Memorandum submitted by Gerry Smith (DFoB 39)

 

Costs of Direct to Store vs. Regional Distribution Centres

 

There are essentially two routes to market via,

 

1. Regional Distribution Centres (RDC)

2. Direct to Store (DTS)

 

Direct to Store (DTS)

 

As the name implies the manufacturer prepares or "picks" each individual store order at their premises and delivers them directly to each of the Customers stores in a given time slot. Consequently, teams of pickers are employed to prepare each individual store order and load them onto the vehicles. This is a more labour intensive task than via RDC where only minimal costs are involved in loading the vehicle and no costs in the picking operation.

 

Additionally, the vehicle utilisation is not optimised because the customer does not order full trolleys of every distinct product type, so the unit distribution cost is increased.

 

DTS deliveries require a larger number of vehicles than RDC because the former delivers to multiple delivery points over a given geographical area. The latter delivers full loads of full trolleys to single delivery points.

 

Where stores are not within the catchment area of the producing dairy, it is necessary for the Producer to distribute via their own depot systems, which effectively become RDC's. In this case, there is a primary distribution cost from the dairy to the depot and a secondary distribution cost from the depot the Customer. The Manufacturer then provides a picking operation (as outlined above) at each of the depots. However, the additional cost of "double handling" the product resides with the producer. This is the highest cost route to market for the Supplier.

 

 

Regional Distribution Centres (RDC)

 

For the Manufacturer, this is the most efficient route to market. Full trolleys and full vehicles, with a minimum of handling, supply the receiving customer RDC with goods at the lowest unit cost (an average distribution cost from Dairy to the customer RDC would be 12ppg). The retailer incorporates the final distribution of product within their existing operation and absorbs the cost of order picking and delivery to each individual store.

 

Summary

 

· Distribution via RDC is the lowest cost route to market for the Supplier because it involves the minimum of handling; there is greater vehicle utilisation, with fewer vehicles and fewer drivers required. There are a small number (less than 10 in the case of Coop) of delivery points.

· DTS deliveries require labour to order pick each individual store requirement and deliver them to several hundred stores daily. A greater cost of labour and distribution is associated with this system.

· DTS deliveries to stores in regions outside the dairy catchment areas require the provision of supplier depots that function in a similar manner to the customer RDC model. These present an additional cost to the Supplier but they can obtain additional extra business in the same area to defray the costs of operating the depot.

· Negotiations between Supplier and Customer recognise the disparity in costs between the different routes to market and it is customary to have differential prices to reflect these differences.

· As indicated at the Enquiry on the 21^st October, the Coop as an example paid DFB a premium Selling price for DTS deliveries of 15ppg, but the actual cost of DTS deliveries for DFB was 45ppg.

· The majority of the Coop DTS business was in the South where DFB had a Depot in London near Heathrow and one in Portsmouth. These Depots were 80% utilised delivering Coop DTS milk and between them were losing DFB some £4 million pa.

· Various discussions with the Coop failed to deliver on promises made to switch deliveries from DTS to RDC in the South. As a result DFB sought a price increase to cover the DTS business that was not accepted by the Coop. Reluctantly, DFB had little option but to resign this volume in the South.

· The same principal applied to the Contract awarded in 2009, ie DFB were competitive on RDC business but not DTS and thus only quoted for two of the five regions in the tender.

 

FACTORS LEADING TO THE DEMISE OF DFB

 

· Strategy/ACC acquisition

· Budgeting

· Regional Milk V Local Choice

· Market Dynamics

· Inflation

· Inter Unit Milk Transfer Price

· Cheese stocks

· Lack of Confidence

· Timing of the 523 Project

· PWC involvement

· The Coop tender

· Relationship between the Board and the Executive team

 

 

Dealing with each point in turn

 

STRATEGY/ACC ACQUISITION

 

· Paid too much for poor quality assets.

· Did not acquire the vast majority of the Freehold, which was retained by the Coop.

· Poor Due Diligence.

· Did not appreciate just what had been acquired and the performance of the sites until the Summer of 2005.

· Acquired a very narrow customer base, too reliant on the Coop.(Coop volume represented circa 200 mlpa of a total of circa 620 mlpa)

· ACC were operating in the "Convenience/middle ground market", the most competitive market in the dairy industry with too many players all seeking growth in a static market and hence margins were very tight.

· Accepting too much was paid for ACC and the assets were the poorest in the Liquid milk market, the strategy was to make another acquisition within a period of two year i.e. acquire/merge with DC, Arla or Wiseman. The trading performance of DFB did not allow the next step in the journey to be made. As Gordon Brown stated in his evidence, the acquisition of ACC was a "ticket to the game".

 

BUDGETING

 

· DFB was a Sales led business. Everything had to be in place to support anticipated aggressive sales growth in a very competitive market.

· The manufacturing assets had to have sufficient capacity to more than match the aggressive sales plan.

· The sales plan was never delivered since the acquisition of ACC.

· This not only impacted on the performance of the Liquids Division but also had a significant impact on the Milk Supply Division also.

· Taking the following as an example, if the milk pool available to DFB in total was say 1.2 billion litres pa, and the Liquids sales requirement was 800ml pa, the MD of Milk supply had to sell 400ml to external customers such as Cadbury and/or process the balance through our cheese plants. This he could plan to do and achieve a high selling price to external customers by contracting up to 12 months in advance. In reality when the Liquid milk sales demand fell away compared to budget, the only readily available outlet for the surplus milk was the spot market where the price achieved was inevitably well below the milk price charged to the liquid milk dairies, resulting in a loss to the Milk Supply Division.

· Taking the extreme position, 300ml pa surplus milk at a spot price of 5ppl below the IUT price was equivalent to £15million lost profit pa.

 

REGIONAL MILK V LOCAL CHOICE

 

· The sales strategy was to build a strong Dairy Farmers of Britain brand, which we succeeded in growing to £150 million pa.

· This strategy included branded Regional milk offering which was replaced with a Tesco Local Choice brand.

· This change in strategy is fundamental in contributing to the demise of DFB.

· Local Choice milk was launched in Tesco in May 2007 and in the period up to 28^th March 2009, DFB suffered losses of £4.758 million on this project.

· The target was to achieve 100ml pa of sales of Local Choice in Tesco, some 10% of all Tesco milk sales.

· In reality, less than half of that target was achieved but the cost and infrastructure to accommodate the sales growth was put in place.

· Investment in dedicated drivers and vehicles to deliver milk to over 630 Tesco stores was made as well as over £5million capital investment at the Dairies.

· The costs of delivery were fixed as far as the driver, fuel and vehicle was concerned, whether the vehicle was full or only quarter full.

· Tesco were very supportive until the end, paying an excellent price for the milk but regrettably the anticipated volumes did not materialise. The project failed primarily due to this lack of sales, which in turn resulted in small, uneconomic production runs, and excessive DTS transport costs.

 

MARKET DYNAMICS

 

· We operated in the most competitive sector of the Dairy industry i.e. the convenience/middle ground market.

· It was difficult to recover inflationary costs.

· Market movements in retail prices in the big four retailers was not always followed in the convenience sector with two market price movements being missed by DFB, leading to margin erosion.

 

INFLATION

 

· Significant inflation was experienced in 2008 with Oil reaching $147 barrel.

· The cost of Poly bottles rose by 20% with Electricity and gas rising by 48% and 40% respectively.

· We recovered some of this inflationary pressure from customers but not all of it. What was achieved in price increases was more than passed on to the Farmers in ex farm gate milk price increases, making the Liquid performance even worse.

 

INTER UNIT TRANSFER PRICE ( IUT )

 

· The price of milk charged to the dairies by the DFB milk supply team (IUT) was fixed at the start of each financial year but could be varied dependent on the market dynamics which impacted on the price paid on farm.

· IUT was calculated by setting the price paid on farm and adding on the transport/admin costs associated with the Milk Supply team.

· As DFB lost farmers and collected less milk from farm, the transport cost per litre rose, due to less volume in each tanker.

· As a result, you could argue that the liquid division was paying more than the market price that its competitors were paying for its main raw material, but being part of a Farmers Co-operative, could not go into the market (as ACC did) to purchase cheaper packages of milk.

· The impact of the higher transport costs included in the IUT price of milk could be as high as 1ppl.With a requirement of circa 500ml pa this would be equivalent to £5million annualised.

 

CHEESE STOCKS

 

· The business was carrying excessively high cheese stocks, much higher than budget, requiring significant cash funding and breaching Bank covenants.

· As a result, HSBC lost confidence in our handling of our cash flow projections. A business critical issue that DFB never recovered from.

 

LACK OF CONFIDENCE

 

· Business is all about confidence.

· We operated in a very competitive market.

· At the first sign of weakness, the competitors attacked.

· The non-payment of the Farmers interest payments put DFB on a slippery slope that it never recovered from.

· Our suppliers were subsequently refused credit insurance.

· At the same time we had many Board/Executive changes.

· Industry commentators were full of gloom and doom," THE END IS NIGH."

 

TIMING OF THE 523 PROJECT

 

· Further rationalisation of our assets had been presented to the Board by the Executive team in each of the two previous financial years and had been rejected by the DFB Board.

· The main reason for the rejection being that to accommodate the Tesco Local Choice opportunity, the 5 Dairies were required to cope with the significant number of Tesco regions.

· If the 523 project had commenced 12 months in advance of the actual start date, the rationalisation process would have been complete and the confidence of all stakeholders secured prior to the commencement of the Coop tender process in early 2009.

· The 523 project was delivered in full, on time and within budget.

· The Liquid milk processing divisions actual results for April and May 2009 show an operating profit of £1.449 million (almost £2 million better than budget) with the cost base showing improvements of £1.5 million compared to budget.

· The cash cost of the project was also some £2 million better than forecast.

 

PWC INVOLVEMENT

 

· During my 4.5 years with DFB, PWC were actively involved in most aspects of the business ranging from confirmation of project paybacks to assisting with the re-financing of the business.

· My understanding is that in early 2009 they were appointed by HSBC/the DFB Board to sell the assets of the business. I assisted them in this process as far as the Liquid processing assets were concerned. The poor timing of this sale process was crucial to DFB's survival.

· At the same time we were completing the 523 project and dealing with the business critical Coop tender.

· It is almost impossible to hold on to the volume with your largest customer when you have a "FOR SALE" sign outside your door.

· Why would our competitors bid for the assets of the business when all they had to do was undercut DFB in the Coop tender (which was only of 12 months duration), thereby destabilising the whole DFB business.

· I was surprised when PWC were appointed as the Receivers. In my view, there had to be some conflict of interest.

· With the success of the 523 project and in the knowledge that we had lost the Coop business effective from August 2009, I led a team that were in the process of developing a Sales strategy to grow our business in the 3 remaining Dairies, i.e. Wales, the North East and the Midlands.

· The team were highly motivated and up for the challenge of more than replacing the lost Coop volume but required the support of all stakeholders.

· It is my view that if all stakeholders had continued to support this business for a further 6 months, with the "FOR SALE" sign removed, we had a fighting chance of succeeding.

 

THE COOP TENDER

 

· Holding on to the Coop volume and succeeding in the Coop tender was business critical to DFB.

· Our best price was submitted to the Coop on 4^th February 2009, following various meetings and discussions with the Coop buying team who were very supportive and as the current supplier gave us a good indication of where to pitch our price to succeed.

· We quoted a price some 27% below our current selling price to the Coop.

· We met with the Coop buying team on Friday 13^th March 2009 and were told we were "uncompetitive across all segments of the tender" and that DFB had a for sale sign and were actively marketing the sale of the business.

· The Coop stated during the meeting they had no issues with relationships, product quality or service levels.

· The price differential we were informed was significant and when pushed, they confirmed we were £millions out.

· The Coop stated they were growing whilst DFB were shrinking and they were looking for suppliers "in it for the long term".

· Despite our protestations re the business criticality of their decision and the political fallout and implications for the Dairy Industry in total, the Coop would not reverse their decision.

 

RELATIONSHIP BETWEEN THE BOARD AND EXECUTIVE TEAM

 

· Coming from a Plc background, the Boards of Plc's comprise the executive directors (who run the business on a daily basis) and the non-executive directors who assist and question and probe direction, performance and strategy.

· Each member of the Board whether executive or non-executive having a vote.

· The Board of DFB was made up entirely of non-executive directors who were not involved in the day to day running of the business.

· The Executive team attended Board meetings when requested by the Board, made presentations and were then asked to leave whilst the Board continued with its agenda.

· This structure differed from that of First Milk and Milk Link where at least the CEO and CFO of both these Coops attended and voted at Board meetings.

· In essence the Executive team at DFB could only advise and recommend actions to the Board but had little power.

 

 

 

Gerry Smith

November 2009