You are on page 1of 15

European Journal of Operational Research 162 (2005) 191205

www.elsevier.com/locate/dsw

Discrete Optimization

Distribution centre location modelling for dierential sales


tax structure
Balram Avittathur a, Janat Shah b, Omprakash K. Gupta

c,*

IIM Calcutta, D.H. Road, Joka P.O., Kolkata 700 104, India
IIM Bangalore, Bannerghatta Road, Bangalore 560 076, India
Prairie View A&M University, Prairie View, TX 77446-0638, USA
b

Received 13 August 2002; accepted 2 October 2003


Available online 19 December 2003

Abstract
The central sales tax (CST) in India results in a dierential sales tax structure. This contributes signicantly to
distribution network decisions that build logistics ineciencies in rms operating in India. In this paper, we develop a
model for determining distribution centres (DCs) locations considering the impact of CST. A non-linear mixed integerprogramming problem that is formulated initially is approximated to a mixed integer-programming problem. Using a
numeric example, the eect of CST rates and product variety on DC locations is studied and found to be having impact.
It is felt that the Indian Government proposal to switch over from the present sales tax regime to value added tax (VAT)
regime would signicantly contribute to reducing the logistics ineciencies of Indian rms.
 2003 Published by Elsevier B.V.
Keywords: Distribution centres; Location; India; Logistics management; Non-linear mixed integer programming; Taris

1. Introduction
The increase in competition and the swings in
the economy in the last few years are compelling
rms to cut costs and improve customer service.
With induction of technology and best manufacturing practices in the last few years, the scope for
improving eciency within the factory premises
*

Corresponding author. Tel.: +1-936-8574010; fax: +1-9368572243.


E-mail addresses: balram@iimcal.ac.in (B. Avittathur),
janat@iimb.ernet.in (J. Shah), om_gupta@pvamu.edu (O.K.
Gupta).
0377-2217/$ - see front matter  2003 Published by Elsevier B.V.
doi:10.1016/j.ejor.2003.10.012

has narrowed substantially. Whereas, the situation


is quite dierent when it comes to outbound logistics. It still has not received the attention that
manufacturing has been receiving. With growing
explosion of product variety and markets, the
scope for improving outbound logistics eciency
is very high. In the Indian context, it is worth
understanding the impact of the current sales taxes
structure on logistics performance of Indian rms.
According to Raghuram and Rangaraj [1], the
main components of logistics costs in India are
inventory, transportation and warehousing cost.
One of the important drivers of these costs in
India is dierential sales tax, owing to central

192

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

sales tax (CST). India comprises of 28 States and


seven centrally administered territories (Union
Territories). The CST is a tari that is applicable
to inter-state trade. It is payable when trading
goods transaction by a manufacturer to his retailer does not happen in the same state or union
territory. In other words, when a manufacturer
located in State A directly distributes goods to a
retailer in State B, the consignment attracts CST
as well as local sales tax of State B. However, if
the manufacturer distributes goods to the same
retailer from his own distribution centre (DC)
located in State B, only local sales tax of State B
has to be paid. Thus, the sales tax is dierential,
depending on the locations of the DCs. Thus, in
order to avoid paying CST, a rm has to maintain
at least one DC in each state, such that material
ow to the retail outlets in a particular state
happens only from DCs of that state. For instance, let a particular rm have its DCs in
Karnataka and Tamil Nadu states respectively at
Bangalore and Chennai. Imagine the procurement
of material by a retailer at Hosur in Tamil Nadu
state. Hosur is about 40 km from Bangalore and
280 km from Chennai. From logistics eciency
viewpoint, dispatching material from Bangalore
DC would be easier than from Chennai DC.
However, to avoid CST burden, a rm will dispatch material to Hosur from Chennai DC. This
implies that an Indian rm with a national presence will require 35 distribution centres (28 States
plus seven Union Territories), one in each state
and union territory, to avoid coming under the
purview of CST. However, from logistics eciency viewpoint this may not be justied, particularly in states with low sales volumes. Apart
from higher inventory costs and higher warehousing costs, large number of DCs result in
higher co-ordination and establishment (facilities)
costs. This issue is all the more signicant as
companies strive to network their stock-points
using information technology (facilities).
Existing literature does not clearly reveal studies that show the relation between CST structure
in India and logistics eciency of Indian rms.
Shah and Avittathur [2] point to a survey that
puts nished goods inventories of the Indian
manufacturing sector roughly at 40 days in the

period 19911997. Rajagopalan and Malhotra [3]


reveal that manufacturing sector nished goods
inventories of United States of America has declined progressively during their study horizon
(19611994) and stood roughly at 14 days in
1994. These gures reveal that logistical eciency
of Indian rms is relatively lower than their
counterparts in the US. The CST structure could
be one of the contributors to this relative ineciency.
Arntzen et al. [4] model global supply chain for
Digital Corporation where they explicitly include
taxes, duties and duty draw back. Since dierent
countries have dierent tax structures and rules
regarding local content requirement, global corporations need to build these concerns into their
decision-making. But since their main focus was
to understand time versus cost trade-os, there
were no specic insights on impact of local taxes
on location decisions. Munson and Rosenblatt [5]
suggested an approach by which one can model
local content rule in classical plant location
model. They transform single plant model into
knapsack problem and suggest a solution procedure. They, however, have worked with deterministic demand structure. Drezner [6] has
surveyed the applications and methods for facility
location problems. However, impact of taxation
has not received attention. We are not aware of
any existing study that has explicitly handled issues of safety stock inventory and location issues
while deciding warehouse location. With increasing product proliferation and high demand uncertainty, impact of safety stock has gained lot of
importance.
In this paper, we attempt to develop a model for
determining DC locations considering the impact
of the dierential sales tax. As already described,
there appears to be a trade-o between CST
structure and logistics eciency in the Indian
context. An exercise to optimally determine the
location of DCs will have to consider this tradeo. This basic model can be used to calculate ineciencies in the current CST structure. We hope
to use this base model to suggest alternate modes
of taxation structure, which are likely to be less
inecient from logistics point of view. Firms in
developing countries like India nd that their cost

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

structures are adversely aected by some of the


local tax rules in addition to the contribution by
poor logistics infrastructure. Currently, entire debate in India regarding sales tax rules are based on
power equations among various parties involved.
We attempt to suggest an approach that can
quantify costs and benets of various tax structures and, thus, bring objectivity to the whole debate. In Section 2, we build distribution centre
location model for dierential sales tax. Findings
are provided in Section 3. Discussion and conclusions are provided in Section 4.

2. Distribution centre location modelling for dierential sales tax


Consider the distribution network of an Indian
manufacturing rm with a national presence,
having a manufacturing facility and a central inventory depot attached to it. This inventory point
is referred to as Central Warehouse. The rm
distributes dierent nished goods (referred now
onwards as products) to its retailers through a
network of DCs, located in dierent states and
union territories. To avoid paying CST, at least
one provincial DC has to be set up in each state
and union territory. A term demand point is
dened to describe the aggregation of all retailer
points in a city and its neighbouring areas. The
geographical spread of a demand point cannot
extend to more than one state or union territory.
For each product at each demand point, the demand in any period is denoted by an i.i.d. random
variable that is normally distributed. The periodic
review inventory policy is followed at the DCs.
Every period, the inventories at the DCs are reviewed and safety stock replenished according to
an periodic review order-up-to level policy [7]. The
distribution centre location modelling refers to the
problem of determining those demand points
where DCs should be located with an objective of
minimizing the total of all relevant costs. As demand varies from one period to another, the objective translates to minimization of the average
of total cost per period.
For each DC, the relevant costs considered in
this modelling are xed cost of installing and

193

operating the DC (DC xed cost), average cost of


carrying inventory as safety stock at the DC
(safety stock inventory cost), the average cost of
carrying inventory in transit between Central
Warehouse to the DC (transit inventory cost) and
average cost of transporting material from Central
Warehouse to the DC (transport cost). In addition, two more costs, average extra transport cost
and average additional sales tax, have to be borne
when a DC serves demand points other than the
one in which it is located at. These demand points
are referred to as external demand points. It is
assumed that a demand point can be served by one
DC only. However, a DC can serve more than one
demand point.
The DC xed cost refers to the installation
(apportioned on period basis) and operational
costs that are independent of the volumes dispensed by the DC. Many costs accounted by a
DC, namely property registration, land tax, electricity expense, telephone expense, clerical expense, rent, etc., have a xed component that
is independent of the distribution volume. The
safety stock inventory cost (for periodic review
inventory policy) and the transit inventory cost
are determined as dened by Silver et al. [7, pp.
3132, 282284]. The transport cost is a function
of the product cost, quantity of products transported and distance between Central Warehouse
and the DC. The extra transport cost is the cost
of transporting material from the DC to an external demand point that it serves and is a function of product cost, quantity of products
transported and distance between DC and the
demand point. The additional sales tax is the CST
that has to be borne if a demand point does not
have a DC and has to be served by a DC that is
located in a dierent state or union territory. In
other words, it comes into picture only when a
DC and an external demand point served by it are
not in the same state or union territory. Certain
distribution costs were not considered, as they are
irrelevant to this modelling. They are the cyclic
inventory carrying cost and the direct cost of installing and maintaining DCs. These costs are
directly related to the volumes transacted and do
not dependent on the number of DCs in operation and their locations.

194

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

The notations used in the model are as


follows:
Parameters and subscripts
I
fiji 1; . . . ; pg, set of products;
J
fjjj 1; . . . ; ng, set of demand points;
lij
mean of per period demand of product i
at demand point j;
rij
standard deviation of per period demand
of product i at demand point j;
hi
unit per period inventory carrying rate of
product i;
dk
distance from Central Warehouse to DC
k, where k 2 J ;
djk
distance of demand point j from DC k,
djk 0 for j k;
F
xed cost per period of installing (apportioned) and operating a DC;
lk
transportation lead-time from Central
Warehouse to DC k. It is assumed that
there is no uncertainty in the transportation process and, hence, lk is a constant;
si
unit cost of transportation per unit distance for product i;
ti
unit additional sales tax for product i,
when applicable;
ujk
a binary parameter that indicates whether
additional sales tax is applicable when
demand point j is served by DC k; ujk 1
when applicable and ujk 0, otherwise.
For j k, ujk 0;
z
safety factor value corresponding to target
inventory service level. The target inventory service level is assumed to be same
for all products and all DCs.

Minimize
TCA

2
4 yk F z

X
X s
hi 1 lk
yjk r2ij
i

(
lk

ujk

hi lij dk djk
)

ti lij yjk 5

si lij

Subject to
yk  yjk P 0 8j; k;
X
yjk 1 8j;

2
3

2.1. Formulation A: non-linear objective function


formulation

4
q

P
P P
P
The terms F k yk , z i hi k 1 lk j yjk r2ij ,
P P
P P
P P P
P
i hi
k lk
j yjk lij ,
i si
k dk
j yjk lij ,
i si
j
P P P
P
d
y
l
and
t
y
l
in
the
objeck jk jk ij
i i
k
j6k jk ij
tive function, denoted by (1), respectively describe
the DC xed, average safety stock inventory,
average transit inventory, average transport,
average extra transport and average additional
sales tax costs per period. The constraint denoted
by (4) indicates that all the variables in the
model are binary variables. The constraint denoted by (2) indicates that yjk can take value of 1
only if yk is equal to 1. The constraint denoted by
(3) indicates that only one DC serves a demand
point.
This formulation is a non-linear mixed integerprogramming problem (NLMIP) owing to the
average safety stock inventory cost term in the
objective function. As there are n demand points
and as the optimal number of DCs could vary
from 1 to n, it can be seen that subject to constraints denotedP
by (2) and (3), the problem is one
n
n
of evaluating
combinations of yjk .
r1 nCr r
Hence, as n increases the number of combinations
of yjk to be evaluated increases exponentially.
Thus, the NLMIP formulation is analytically
complex to solve for a large value of n.

We begin with an accurate formulation of the


problem considering all the relevant costs mentioned earlier. This formulation is as shown below:

Proposition 1. When average safety stock inventory


costs are not considered in (1), a DC located at
demand point j will denitely serve demand point j.

Decision variables
yk
1, if a DC is located at demand point k; 0,
otherwise;
yjk
1, if demand point j is served by DC k; 0,
otherwise.

yk ; yjk 2 0; 1:

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

Proof. The proof is given in Appendix A.

195

Subject to

2.2. Formulation B: approximate mixed integer


programming formulation

yk  yjk P 0 8j; k;
X
yjk 1 8j;

6
7

Owing to analytical complexity of solving the


NLMIP formulation as described above, an alternate mixed integer programming formulation is
proposed. In NLMIP, the average safety stock
inventory
cost term,
which contains the expression
q
P
2
1 lk j yjk rij , makes the objective function
non-linear. The approximate mixed integer programming formulation (AMIP) is developed by
substituting this non-linear term by two linear
terms.
According to Proposition 1, if yk 1, then
yjk 1 for j k. In the alternative approximate
formulation, the average safety stock inventory
cost is dened in a similar manner as the extra
transport cost term. By Proposition 1, yk 1 implies that DC k at the minimum serves at least
demand point k. The average safety stock inventory
cost
p
P for this situation is equal to
z 1 lk i hi rik . This is referred to as base safety
stock inventory cost. A parameter, cjk , is introduced to dene the additional safety stock inventory costs as a result of DC k serving demand
points other than the one where it is located. Accordingly, the sum of additional safety stock inventory costs as a result of DC k serving demand
points other than
the P
one P
where it is located is
p
described by z 1 lk i hi j cjk rij yjk . It may be
noted that cjk 0 for j k.
Accordingly, the AMIP formulation becomes
Minimize
TCB

"(

)
p X
F z 1 lk
hi rik yk

(
z

p X X
1 lk
hi
cjk rij

lk

hi lij dk djk

ujk

X
i

)
ti lij yjk

si lij

yk ; yjk 2 0; 1:

Though, Formulation B (AMIP) is simpler and


analytically easier to solve than Formulation A
(NLMIP), it has to be remembered that the optimal solution arrived at by the former is only an
approximation of the actual optimal solution. The
error in optimal solution of AMIP will be minimal
if the parameter cjk is selected judiciously.

3. Findings
AMIP as proposed in Section 2 is validated by a
numeric example in this section. In addition, we
also attempt to understand the impact of the important parameters on the DC location decision
through a series of sensitivity analyses using realistic parameter values. The example is based on the
data provided by a consumer durables manufacturer of India. Although, this rm has a national
presence, only the northern region data is used for
simplicity in presentation of results. In this example, the period is considered to be a week.
In the northern region, the rm presently markets 47 products through six demand points
Delhi, Kanpur, Jullunder, Jaipur, Faridabad and
Dehra Dun. Each of these demand points belongs
to dierent states and union territories. For these
six demand points, j 1; . . . ; 6,P
it is observed that
the total sales in value terms
i Vi lij as well as
summations of weekly
demand
standard deviaP
tions in value terms i Vi rij are respectively in the
proportion 0.40:0.16:0.16:0.16:0.08:0.04, where Vi
is the cost of product i. The DCs that serve these
demand points are served by a Central Warehouse
located at Bangalore in South India. In reality, the
xed cost per period of installing (apportioned)
and operating a DC (F ), the inventory service level
considered for all DCs (z), the inventory carrying
rate per week and unit cost of transportation per
kilometre for each product for this rm are respectively 2500 Indian Rupees per week, 95%,

196

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

(equivalent to a value added tax structure), 1%


(nominal CST rate), 4% and 10%. Depending on
what the product is, the latter two rates are the
rates in eect currently in India.
We developed our own software code for determining the optimal solution for NLMIP. It was
coded in Java programming language. It determines the least cost and the corresponding DC

0.35% (corresponds to 18.2% per year) and 0.002%


of the total product cost. The CST rate applicable
is 4% presently. The data pertaining to variables
dk , lk , djk , ujk and cjk are shown in Tables 14.
Detailed discussion and computation of the cjk
values in Table 4 is shown in Appendix B.
We use four rates of CST (representing ti values) for all the sensitivity analyses. They are 0%

Table 1
Demand point specic data
dk (km)
lk (week)

Delhi

Kanpur

Jullunder

Jaipur

Faridabad

Dehra Dun

2050
1

1855
1

2415
1

2000
1

2020
1

2240
1

Delhi

Kanpur

Jullunder

Jaipur

Faridabad

Dehra Dun

0
480
375
260
30
235

480
0
855
520
450
575

375
855
0
635
405
365

260
520
635
0
290
495

30
450
405
290
0
260

235
575
365
495
260
0

Delhi

Kanpur

Jullunder

Jaipur

Faridabad

Dehra Dun

0
1
1
1
1
1

1
0
1
1
1
1

1
1
0
1
1
1

1
1
1
0
1
1

1
1
1
1
0
1

1
1
1
1
1
0

Table 2
Distances matrix (djk values in km)
Delhi
Kanpur
Jullunder
Jaipur
Faridabad
Dehra Dun

Table 3
CST applicability matrix (ujk values)
Delhi
Kanpur
Jullunder
Jaipur
Faridabad
Dehra Dun

Table 4
Additional safety stock inventory proportionality matrix (cjk values)
Demand point j
1
2
3
4
5
6

DC k
Delhi

Kanpur

Jullunder

Jaipur

Faridabad

Dehra Dun

0.000
0.158
0.158
0.158
0.158
0.158

0.399
0.000
0.399
0.399
0.399
0.399

0.399
0.399
0.000
0.399
0.399
0.399

0.399
0.399
0.399
0.000
0.399
0.399

0.451
0.451
0.451
0.451
0.000
0.451

0.474
0.474
0.474
0.474
0.474
0.000

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

allocation by enumerating all


P the feasible solutions. As mentioned earlier, nr1 nCr rn combinations have to be enumerated for NLMIP. For a six
demand point problem (n 6), this corresponds to
217,392 combinations. Each simulation run, for a
specic set of parameter values, took less than a
minute for the six demand point problem when
run on a PC with Pentium 4 processor. The
number of combinations increases to 1.42 1011 ,
2.52 1019 and 2.43 1028 for n 10, 15 and 20,
respectively. Contemporary PCs may nd it dicult to enumerate problems with this many combinations. Hence, for large problems, complete
enumeration may not be a feasible option.
General algebraic modeling system (GAMS)
2.25 is used to determine the solutions as per
AMIP. For a PC with Pentium 4 processor, the
optimal solution for AMIP is obtained in few
seconds time.
The optimal allocations of DCs based on the
parameters valid for this rm, for the dierent
CST rates, are as shown in Table 5. The current
CST rate is 4% and the solution as per AMIP
matches the present practice of the rm of having a
DC at all the six demand points. As can be seen in
Table 5, optimal number of DC locations is quite
sensitive to CST rate. Given that the Government
intends to reduce CST progressively to 0%, this
has strategic implication for most of the rms
operating in Indian market [8].

197

Using simulation we carryout separate sensitivity analyses of dierent parameters with the
CST rate. For each sensitivity analysis, only one
parameter is varied at a time, keeping the other
parameters at a central level. The levels used for
each parameter were such that the range covered a
wide variety of industries. The parameter values
for the rm in the numeric example are used as the
central levels for the parameters that were being
considered in the sensitivity analyses. For each
simulation, the optimal solutions (least total cost
per week and optimal number of DCs) are determined for both NLMIP (using our software code)
and AMIP (using GAMS 2.25). The results are
as shown in Tables 610.
The dierent parameters considered for sensitivity analysis with respect to CST rate are DC
xed cost (Table 6), DC service level (Table 7),
unit transportation cost per km (Table 8), product
variety (Table 9) and demand distribution among
the demand points (Table 10). The results in Tables 610 are represented graphically in Fig. 1ad
(sensitivity of total cost per week) and Fig. 2ad
(sensitivity of number of DCs).
Referring to Fig. 1ad, the total cost per week
increases with increase in parameter value for all
four parameters. It is also seen that for a particular
parameter value, in all four gures, the cost increases as the CST rate increases from 0% to 4%.
Except one simulation (F 4000 in Table 6), the

Table 5
Optimal solutions for the real-life situation
Case

t (%)

Demand points served by the DCs located at


1

3
4

4
10

2
2
2

4
3
3

4
4

5
5

TCB

Error
(%)

134,918

134,918

146,408

146,514

0.07

152,507
152,507

152,507
152,507

1, 2, 3,
4, 5, 6
1, 3, 5,
6
1
1

TCA

6
6

Demand points served are described by numbers with 1, 2, 3, 4, 5 and 6 respectively indicating Delhi, Kanpur, Jullunder, Jaipur,
Faridabad and Dehra Dun.
TCA : least total cost per week as per NLMIP (Formulation A).
TCB : least total cost per week as per AMIP (Formulation B).
Error: jTCA  TCB j=TCA .
All cost gures are in Indian Rupees.

198

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

Table 6
CST (t)DC xed cost
Case
1
2
3
4
5
6
7
8
9
10
11
12

t (%)
0
0
0
1
1
1
4
4
4
10
10
10

AMIP

NLMIP

Error (%)

No. of DCs

TCB

No. of DCs

TCA

1000
2500
4000
1000
2500
4000
1000
2500
4000
1000
2500
4000

2
1
1
3
3
2
6
6
5
6
6
6

133,121
134,918
136,418
142,014
146,514
150,121
143,507
152,507
160,754
143,507
152,507
161,507

2
1
1
3
3
2
6
6
5
6
6
6

133,088
134,918
136,418
141,908
146,408
150,088
143,507
152,507
160,646
143,507
152,507
161,507

z (%)

AMIP

0.02
0.00
0.00
0.07
0.07
0.02
0.00
0.00
0.07
0.00
0.00
0.00

Table 7
CST (t)DC service level
Case
1
2
3
4
5
6
7
8
9
10
11
12

t (%)
0
0
0
1
1
1
4
4
4
10
10
10

90.0
95.0
97.7
90.0
95.0
97.7
90.0
95.0
97.7
90.0
95.0
97.7

NLMIP

Error (%)

No. of DCs

TCB

No. of DCs

TCA

1
1
1
3
3
2
6
6
6
6
6
6

132,169
134,918
137,591
142,269
146,514
150,522
146,952
152,507
157,910
146,952
152,507
157,910

1
1
1
3
3
2
6
6
6
6
6
6

132,169
134,918
137,591
142,186
146,408
150,482
146,952
152,507
157,910
146,952
152,507
157,910

total cost remains same as CST rate increases from


4% to 10%.
Referring to Fig. 2a, b and d, the optimal
number of DCs remains same or decreases as the
parameter value increases (DC xed cost, DC
service level and product variety, respectively).
Referring to Fig. 2c, the optimal number of DCs
remains same or increases as the unit transportation cost per kilometre increases. It is also seen
that for a particular parameter value, in all four
gures, the optimal number of DCs increases as
the CST rate increases from 0% to 4%. Except one
simulation (F 4000 in Table 6), the optimal
number of DCs remains same as CST rate increases from 4% to 10%.

0.00
0.00
0.00
0.06
0.07
0.03
0.00
0.00
0.00
0.00
0.00
0.00

For deriving dierent values of p, the existing


products that are similar are combined on the
basis of three existing product attributes and exploded on the basis of a fourth product attribute
that the rm is planning to introduce in future to
boost product variety. By combining the three
existing product attributes, product variety drops
from 47 to 10. By exploding on the fourth product
attribute, the product variety increases from 47 to
70. Further variety on this attribute increases
product variety to 100. Thus, the p values used are
10, 47, 70 and 100.
Referring to Table 10, we do not observe a
specic trend for total cost per week for change in
demand distribution among demand points from

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

199

Table 8
CST (t)DC unit transportation cost (per km)
Case
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

t (%)
0
0
0
0
1
1
1
1
4
4
4
4
10
10
10
10

s (%)

AMIP

NLMIP

Error (%)

No. of DCs

TCB

No. of DCs

TCA

0.001
0.002
0.003
0.004
0.001
0.002
0.003
0.004
0.001
0.002
0.003
0.004
0.001
0.002
0.003
0.004

1
1
2
2
2
3
3
3
6
6
6
6
6
6
6
6

79,278
134,918
189,426
242,731
93,816
146,514
198,579
250,644
100,647
152,507
204,367
256,227
100,647
152,507
204,367
256,227

1
1
2
2
2
3
3
3
6
6
6
6
6
6
6
6

79,278
134,918
189,393
242,698
93,783
146,408
198,473
250,538
100,647
152,507
204,367
256,227
100,647
152,507
204,367
256,227

AMIP

0.00
0.00
0.02
0.01
0.04
0.07
0.05
0.04
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

Table 9
CST (t)product variety
Case
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

t (%)
0
0
0
0
1
1
1
1
4
4
4
4
10
10
10
10

10
47
70
100
10
47
70
100
10
47
70
100
10
47
70
100

NLMIP

Error (%)

No. of DCs

TCB

No. of DCs

TCA

1
1
1
1
3
3
2
2
6
6
6
6
6
6
6
6

132,602
134,918
137,637
142,673
142,936
146,514
150,581
156,988
147,826
152,507
158,004
168,182
147,826
152,507
158,004
168,182

1
1
1
1
3
3
2
2
6
6
6
6
6
6
6
6

132,602
134,918
137,637
142,673
142,850
146,408
150,541
156,935
147,826
152,507
158,004
168,182
147,826
152,507
158,004
168,182

varied distribution to equal distribution. However,


it is seen that for a particular demand distribution
among demand points, total cost increases as the
CST rate increases from 0% to 4%. The optimal
number of DCs remains same for both demand
distributions. However, it is seen that for a particular demand distribution among demand
points, the optimal number of DCs increases as the
CST rate increases from 0% to 4%.

0.00
0.00
0.00
0.00
0.06
0.07
0.03
0.03
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

For the simulations shown in Tables 610, it is


seen that average error (dierence in total costs as
per Formulations A and B) in percentage terms is
just 0.01% with highest error value at 0.36%. The
next highest error gure is 0.07%. It can be seen
that the error is zero when DC locations are located either in one demand point or in all the n
demand points (each DC serves only the demand
point where it is located). This is obvious given the

200

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

Table 10
CST (t)demand distribution across demand points
Case
1
2
3
4
5
6
7
8

t (%)
0
0
1
1
4
4
10
10

Demand
distribution

AMIP
No. of DCs

TCB

No. of DCs

NLMIP
TCA

Error (%)

Varied
Equal
Varied
Equal
Varied
Equal
Varied
Equal

1
1
3
3
6
6
6
6

134,918
134,430
146,514
151,233
152,507
153,621
152,507
153,621

1
1
3
3
6
6
6
6

134,918
134,430
146,408
150,691
152,507
153,621
152,507
153,621

0.00
0.00
0.07
0.36
0.00
0.00
0.00
0.00

170000

150000

130000
0

1000

2000

3000

4000

5000

Total Cost Per Week

Total Cost Per Week

TCA : least total cost per week as per NLMIP.


TCB : least total cost per week as per AMIP.
Error: jTCA  TCB j=TCA .

170000

150000

130000
85.0

(a)

t = 0%

t = 1%

t = 4%

90.0

95.0

100.0

DC Service Level %

Fixed Cost per DC


t = 10%

(b)

t = 0%

t = 1%

t = 4%

t = 10%

170000

Total Cost Per Week

Total Cost Per Week

270000
220000
170000
120000
70000
0.000

0.001

0.002

0.003

0.004

t = 0%

t = 1%

t = 4%

130000
0

0.005

s%

(c)

150000

20

(d)
t = 10%

40

60

80

100

Product Variety
t = 0%

t = 1%

t = 4%

t = 10%

Fig. 1. (a) Sensitivity with xed cost; (b) sensitivity with service level; (c) sensitivity with unit transportation cost (per km); and
(d) sensitivity with product variety.

denition of the cjk values (detailed discussion as


shown in Appendix B). The most important result
is that optimal number of DCs is same as per
NLMIP and AMIP for all simulations. Hence,
AMIP is good approximation of NLMIP. As
mentioned earlier, the software code for NLMIP

would have diculty in solving large problems. As


has been demonstrated by above simulations, the
approximate MIP formulation provides a good
solution and diers from optimal solution on an
average by 0.01%. This is the basis for our plan to
use AMIP for future studies.

6
4
2
0

0
0

1000

2000

3000

4000

5000

85.0

90.0

Fixed Cost per DC


t = 0%

t = 1%

t = 4%

(b)

t = 10%

6
4
2
0
0.000

95.0

100.0

DC Service Level %

Number of DCs

Number of DCs

(a)

t = 0%

t = 1%

t = 4%

t = 10%

6
4
2
0

0.001

0.002

0.003

0.004

0.005

10

20

30

t = 0%

t = 1%

40

50

60

70

80

90 100

Product Variety

s%
(c)

201

Number of DCs

Number of DCs

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

t = 4%

t = 10%

(d)

t = 0%

t = 1%

t = 4%

t = 10%

Fig. 2. (a) Sensitivity with xed cost; (b) sensitivity with service level; (c) sensitivity with unit transportation cost (per km); and
(d) sensitivity with product variety.

4. Discussion and conclusions


A model for determining the location of DCs
for dierential sales tax has been developed in this
paper. It is seen that an accurate formulation results in a complex non-linear mixed integerprogramming problem. The optimal solutions for
the approximate mixed integer programming formulation shows results that are very close to the
optimal solutions for the non-linear mixed integer programming formulation. Validation of the
model using a real-life numeric example shows that
the result as per model was same as the real-life
situation. Simulations to understand the impact of
dierent parameters and the CST rate on the DC
location decision are discussed in the following
subsections.
4.1. Eect of DC xed cost
Referring to the objective function, increasing
the DC xed cost term in a minimization problem
would have the eect of reducing the number of
DCs. Our ndings show that as DC xed cost in-

creases, the total cost per week increases and the


optimal number of DCs decreases or remains
same. For CST of 4% and above, it is seen that the
high sales tax, incurred when a demand point is
served by a DC located in some other demand
point, becomes the dominant cost, which forces a
DC at all demand points. Hence, the rm has a
DC at all demand points except for one case,
where CST 4% and DC xed cost Rupees 4000
per week, for which the optimal number of DCs
turned out to be ve.
4.2. Eect of DC service level
Referring to the objective function, the DC
service level (z) appears in the safety stock inventory term. As the service level required at each DC
increases, the safety stock requirement also increases. Looking at the safety stock inventory expression in the objective function, it is seen that
this cost term can be reduced by pooling demands
at the dierent demand points. Hence, increasing
the DC service level term in a minimization
problem would have the eect of reducing the

202

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

number of DCs. Our ndings show that as DC


service level increases, the total cost per week increases and the optimal number of DCs decreases
or remains same. For CST of 4% and above, it is
seen that the high sales tax, incurred when a demand point is served by a DC located in some
other demand point, becomes the dominant cost,
which forces a DC at all demand points for all
three service levels.

and the optimal number of DCs decreases or remains same. For CST of 4% and above, it is seen
that the high sales tax, incurred when a demand
point is served by a DC located in some other
demand point, becomes the dominant cost, which
forces a DC at all demand points.

4.3. Eect of transportation cost

The optimal number of DCs remained the same


for both varied and equal demand distribution
across the demand points. The total costs were
almost same except when CST rate was 1%. The
demand distribution across demand points would
impact the safety stock inventory term, though, its
impact may not be signicant. It was not possible
to make rm conclusions on the impact of demand
distribution on the basis of our simulation results.

Referring to the objective function, the unit


transportation cost per km (s) appears in the
two transportation cost terms. As s increases,
the transportation costs increases. Looking at the
transportation cost expressions in the objective
function, it is seen that these cost terms can be
reduced if each demand point is served by a DC
located locally (incur no extra transportation
cost). Hence, increasing s in this minimization
problem would have the eect of increasing the
number of DCs. Our ndings show that as s increases, the total cost per week increases and the
optimal number of DCs increases or remains same.
For CST of 4% and above, it is seen that the high
sales tax, incurred when a demand point is served
by a DC located in some other demand point,
becomes the dominant cost, which forces a DC
at all demand points for all four transportation
costs.
4.4. Eect of product variety
As product variety increases, demand at each
demand point further disaggregates. This results in
the increase in demand uncertainty at the product
level, though, demand uncertainty may remain
same at the aggregate level. Thus, the increase in
product variety, or the number of products, will
result in the increase in safety stock inventory cost.
Looking at the safety stock inventory expression in
the objective function, it is seen that this cost term
can be reduced by pooling demands at the dierent
demand points. Hence, increasing the product
variety would have the eect of reducing the
number of DCs. Our ndings show that as product
variety increases, the total cost per week increases

4.5. Eect of demand distribution across the demand


points

4.6. Impact of central sales tax


As the CST rate increases the number of DCs
required increases. When CST rate is high, the
benet of pooling safety stocks and the reduction
of DC xed cost, owing to lesser number of DCs,
are negated by the high additional sales tax that
has to be borne owing to DCs and their respective
external demand points not being in the same state
or union territory. Hence, we see that for 4% or
10% CST, the rm would locate a DC at all demand points irrespective of the demand serviced.
The only exception was when CST was 4% and the
DC xed cost was highest at Rupees 4000 thousand per week.
Clearly, CST rate is an important driver of the
optimal number of DCs required. In fact, in all
simulations for CST rates of 4% and 10%, except
one where CST was 4% and the DC Fixed Cost
was highest at Rupees 4000 thousand per week, we
nd that change in parameter value has no impact
on the solution. This indicates the dominant eect
of this cost term.
4.7. Managerial implications
The present CST structure in India has dierent rate slabs, starting from 1% to 4% being the

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

most commonly used rate. The simulations with


CST of 4% and 10% show that it is economical to
locate DCs at all demand points, irrespective of
the demand serviced. The simulations also reveal
that the central sales tax transaction occurs only
once for the dierent simulations with CST rates
of 4% and 10%. However, for CST rate of 1%,
the optimal number of DCs varies between 2 and
3 in all the simulations. Thus, central sales tax
transaction occurs in all the simulations with CST
rate of 1%. This implies that the Government
receives a higher income through CST when it is
lower at 1%.
For rms, increase in CST rate increases their
total cost as the number of DCs to be located increases. The present CST structure contributes
substantially to high levels of nished goods inventories and logistics costs in India. It is common
knowledge that holding large inventories is highly
detrimental to rms as well as to developing
economies that suer from nancial resources
scarcity. Given the drawbacks of the present system, from a logistics management viewpoint it is
highly worthwhile to search for alternatives that
are much simpler and ecient, while ensuring that
government revenues are maintained. The Indian
Government proposal to switch over from present
sales tax regime to value added tax regime, which
is equivalent to 0% CST rate, in the future is a
positive attempt at addressing the anomalies in the
Indian logistics sector. This would have signicant
impact on the distribution network design for the
Indian companies. As we have shown, based on
product characteristics (value, weight, volume),
product variety and demand variability, the optimal number of distribution centres would vary
from rm to rm. Even though it is possible to
understand how each of these variables aect
network design individually, it is dicult to work
out intuitive solutions for various combinations of
the relevant parameters. Given that the government has announced a time schedule for changes
to the taxation structure [8], it is imperative for
Indian rms to redesign their distribution networks. The comprehensive model proposed in this
paper should provide help to the decision maker in
arriving at the optimal solution for their respective
networks.

203

4.8. Limitations and directions for future research


We have assumed that the service to customers
at the demand points is same irrespective of where
the DCs that serve them are located. For certain
industries, this assumption may not be valid. The
denition of the cjk values as described in Appendix B resulted in negligible dierence between optimal total costs as per NLMIP and AMIP for the
numerical example we used (n 6). Owing to
diculty in obtaining optimal solution, we could
not test the suitability of the cjk denition for
larger problems.
We intend to address these limitations in our
future studies. In addition, we also intend to extend this study to consider change in CST rate
over a period of time. As per the plan of Government of India, the CST rate will be reduced
gradually in stages. Hence, rm needs to work out
an optimal plan to manage the transition, where it
needs to work out the robust solution for optimal
number of depots for each CST rate change.
Acknowledgements
We wish to thank Mr. Amit Gupta, PGP Student, IIM Bangalore for developing the software
code for solving NLMIP in this paper.
Appendix A. Proof of Proposition 1
The objective of this proposition is to prove
whether a DC located at a demand point will serve
it or not. Consider a n demand points example
where a particular demand point can be served
either by a DC located in that demand point or by
a DC located in any of the n  1 other demand
points.
If DC average safety stock inventory costs are
not considered, incremental total cost at DC k that
is incurred due to serving demand point j, TCjk ,
can be represented as
X
TCjk lk
hi lij dk djk
i

X
i

si lij ujk

X
i

ti lij :

A:1

204

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205

For easiness of understanding, let hi , si and ti


respectively be equal to hVi , sVi and tVi , where Vi is
the unit value of product i. Let for demand point
1, TC11 is greater than TC12 , such that
X
Vi li1 :
A:2
a TC11  TC12 =
i

It is obvious that a > 0.


Also, d11 0 and u11 0 as per denitions.
From (A.1) and (A.2)
a l1  l2 h d1  d2  d12 s  u12 t:

A:3

For demand point m, where m 6 1, 2


TCm1  TCm2 fl1  l2 h d1 dm1  d2  dm2 s
X
um1  um2 tg
Vi lim : A:4
i

Substituting (A.3) in (A.4)


TCm1  TCm2 fa dm1 d12  dm2 s
u12 um1  um2 tg

Vi lim :

A:5
It is obvious that dm2 has to be less than or equal
to the sum of d12 and dm1 . It can be seen that the
term (u12 um1  um2 ) is always greater than equal
to zero. When demand points 1, 2 and m are in
dierent states, u12 , um1 and um2 are equal to one.
Hence, u12 um1  um2 1. When demand
points 1 and 2 belong to one state and demand
point m to another state, u12 is equal to 0 while um1
and um2 are equal to one. Hence, u12 um1 
um2 0. When demand points 1 and m belong
to one state and demand point 2 to another state,
um1 is equal to 0 while u12 and um2 are equal to
one. Hence, u12 um1  um2 0. When demand
points 2 and m belong to one state and demand
point 1 to another state, um2 is equal to 0 while
u12 and um1 are equal to one. Hence, u12
um1  um2 2. When demand points 1, 2 and m
are in same state, u12 , um1 and um2 are equal to zero.
Hence, u12 um1  um2 0. Thus, u12 um1 
um2 is never less than 0. Combining (A.2) and
(A.5)
TCm1  TCm2 > 0

A:6

From (A.6), TCm1  TCm2 > 0 whenever TC11 


TC12 > 0. Hence, it is obvious that if DC 1 does
not serve demand point 1 in optimal solution, it
would not be optimal for it to serve any other
demand point. In other words, if a DC is located at
demand point j, it must at least serve demand
point j. That is, if yk 1, then ykk 1.

Appendix B. Derivation of the cjk values in Table 4


By Proposition 1, DC k at the minimum serves
at least demand point k. When DC k serves only
demand point k, totalpsafety
stock inventory cost
P
at DC k is equal to z 1 lk i hi rik . Had all the
demand points been served by DC k, the total
safety stock inventory cost at DC k would have
p P q
P 2
been z 1 lk i hi
j rij . Referring to (5), it
can be seen that cjk is introduced to dene the
additional safety stock inventory costs as a result
of DC k serving demand points other than the one
where it is located. It is already seen from (5) that
the additional safety stock inventory cost at DC k
as a result of DC k serving
demandP
point j, where
p
j 6 k, is described by z 1 lk cjk yjk i hi rij . It may
be noted that cjk 0 for j k.
The cjk values used in Table 4 are arrived at by
the following manner:

P 2
P q
i hi
j rij  rik
P P
cjk
for all j 6 k
j6k
i hi rij
and
cjk 0

for j k:

The above denition ensures that the total


safety
stock
p
P inventory cost at DC k is equal to
z 1 lk i hi rik when it serves only
demand point
p P q
P 2
k and is equal to z 1 lk i hi
j rij when it
serves all the demand points.

References
[1] G. Raghuram, N. Rangaraj, Logistics and Supply Chain
Management: Cases and Concepts, Macmillan India Limited, 2000.

B. Avittathur et al. / European Journal of Operational Research 162 (2005) 191205


[2] J. Shah, B. Avittathur, Improving supply chain performance
through postponement strategy, Management Review 11 (2)
(1999) 513.
[3] S. Rajagopalan, A. Malhotra, Have US manufacturing
inventories really decreased? An empirical study, Manufacturing and Service Operations Management 3 (1) (2001) 14
24.
[4] B.C. Arntzen, G.G. Brown, T.P. Harrison, L.L. Trafton,
Global supply chain management at digital equipment
corporation, Interfaces 25 (1) (1995) 6993.

205

[5] C.L. Munson, M.J. Rosenblatt, The impact of local content


rules on global sourcing decisions, Production and Operations Management 6 (3) (1997) 277290.
[6] Z. Drezner, Facility Location: A Survey of Applications and
Methods, Springer, New York, 1995.
[7] E.A. Silver, D.F. Pyke, R. Peterson, Inventory Management
and Production Planning and Scheduling, third ed., John
Wiley & Sons, New York, 1998.
[8] G.M. Rao, Reform in central sales tax in the context of
VAT, Economic and Political Weekly 38 (7) (2003) 627636.