal prohibition and the present-day liquor distribution system was designed and put into place.

A bill for beer and wine (defined legally as under 21 percent alcohol by volume) was passed that allowed distribution from brewers and wineries to private wholesalers who then resell to retailers. However, all distilled “spirits” (defined legally as over 21 percent alcohol by volume) were to be purchased by the State of Michigan. Michigan “come-to-rest” laws required that any distilled liquor moving through or stored in state bailment warehouses must be handled by state employees. Package liquor sales were allowed through any hotel or established merchant. Many of the merchants were druggists who also had the right to dispense “medicinal” liquors as well as valid medical prescriptions. A local option was also set up to provide for on-premise consumption.

The State of Michigan’s decision in 1933 to exercise public, rather than private control over distilled liquor distribution was due to a variety of reasons. First, Michigan’s geographical proximity to Canada made politicians familiar with Ontario’s system of monopoly control. Second, there was a strong influence of “dry” sentiment and a fear of bootlegging, which was common during Prohibition years. Third, druggists exerted considerable political influence at the time and were positioned to benefit from state control. Finally, the state believed government control would protect the public from middleman profiteering and excessively high private enterprise pricing.

Currently, Michigan is one of 18 states in the United States that completely controls the wholesale distribution of distilled liquor between distillers and retail licensees. The remaining 32 states utilize an “open” private license system in which the state government is not involved in wholesale distribution at all.

In 1993, Michigan and many other states throughout the country faced the problem of rapidly increasing costs of government services and strong citizen resistance to any tax increases to provide those services. Unlike nearly all other Michigan government functions, the control and distribution of liquor generates a considerable general revenue contribution for the state. Distilled liquor tax contributions go directly to the General Fund in the Executive Budget for running the State of Michigan. At present, taxes of 11.85 percent are assessed on the full price of liquor as follows: 4 percent for excise taxes, 6 percent for a Michigan school-aid fund, and 1.85 percent on packaged liquor.

Public sensitivity toward liquor as a social issue and its ability to provide the state with significant revenue make liquor control a high-profile government activity. Under a recent directive from the governor, all state functions must be examined to determine how state government efficiency could be improved. Despite the contribution of current operations, considerable room for improvement appears to exist. For example, even in light of technological improvements and the addition of more modern facilities, the cost of liquor distribution has continued to increase. Specifically, administrative cost as a percentage of sales has risen 121 percent over the past 11 years, while the number of inventory turns has decreased from 6.7 to 5.5.


The Liquor Distribution Process

Distilled liquor distribution in the State of Michigan during the fiscal year 2000-2001 involved the shipment of 6.97 million cases of liquor to retail markets, and generated $515.0 million in revenue for the state. After purchase costs and operating expenses, the net contribution to the state came to $61.5 million. The state also realizes roughly $50 million per year from taxes on distilled liquor.

Contributions from the sale of distilled liquor are generated in the following manner: the state buys liquor directly from a distiller at a delivered price of, for example, $10.00 per bottle. Then, the state factors in transportation and other costs and marks up the $10.00 bottle a state mandated 51 percent to $15.10. Retailers buy liquor from the state at a 17 percent discount off the “markup” price, and in this example would pay a wholesale price of $12.53. Thus, the state markup (51 percent) and retail gross profit margin (17 percent) are fixed by Michigan law. The net result is that consumers pay the same retail price for distilled liquor everywhere throughout the state. The state-imposed taxes of 11.85 percent are assessed on the $15.10 price and collected by the retailer upon sale to consumers.

Any alteration of Michigan liquor distribution must consider potential effects on liquor prices at the retail level. In terms of consumer purchase behavior, liquor quantity is generally price inelastic. The price elasticity of liquor sales with respect to total expenditures is, however, fairly elastic. These conditions imply that as prices are raised, consumers will generally purchase the same quantity of liquor but will shift their consumption to cheaper brands. This shift reduces projected consumer expenditures and tax revenues. If system changes require that prices be raised, the effect on tax revenues could be detrimental.

Currently, distilled liquor is distributed through a two-tier network consisting of three state-owned-and-operated warehouses, 75 smaller second-tier state warehouses (known as “state stores”), which function as wholesale outlets, and 12,000 retail licensees serving the consuming public throughout the state (see Figure 1). Licensees are divided into two categories of approximately 6,000 members each: (1) on-premise bars, restaurants, and hotels that serve liquor by the glass and (2) off-premise package liquor dealers/stores. The package liquor dealers represent a wide variety of businesses, ranging from traditional liquor or party stores to large retail grocery superstores like Meijer, Inc. The first 600 retail licensee outlets were authorized in 1934 and have steadily increased to their current level. The number of state stores has remained fairly constant over the years and most of the original 75 stores are still in their original cities.

The cost to operate the current distribution network is approximately $20 million per year. Average distilled liquor inventory within the 75 second-tier warehouses is $25 million. Inventory carrying cost is assumed to be 15 percent and is considered a conservative estimate compared to figures used in private industry liquor analysis.

Distillers ship their products to the three state-owned-and-operated warehouses based on state-suggested shipping quantities. The distillers are charged a handling fee for storage of their product because the State of Michigan does not take title to the liquor until it has been shipped from the three warehouses to one of the state stores. The process of title transfer in the system is essentially a consignment arrangement. Under consignment, a product is sent to a sales agent (in this case, the State of Michigan) for sale or safe-keeping. From the State of Michigan’s perspective, the consignment arrangement reduces inventory ownership risk and inventory carrying costs because the state does not take title until retail licensee demand is established. This operational arrangement was implemented several years ago; however, distillers circumvented the state’s fiscal efforts by sufficiently raising prices to cover their increased storage costs. No direct shipments are made from the three state-owned-and-operated warehouses to retail licensees. Transhipment among the three state-owned-and-operated warehouses and the state stores is minimal. Licensees place their orders weekly through a centralized order processing system and may either pick up an order in person or have it delivered by common carrier. The only exception to this delivery system occurs in the Detroit metropolitan area, where state delivery service is mandated from the largest state store to all its retail licensees.

Geographically, Michigan’s liquor distribution network is broken down into three operating districts. Figure 2 illustrates the districts which each contain one of the major state-owned-and-operated warehouses. The Lincoln Park warehouse serves the Detroit area (District 1); the Lansing warehouse serves the western and central portion of the state (District 2); and the Escanaba warehouse serves the northern portion, or Upper Peninsula, of the state (District 3). District population, case liquor sales, and facility costs are shown in Table 1.

While the state does not directly pay the cost of inbound freight from distillers, research indicates that the cost is approximately $1.00 per case. Transfer freight is defined as freight movements from and between the three state-owned-and-operated warehouses to the 75 state stores. Customer freight is defined as freight movements between state stores and a retail licensee. Transfer and custom freight charges are listed in Table 2.
Current Issues
Redesigning the liquor control system in Michigan is not a new idea. Lawrence Desmond, business manager for the MLCC, says “When you talk about the liquor commission you’re really talking about two distinct aspects. One is a regulatory agency that enforces the state’s liquor laws. The other is the fact that we’re the state’s sole wholesaler of spirits, and along with our licensing process, we directly contribute to the state’s general fund.” The subject of system redesign has been raised numerous times for a variety of reasons, and many powerful economic and political special interest groups have strong opinions on the two issues of liquor enforcement and sales and licensing.

Liquor enforcement is a highly sensitive social issue. From 1992–2000, nationwide per capita consumption of distilled liquor declined about 3 percent per year. Michigan sales figures mirror the national trend (see Figure 3). Increased public awareness of alcohol abuse has been heightened through the efforts of the distillers and brewers, government agencies, and groups such as Mothers Against Drunk Driving (MADD). Anti-alcohol groups such as MADD argue that the state’s highly controlled system contributes to strong enforcements of liquor violations, and thereby acts as a deterrent to alcohol abuse. “Alcohol is a problem-causing narcotic drug, and we need to retain as much control as possible,” says Reverend Allen West of the Michigan Council on Alcohol Abuse and Problems.

The chairperson and the five commissioners of the MLCC are appointed by the governor of Michigan. Given the nature of the political process, the MLCC and its licensing procedures have historically been subject to frequent charges of political patronage, graft, and corruption by whichever political party is out of power in the state legislature. The MLCC employs approximately 620 people and a considerable number of the positions are well-paying, low-skill jobs. Although the population of Michigan is concentrated in the lower third of the state, many of the MLCC positions are located in geographically remote areas where it is unlikely that employees would be able to secure similar, private sector jobs if system redesign eliminated their positions. Also, approximately 500 MLCC employees are represented by United Auto Workers local unions. Teamsters Union delivery firms with long-term contracts for hauling liquor also exist, especially in the Detroit metropolitan area.

A number of state budget analysts and legislators, as well as academic and professional consultants, believe that the state liquor distribution system is considerably less efficient than private industry. They argue that, for example, mandated state delivery contracts and state employees with little job performance incentive hinder productivity improvement.

Lower volume retail licensees fear that redesigning the current system may hinder their ability to purchase small quantities of liquor, particularly if minimum order sizes or delivery freight breaks are instituted. They believe that changing the current setup will severely disadvantage them relative to larger, high-volume chains and retailers. Jerry Faust, spokesperson for a state organization representing retailers says, “If the system ain’t broke, don’t fix it.” Many consumer advocates argue that the current distribution system of state-set, single pricing at all retail outlets provides consumers with an economically equitable system.

Challenges of System Redesign

Before leaving the office, Joseph outlined two general objectives of distribution network redesign: (1) increase the state’s return from liquor distribution by reducing distribution costs and inefficiencies and (2) improve inventory management by utilizing Management Information Systems (MIS) to further increase efficiency. He also identified four specific objectives: (1) maintain the current service level; (2) increase inventory turns; (3) decrease administrative costs; and (4) maintain the current level of control over a highly sensitive socioeconomic policy area.
Joseph realized he would need to contact a variety of people upon his return to work on Monday in preparation for Wednesday’s meeting. He sketched out plans to meet with representative MLCC staff and operations personnel, MIS staff, external industry experts in liquor and custom delivery operations, and academics in marketing and logistics at the nearby state university.

Joseph decided that any changes in distilled liquor distribution would have to reflect key operational issues of pricing, service level, projected retail sales and tax impact, direct delivery from distillers to major chain warehouses, and delivery cost considerations—not to mention a host of economic and political special interest group concerns. He began to realize that the topic of liquor distribution in Michigan was a much more complex issue than it had seemed a few hours earlier.

Questions:

1. What alternative designs for distilled liquor distribution in Michigan might be considered? Explain the rationale for your suggestions.
2. Discuss the benefits and risks of alternative designs for distilled liquor distribution.
3. Are the historical conditions which the current liquor distribution system is based upon still important today? What, if any, other factors exist that require consideration?
4. Does an inherent social conflict exist when state governments rely upon tax contributions from liquor sales to fund educational programs?
5. How would you organize the final report on distilled liquor distribution in Michigan if you were Joseph Duncan?

Happy New Year Classmate:)!!!