The price is wrong

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The latest trend in the drive to improve operational efficiency in retail supply chains, factory gate pricing (FGP), is beginning to establish itself in the UK groceries sector. But like most initiatives in this field, while FGP promises price and service improvements for consumers, it has the potential to further damage already fraught relationships between retailers and their manufacturers and suppliers.

The principle behind FGP is simple. Traditionally, retailers have paid their suppliers a delivered price (at the individual store or, more likely these days, at a distribution centre), and the supplier then has responsibility for delivery, albeit to a schedule dictated by the retailer.

Under FGP, the retailer pays for and arranges distribution from the supplier’s factory gate onwards, and pays the supplier only the value of the goods themselves, without any of the overheads associated with distribution. This change sounds trivial, and has indeed for some time been commonplace in heavily process-driven areas of manufacturing such as car assembly, where it is quite usual for manufacturers to organise the inbound logistics of critical supplies. In retail, though, the concept is new, starting in North America where Wal-Mart Canada, for example, now contracts for 80 per cent of non-food items this way, and being taken up in the past 15 months in the UK by Tesco and Sainsbury.

When the Competition Commission examined relationships in supermarkets’ supply chains in 2000, FGP didn’t show on the radar: a recent Institute of Grocery Distribution survey showed a third of respondents actively engaged in FGP (albeit in low volumes) and most feeling that FGP is ‘here to stay’. From the retailer’s perspective, the case for FGP rests on two assumptions: that with their size, buying power, level of investment in and understanding of the supply chain the retailer can organise distribution more efficiently and at lower cost than the typical supplier; and that because of a lack of transparency in costing, efficient retailers are paying a margin on delivery costs which is effectively subsidising their less efficient competitors.

Both these premises may be true – but only sometimes, and perhaps only when considered in isolation. Tesco, for example, spends almost one fifth of the £3.75billion cost in its supply chain on transport between manufacturers and distribution centres.

Operated by individual manufacturers, and with little opportunity for backhaulage, truck utilisation is low, whereas in theory Tesco could use its oversight of the whole supply chain – and investment in optimisation technology – to raise utilisation rates dramatically (with incidental environmental benefits).

There are many potential benefits to suppliers. The retail majors are typically the most demanding and awkward customers and the effort and capital required to meet their service requirements may be an order of magnitude greater than that required by the mass of ‘ordinary’ customers. Why not let stores take responsibility for meeting their own extreme requirements?

For smaller and regional suppliers with limited buying power national distribution may be quite impractical, unless they can tap into a retailer’s existing distribution system. If they can, there is the prospect of considerable growth without any capital investment in distribution (although there will still be the need for investment in integrating ordering systems and the like).

So what’s the problem? From the perspective of major manufacturers, Unilever, say, or Proctor & Gamble, the argument that a retailer’s distribution is necessarily more efficient is dubious. Such manufacturers have at least as much buying power, technological investment and supply chain savvy as anyone. And third parties, where they are used, are exactly the same companies as the retailers use. But if 20 or 40 per cent of their distribution is taken out of their hands, their buying power is eroded and significant diseconomies of scale arise (increasing costs which will inevitably be passed to smaller customers, thus potentially damaging competition). And while FGP may improve efficiencies on the manufacturer-DC leg, it could undermine manufacturer’s own backhaul operations. As a delegate at last Autumn’s Logistics & Supply Chain Forum noted: ‘We match inbound to outbound, and we’ve already got some synergies going – and now if the outbound is suddenly taken away, I have adverse cost variance coming my way on the inbound traffic.’ (Ironically, this is in part because of manufacturers’ FGP relations with their own suppliers!)

More fundamental to the fears of suppliers large and small is the question of trust. Suppliers doubt a ‘level playing field’. They suspect that retailers running their own inbound logistics will happily change drop times and consignment quantities to their own convenience (and with knock-on effects on manufacturers’ operations) in a way they would never tolerate from a supplier.

The most fundamental fears, though, are commercial rather than operational. Retailers fear, rightly or wrongly, that they are being ‘ripped off’ on transport costs passed through by manufacturers, but under FGP the same could be true in reverse. Suppliers manufacture to a target price ‘on the shelf’; if the transport cost element is now dictated by the retailer, the margin available on manufacturing can be squeezed ever tighter.

Currently, FGP is genuinely being driven by supply chain people interested in logistical efficiencies, but there is a real fear (on both sides) that product buyers will hijack the process to create another stick with which to beat suppliers.


Briefing points

  • Factory gate pricing can be a powerful driver of logistical efficiencies – in some circumstances. It shouldn’t be imposed across the board.
  • FGP offers real benefits to suppliers, especially smaller ones, in terms of access to market without excessive capital expenditure.
  • Those seeking to introduce FGP need to assess the impact on the whole supply chain, not just the manufacturer-DC transport leg.
  • Contracts need to specify (with penalties if necessary) retailers’ obligations to perform – the mirror image of retailers’ current requirements from suppliers.
  • Despite the name, FGP is about logstics cost, not product price, and needs to be kept that way.
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