Case No.18: Bose Corporation: The JIT II Program (A)
I. Case Background:
Bose Corporation was founded in 1964 by. Dr. Amar Bose, a professor of Electrical Engineering and Computer Science at the Massachusetts Institute of Technology, where Sherwin Greenblatt and Hose shared a love of music, but recognized that the high fidelity (hi-fi) products then available did not accurately reproduce sound Greenblatt become Bose Corporation’s first employee, the two planned to built a company based on innovations in acoustics and electronics. For three years, virtually all the company’s revenues were earned by developing portable battery operated equipment, hi-fi was considered “the hobby side of the business”. In 1968, however, Bose Corporation launched the 901 speaker, which incorporated proprietary Direct/Reflecting technology, simulating the feeling of live sound by radiating sound waves to the listener directly and via reflections off walls, ceilings, and doors. This speaker was a huge success, landed by a growing market of audio enthusiasts. Two years later Bose introduced the 501 speaker, which also had Direct/Reflecting technology but was half the size of the 901 speaker. In 1973, Bose introduced the 301 speaker, which produced true hi-fi sound but could fit on a bookshelf.
During the 1970’s, sales of Bose speakers grew rapidly, and Bose executives approached the Delco division of General Motors with a proposal to develop a car stereo that would produce exceptional sound. The Cadillac Seville first offered an option for a Delco-Bose sound system in 1982, by 1990 sound systems were available in cars made by General Motors, Honda, Acura, Audi, and Nissan.
Bose Strategy:
In 1990, Bose was privately held, with revenues estimated at $720 million. Amar Bose was chairman of the company, and Sherwin Greenblatt was president. Approximately one-third of the company’s sales were in Japan, one-third in Europe, and one-third in the United States. The company’s motto was “Better Sound through Research,” and Bose Corporation was widely considered the world’s largest manufacturer of component quality speakers.
The company’s mission, to “provide outstanding sound experience to everyone in the whole world”, was manifested in three aspects of the company’s strategy. First, the company constantly sought new markets around the world and had exceptional perseverance in opening markets. For example, Bose entered Japan in 1970 and weathered substantial losses as it tried to establish the Bose brand name among Japanese consumers. The company received its first order from the Japanese car manufacturer of component-quality stereo speakers in Japan (as well as in Holland, France, Australia, and other countries). Management at Bose believed that the desire for good sound was universal, and planned to continue opening new markets around the world.
Second, Bose Corporation sought broader channels of distribution. Originally, Bose speakers were sold exclusively in high-end specialty stores that served audio enthusiasts. Throughout the 1980’s, Bose added new channels, including electronics retailers including Lechmere, Circuit City, Sears, and Montgomery Ward. Also, Bose began to sell some products by direct marketing.
Third, the company produced systems as well as components. In the early days, true high-fidelity sound had been available only to consumers willing to invest time, money, and patience in their stereo systems. By 1991, consumers expected hassle-free sound and the market for integrated audio-systems and portable audio equipment grown to be more than twice as large as the market for separate audio components. Analysis expected the trend toward integrated systems to continue, driven by advances such as home theatre television, which linked big-screen video with surround-sound audio, or “plug and play” equipment, which required minimal setup by the consumer. In 1989, after 14 years of development, Bose had introduced the Acoustic Wave Music system incorporating speakers, an AM/FM receiver, and a cassette tape deck. The product was oriented towards the high end of the portable audio market.
Manufacturing at Bose:
It was well-recognized that speakers were among the most important parts of any audio system-if they were of poor quality, even the best sound systems would not produce high-quality sound. Speakers were judged on their ability to reproduce sound accurately, and sound reproduction depended on speaker design, the quality of materials used in construction, and careful attention to detail in production processes. Speakers were one of the most competitive segments of the audio business, with dozens of manufacturers in the United States, Europe, and Far East producing a diverse array of designs and technologies. Three subassemblies were the critical components of all speakers:
• Transducer
• Electronics
• The cabinet- the speaker’s exterior, the cabinet had to both direct sound waves from the speaker and be attractive in a home or car.
Bose headquarters were located 23 miles west of Boston in Framingham, Massachusetts. The company had three manufacturing facilities:
• Westboro, Massachusetts
• Ste-Marie, Quebec
• Carrick-Macross, Ireland
Due to the company’s rapid growth, two other manufacturing facilities were planned:
• Hillsdale, Michigan
• San Luis, Mexico
In addition, the increasing success in the Japanese market caused some managers to wonder whether a manufacturing facility would soon become necessary in or near Japan.
Corporate Procurement:
In 1990, Corporate Procurement at Bose purchased materials totalling $300 million. Corporate Procurement was headed by Lance Dixon, director of Purchasing and Logistics. Dixon reported to Tom Beeson, vice-president of Manufacturing.
The Corporate Procurement was responsible for locating new vendors and sourcing new parts. Vendors were typically involved early on in new product development efforts.
In 1990, four types of personnel were typically involved in the procurement process:
• Design engineer
• Materials planner
• Buyer
• Vendor salesperson
The new products group, who monitored the supplier base to find technologies and components, were at the heart of corporate procurement. Engineers developing new products relied on them to find components that could meet design, performance, and cost standards. New products also provided a conduit to incorporate vendor input in products under development.
Purchasing at Westboro:
Until 1988, no purchasing had been done by the plants, instead, all items had been purchased by corporate procurement but delivered to the plants. By 1990, purchasing at Bose Corporation was more decentralized. The plants in Westboro, Canada, and Ireland did their own day to day purchasing, typically against contracts negotiated centrally. It was expected that the planned facility in Michigan would also manage its incoming material flow.
Westboro spent about $140 million per year on items purchased from an active base of about 200 vendors. About 50% of the plant’s purchasing dollars were spent in five categories: electronic components, plastics, printing, corrugated boxes/packaging, and cables/cords. Purchasing was planned in a three-stage cycle:
Stage I: Business Planning
Stage II: Aggregate production planning
Stage III: Production scheduling
Westboro buyers preferred vendors who maintained a secure financial position, were located close to Westboro, could provide fast delivery, maintained consistent production processes, and provide good references through corporate procurement or other customers. The average lead time on purchase orders placed by Bose Corporation was four to six weeks, but one third of all purchase orders had less than 10 days lead time. About 35% of all orders were changed within 30 days after placement.
The Evolution of JIT II
In the early 1980’s, shortly after he had been hired by Bose, Lance Dixon requested that Corporate Procurement’s budget be increased significantly to add more experienced buyers, upgrade the department’s information systems, and develop global sourcing programs. Dixon promised a one-year payback on the funds requested, but his request was turned down because company resources were focused on efforts in Japan. As the company grew, Dixon found that every year he needed more people in procurement, and every year at budget time he fought with management over staffing levels.
Dixon and Joe Giordano, vice-president for Finance, developed an alternative solution put purchasing its “profit center mode”. Wherever Dixon could drive expenses below standard costs, he would be allowed to reinvest half the savings back into the department’s budget. If Dixon did not generate any savings, Corporate Procurement would maintain a level budget. As Dixon said, “I can get the people I need to do the job and not add anything to the payroll.”
Dixon also instituted a program to pay cash incentives to buyers. Anytime buyer saved the company money on purchased items, the buyer received a cash reward, typically $100 to $300. This arrangement was patterned after incentive programs commonly found in sales departments. Awards were given for keeping monthly expenditures under standard cost, for unique ideas that led to cost savings, and for other exceptional efforts.
In 1990, Dixon proposed to change the relationship between Bose and certain vendors under a program he called “JIT II.” Under JIT II, a vendor representative (the “rep”) would replace the vendor salesperson, the Bose buyer, and the Bose materials planner and would be authorized to decide what, when, and how much to order for a particular range of products or services. Reps would determine order quantities, placing orders to their companies supply Bose without Bose carrying unnecessary inventory. Reps would also provide engineering expertise in their commodity area and help solve problems on the production floor, much as a Bose facility and would. The reps would be stationed full-time at a Bose facility and would be empowered to use the Bose computer systems, but would be hired, evaluated, and paid by the vendor.
Dixon had recommended the commodity areas of plastics and printing as initial candidates for the JIT II program. Plastics in 1991, Bose Corporation expected to spend close to $14 million on purchases of plastic components. Producing plastics to meet Bose quality standards required considerable experience and skill. Bose used 10 vendors for plastics, the top five vendors received 6% of the dollar volume Dixon recommended G&F Industries to be a JIT II vendor in plastics.
G&F’s headquarters and plant were located in Sturbridge, Massachusetts. about 40 miles west of Bose headquarters. The company employed about 60 people and had total annual revenues of $12 million. Of G&F’s 50 active customers, Bose was the largest account, providing about $2.1 million in annual revenues. The plastics components sold to Bose typically generated 10% before tax profit margin. G&F was owned by John Argitis, who served as president and CEO. Argitis had 15 years experience molding plastics parts at American Optical in 1978 he moved to G&F as vice-president, and in 1986 he purchased the company.
G&F specialized in the production of injection molded plastic parts. In injection molding, pellets of plastics resin were heated to liquid state; the liquid was then injected into a mold where it solidified in the shape of the mold’s interior. A typical injection of molding machine cost up to $200,000, molds to $75,000- $150,000. Molds were made to produce a part of a specific size and shape, although minor alterations were possible. Molds were typically paid for and owned by the customer.
On any particular job, set-up costs of injection molding could often be greater than the cost of machine operations. Set-up timers averaged four hours to change resin colors (keeping the same resin materials), six hours to change molds, and 17 hours to change molds, colors, and resin materials. The set-ups were performed by highly skilled technician who were supervised by plastics engineers, after set-up, machine operation required less skill.
Even if G&F became the JIT II vendor for plastics, if was not clear that G&F would supply all the Bose plants. The facilities planned in Michigan and Mexico would use considerable volumes of plastics, particularly in speaker enclosures for Michigan. The two facilities could either source locally, or use parts that were purchased by Corporate Procurement but shipped directly to the plants.
Plants Materials:
Printed materials included items such as instruction booklets, warranty cards, and promotional materials. In 1990, each Bose department sourced its own printed materials, with 12 vendors supplying printed materials to Bose Corporation. Dixon was concerned that the current decentralized arrangement allowed vendors to charge each manager different price according to that manager’s price sensitivity, and wished to established United Printing as a JIT II vendor, United received only 12% of the company’s overall printing business in 1990, so this would necessitate centralizing the procurement of printed materials. Dixon was concerned that the individual departments might object.
The Management of JIT II:
Neither Beeson nor Dixon was sure that vendors would be interested in participating in JIT II. A qualified rep might cost the vendor $80,000 per year (fully loaded). Dixon and Beeson planned to approach United after they knew whether G&F would participate.
Even if G&F did agree to participate, several issues remained to be resolved. Dixon felt that vendor representatives should be treated, in every respect, as Bose employees- to be listed in Bose telephone directories and have access to all Bose facilities, people, and computer systems. However, several Bose managers had voiced concerns about this arrangement. Some buyers felt that certain information, such as quantities and prices of parts bought from other vendors, should remain confidential-at least to provide an advantage during negotiations.
In the past, vendor’s representatives had typically worn badges that identified them as vendors, and were permitted access only to approved locations within Bose facilities. Dixon proposed changing the policy, he advocated that the reps for BIT II vendors are issued badges just like Bose employees and be free to come and go as they close.
There was also debate about how to ensure that vendors supplied goods at fair prices over the course relationship. Dixon felt that the company’s previous purchases in a given category provided experience to evaluate vendor prices, but others argued that inflation or changes in raw material prices could quickly render this information obsolete. Finally, although Dixon wished to start the program with G&F and United; formal criteria for determining when and with whom to establish JIT II relationships had not been developed.
Finally, there were questions how long a JIT II relationship would last in a company growing as rapidly as Bose. As Tom Beeson said: “There’s always a conflict between purchasing and manufacturing, Lance wants to buy everything and I want to make everything. However, I don’t want vendors assuming responsibility for what we should be doing ourselves. Does the JIT II program facilitate the process of moving into self-control or does it delay that process?”
Sunday, January 10, 2010
Monday, January 4, 2010
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:)!!!
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:)!!!
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