This article discusses an important trend within the North American grocery retail sector towards outsourcing distribution operations to third party logistics (3PL) service providers. This is certainly not a new trend as plenty of retailers have outsourced some aspect of the logistics function going back to the 1970’s. Traditionally, it has been more common for grocery retailers to internally control warehouse operations rather than outsource to a third party. Quite simply, many grocery retailers view the 3PL management fee as an incremental expense that can only be cost justified if there is an offsetting warehouse labor expense savings. In order for this to be the case, the 3PL must either run a more efficient distribution operation than the retailer, or the 3PL offers its workers substantially lower wages and benefits that the retailer. It is the latter scenario that is driving the outsourcing trend and today we have a very different management mindset that is being driven to a great extent by labor strategy.
The Case against Outsourcing
Self-distributing retailers must execute maximum efficiency in their distribution operations to enable the stores to be competitive on retail price. This is because warehousing and transportation operating expenses are typically charged as a direct pass-through that is ultimately paid by the stores on their invoices. Pricing at retail is typically determined as some form of markup over the net landed cost of goods plus the corporate upcharge to pay for distribution services. The upcharge is often added to the cost per case to finance the sum total of inbound transportation, warehousing and outbound transportation expenses that are incurred to deliver the goods to the retail store. Hence the store’s percentage gross margin is applied on top of the total case cost plus the upcharge. If distribution support services are too expensive, then the upcharge to the stores will be disproportionally high and the retail stores will be less competitive - it’s that simple.
Warehouse labor expense represents a very important cost component within the retailer’s controllable operating expenses. If warehouse wages and benefits increase beyond an acceptable level or are disproportionate to the market place, then the retailer requires a higher upcharge to service the store. The store needs to generate an acceptable rate of return to justify its existence and so its price levels must be set higher than competing supermarkets because of the costlier upcharge. When a 3PL is hired to run the distribution center, the profit margin of the 3PL must be paid for. Let us say for the sake of discussion that the 3PL requires a minimum rate of return of 14% to justify being in business. This 14% margin is applied to all operating expenses that the 3PL is responsible to manage whether that be the labor force, the building lease, etc. Hence by hiring a 3PL to operate the distribution center, the retailer can expect to pay a 14% premium on warehouse labor expense versus keeping this function in-house. Having said this, then why on earth would any reasonably efficient self-distributing retailer outsource their distribution operation to a 3PL? Doesn’t this translate into higher operating expenses? The answer is that this is not always the case.
The Case for Outsourcing
To start, 3PL Outsourcing is certainly not a strategy that highly competitive grocery retailers resort to out of choice unless they inherently recognize that they have never been efficient at distribution in the first place or that they simply don’t want to invest corporate assets into an area of their business that is not considered as a core competency. Some retailers are strictly interested in investing capital into more stores and would rather pay a higher on-going operating expense for distribution services then invest corporate assets into a self-distribution infrastructure. Other retailers have sold off their inventories and distribution centers to the larger wholesale distributors such as C & S Wholesale and SuperValu in an effort to reduce corporate debt.
The fundamental driver causing grocery retailers to outsource distribution center operations is unquestionably labor strategy. Traditional grocery retailers simply cannot be expected to compete effectively in the market place if they are being held hostage to the unrealistic wage and benefit demands of organized labor. If the unions threaten to strike unless their demands are satisfied, then the retailer’s only defense is to either continuously give in to the increases expected by the unions, or to outsource the distribution operation to a third party and thereby create an arm’s length agreement between the retailer and the labor force.
For the most part, the management teams do not consist of cruel and heartless people whose main intent is to squash the unions. In my experience, many of these companies are stuck between a rock and a hard place. On the one hand, rising labor costs due to increasing wages and as importantly, rapidly escalating health care costs, are causing operating expenses to rise significantly faster than inflation. On the other hand, nonunion retailers such as Walmart are forcing entire markets to compete on the basis of low cost and therein lies the conflict.
Today, there are companies in California that pay fully loaded annual salaries for unionized warehouse labor in excess of $US 80,000 per annum. These companies are expected to compete against Walmart where nonunion wage rates are closer to half of this figure. The hard and cruel fact is that the unions have unrealistically priced themselves out of the market. The Walmart effect has kicked in and has forced traditional grocery retailers to invoke outsourcing strategies as a means to shed unionized labor contracts that are too costly to carry forward into the future. In other words, 3PL outsourcing is a viable labor strategy that is being systematically used to normalize the cost of blue collar labor in markets where these labor rates have simply become excessive. Despite the 3PL management fee premium, the total cost of outsourced labor is still less expensive than maintaining an internally run self-distribution operation. Some examples of this phenomenon are discussed below - it should be noted that we discuss the examples below strictly to illustrate the point of this article.
- In 1994, Walmart acquired Woolco Canada and entered into the Canadian market place for the first time. The acquisition included 122 Woolco retail stores but excluded the Woolco’s distribution centers which were heavily unionized. Walmart decided to startup new facilities and to outsource its Canadian distribution operations to UK-based Tibbett & Britten Group (which was subsequently acquired by Exel Americas). Today, Exel continues to manage the majority of Walmart Canada’s distribution operations through an operating division called Supply Chain Management Inc. Walmart clearly was not interested in inheriting the union contracts associated to the Woolco distribution centers and decided to opt out of them. All of the Woolco distribution facilities were shut down and the jobs were eliminated.
- Kroger is the second largest grocery retailer in the United States (Walmart is the largest) with well known banners including Fred Meyer, King Soopers, Ralphs, Dillons, Smith’s Food & Drug Centers, Food 4 Less, Tom Thumb, and Fry’s Marketplace amongst others. The company operates 34 regional distribution centers across the United States totaling an estimated 20 Million square feet. The majority of its distribution operations are have organized labor contracts with the Teamster’s Union. Over the past decade, Kroger has outsourced distribution operations at numerous distribution centers that in our estimation total approximately 6.7 Million square feet of space or roughly one third of their total distribution capacity. Outsourced facilities include:
- Peyton’s Phoenix, AZ; Peyton’s Fountain, CO; King Sooper’s Dry Grocery facility in Aurora, CO; King Sooper’s Dry Grocery in Denver, CO - to SuperValu Advantage Logistics.
- King Sooper’s Perishables distribution center to Compass Logistics.
- Kroger’s East Point Atlanta GA Perishables facility; and Kroger’s Full-Line distribution center in McDonough, GA - to CS Integrated LLC.
- Kroger’s Shelbyville, IN facility - to Atlas Cold Storage.
- Kroger’s Keller, TX distribution center - to Exel Americas (formerly Tibbett & Britten division).
- Kroger’s Mid-Atlantic/Roanoke Perishables/Freezer Distribution Center in Salem, VA - to Atlas Logistics.
- Kroger’s Indianapolis, IN distribution center; Kroger’s Woodlawn, OH distribution center; and Kroger’s Mid-South distribution center in Louisville, KY - to Zenith Logistics, Inc.. Kroger sold the 776,000 square foot Louisville, KY distribution center outright in 2006 citing mismanagement of the facility as the main reason for the company to go third party. Zenith reportedly offered jobs to the released Teamster employees at $5 to $6 less per hour as a starting point for negotiations.
- Ahold USA has taken numerous decisions to outsource distribution to C&S Wholesale over the past 10 years as part of a labor strategy that is clearly is intended to reduce the company's reliance on unionized labor.
- In March, 2011, Ahold announced the closure of its unionized Jessup, MD Dry Grocery distribution center stating that the business is being transferred to a non-union C&S distribution center in PA. The decision eliminated 450 Teamster jobs.
- Stop & Shop and Giant of Carlisle outsource a portion of their dry grocery volume through C&S Wholesale.
- In Canada, both The Loblaw Company Limited and Overwaitea Foods Group have fought lengthy battles with the UFCW that have ultimately ended up with distribution operations being outsourced to third parties:
- Overwaitea outsourced its Calgary distribution center to Linkfast and its Aldergrove, BC Dry & Perishables distribution centers to EVG Logistics.
- Loblaw’s has outsourced numerous distribution centers to Atlas Logistics Retail LLC including the South Surrey, BC operation; the 870,000 sq. ft. distribution center in Ajax, ON and a 500,000 sq. ft. facility that is being constructed in Regina, SK for a 2010 opening. In 2007, prior to outsourcing the Ajax distribution operation, Loblaws closed its Mississauga, ON distribution center eliminating 850 UFCW jobs. Similarly, Loblaws is reportedly planning to shutter its Saskatoon, SK Western Grocer’s distribution center which would eliminate 300 UFCW jobs when the work is transferred to the new 3PL.
- Sobeys has outsourced labor at its 543,000 sq. ft. Perishables distribution center in Milton, ON to Axis as well as its 456,500 sq. ft. Whitby, ON perishables distribution center to Ryder Logistics.
- 7-Eleven is well known for outsourcing core business functions to specialized service providers. In the United States, 7-Eleven has outsourced all 24 of its CDC (Combined Distribution Center) facilities to a variety of third party service providers. One of the more recent distribution operations to be opened is the 130,000 sq. ft. chilled commissary located in Bohemia, NY on Long Island which has been outsourced to a local firm called The Constance Food Group Inc.
- C&S Wholesale is a company that has benefited significantly from the outsourcing trend. The grocery wholesale distributor has enjoyed tremendous growth over the past 25 years by taking over distribution operations from retailers that operate unionized distribution centers with higher labor costs. C&S has reportedly shut down more than 20 union warehouses, moving work to non-union facilities where workers are paid 40 - 60% less (a claim made by the Teamsters Union). The Teamsters further claim that the non-union distribution centers are often geographically located hundreds of miles away from the stores which we believe to be a fair statement. The Teamsters rightly point out that companies that have outsourced to C&S and subsequently filed for Chapter 11 bankruptcy include: Bruno’s; Bi-Lo; Grand Union; Pathmark; and A&P. In all fairness, these companies made outsourcing decisions as a result of financial debt difficulties such that the sale of the distribution center and the inventory assets were used to reduce debt on the balance sheet. It is not necessarily a fair statement to say that logistics outsourcing decisions led to bankruptcy for any of these companies although once could debate that giving up control of inventory purchasing does have a profound impact on a company's ability to generate profit.
- The list goes on. Other food retailers to outsource some portion of their distribution operations include Ahold USA; Safeway; Trader Joe’s; A & P; Pathmark; King Kullen Grocery Co.; Bruno’s Supermarkets; BI-LO LLC; Wawa; and United Supermarkets.
The retail grocery industry runs on the thinnest of margins whereby most companies are at or around 2.0% net margin or less. This article serves to highlight that outsourcing in the retail grocery sector is directly correlated to the Walmart factor. Established retail grocery companies that are saddled with expensive unionized labor contracts cannot compete against nonunion Walmart. The level of outsourcing in the retail grocery industry that is currently taking place is unprecedented and is clearly a strategy aimed at lowering labor costs by replacing high-priced union jobs with lower cost nonunion jobs. These retailers quite simply have no choice as this is a matter of economic survival. Failure to act will simply result in the same demise that has caused 31 major regional grocery retailers to declare bankruptcy in the United States since Walmart began testing the sale of groceries in its first Supercenter in 1988 (ed. note Walmart operated 2,737 Supercenters in the U.S. at the start of 2010).
We conclude this article by predicting that the trend towards retail grocery firms outsourcing distribution can be expected to continue and that this will result in profound negative impact on the strength of organized labor in the United States. As long as the playing field between Walmart and traditional grocery firms remains as it is today, we cannot expect grocery retailers to “do nothing”. The competitive pressures caused by the Walmart effect are far too powerful to ignore as has been experienced in the United States over the past two decades; and as will soon be experienced in Canada with Walmart’s plans to significantly increase the number of Supercenters across the country.
Marc Wulfraat is the President of MWPVL International Inc. He can be reached at +(1) (514) 482-3572 Extension 100 or by clicking here. MWPVL International provides unbiased consulting services to help companies evaluate 3PL outsourcing strategies. Our services include: requirements definition; 3PL RFP bid specification development; vendor evaluation; and contractual negotiation strategy.