Cognizant 20-20 Insights

Indias Goods and Service Tax: the Case for Distribution Network Redesign
Executive Summary
Fiscal costs have remained a key determinant of supply chains in India, with manufacturing bases and distribution networks engineered to harness fiscal benefits. The availability of differential tax structures across geographies has remained one of the key decisional elements for structuring the supply chains, procurement patterns and distribution networks in India. With that consideration, the Goods and Service Tax (GST) stands as an inflexion point in Indias fiscal landscape. It marks the transition from an existing origin-based taxation regime to a destination-based taxation regime. The introduction of GST is expected to remove the cascading effect of taxes by moving to a common tax base and subsuming various state and central taxes into Central Goods and Service Tax (CGST) and State Goods and Service Tax (SGST). The introduction of such a common tax structure will significantly impact the procurement patterns, supply chains and distribution networks of manufacturing firms. This will present both opportunities and challenges for firms doing business in India. One of the opportunities is to make the supply chain leaner, but the challenge lies in actually doing it. Optimizing the supply chain entails relooking at the business model in a fundamental way because it impacts so many areas of the business. For example, some of the options around redesigning the supply chain would relate to the following:

Indigenous supplies vs. imports. Intrastate or interstate procurement of goods and services. Manufacturing and warehousing locations. In-house or contract manufacturing. Direct sale vs. stock transfers.

Warehousing changes can be taken as a case in point here to understand the impact that GST may have on supply chains and other elements of business.

What Defines Warehouse Location?

Warehouses are an important part of any supply chain. A strategically placed warehouse not only improves customer service levels but also reduces the burden on other elements of a supply chain. In India, apart from other criteria such as customer service levels, freight costs, etc., the differential state and central taxes levied on sales of goods largely affects the location of a warehouse. To understand this, we will use a typical supply chain setup as shown below.

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Typical Supply Chain

Firm

Warehouse/ Depot

Distributor

Retailer

Customer

Figure 1

Current State
Lets look at two scenarios that show how a consumer goods (CG) manufacturer sells its goods to a distributor and how that impacts the location of the warehouse in a non-GST environment. The input tax credit at the source and the logistics costs in landed cost component have been ignored for simplicity. Scenario A: Stock Transfer Sale Lets assume a firm operates a warehouse in another state and does a stock transfer of its

goods to the warehouse before actually selling it to the distributor in that state. According to current tax laws, this transfer carries no central sales tax (CST) since no sale has been realized. In this case, the value added tax (VAT) is applied only after a sale is made to a distributor using the warehouse. Also, the VAT paid by the distributor to buy from the warehouse is used as an input tax credit bringing down the price before tax of the goods for retailers. A sample calculation is shown below for understanding.

Current State: Stock Transfer Sale

3
Supply Chain Point Firm Warehouse Distributor Retailer Landed Cost (in `) 200 250 260 280.8 Margin (in `) 50 0 20 15 Input VAT Price Credit Before Tax (in `) (in `) 0 0 10 10.8 250 250 270 285 VAT 0% 4% 4% 4% CST 0% 0% 0% 0% Total Tax (CST+VAT) (in `) 0 10 10.8 11.4 Final Price (in `) 250 260 280.8 296.4

Scenario B: CST sales to Distributor Lets assume the firm decides to sell its goods directly to the distributor located in another state without holding a warehouse in that state. In this

case, the firm pays CST on this interstate sale. The rest of the transactions in the supply chain remain the same. Now the calculations look as shown below.

Current State: CST Sales to Distributor

Supply Chain Point Firm Warehouse Distributor Retailer Landed Cost (in `) 200 0 255 286 Margin (in `) 50 0 20 15 Input VAT Credit (in `) 0 0 0 11 Price Before Tax (in `) 250 0 275 290 VAT 0% 0% 4% 4% CST 2% 0% 0% 0% Total Tax (CST+VAT) (in `) 5 0 11 11.6 Final Price (in `) 255 0 286 301.6

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In scenario two the final price (`301.6) for the consumer increases in comparison to the final price (`296.4) paid by consumer in the first scenario. To maintain the same price (MRP) for the end consumer, the firm has to take a hit on its margins so that the distributor and retailer margins are preserved. This happens because unlike VAT, CST cannot be claimed as an input tax credit. So, when the distributor adds its own margin to an already high landed cost, the total cost for the retailer increases. Since the distributor will not like to give the same product at a higher price to the retailer, the firm has to take a hit on the margin. The above two scenarios clearly show that distributors will like to buy from a warehouse in the same state rather than buying directly from the firm in another state. This type of provision in the current tax structure has forced firms to locate warehouses in all the states where they do business. Instead of focusing on supply chain efficiency that can be generated from strategical-

ly located warehouses, the firms focus on saving their margins. The above scenarios also show why most businesses would prefer to source locally and not through interstate purchases.

Future State
With the introduction of GST, the tax barrier on cross-border sales will be removed. The tax disincentive of cross-border sales due to the presence of CST will be eliminated. There can be two scenarios by which the government can achieve this task. Scenario A: Complete Elimination of CST Charged on Interstate Sales In this case a firm can sell directly to the distributor in another state without paying the CST. The calculations shown below verify that this would not lead to any loss of margin for the firm and distributors and retailers can enjoy their share of margins without increasing the final price of goods.

Future State: Eliminate CST Charged on Interstate Sales

Supply Chain Point Firm Warehouse Distributor Retailer Landed Cost (in `) 200 0 250 280.8 Margin (in `) 50 0 20 15 Input Tax Credit (in `) 0 0 0 10.8 Price Before Tax (in `) 250 0 270 285 GST 0% 0% 4% 4% Total Tax (in `) 0 0 10.8 11.4 Final Price (in `) 250 0 280.8 296.4

Scenario B: Elimination of CST But Interstate Sale or Transfer Is Charged with Provision of Input Credit Lets assume that CST is abolished and interstate sale is taxed with input credit allowed on the

subsequent sale. Even in this case the margins for companies, distributors and retailers are maintained without affecting the final price for the consumer. This is depicted in the calculations below.

Future State: Eliminate CST but Charge Interstate Sale or Transfer

Supply Chain Point Firm Warehouse Distributor Retailer Landed Cost (in `) 200 0 260 280.8 Margin (in `) 50 0 20 15 Input Tax Credit (in `) 0 0 10 10.8 Price Before Tax (in `) 250 0 270 285 GST 4% 0% 4% 4% Total Tax (in `) 10 0 10.8 11.4 Final Price (in `) 260 0 280.8 296.4

The scenarios below clearly show that with the advent of GST, having a warehouse in every state where a firm does business will no longer remain a necessity. The supply chain can be designed purely on logistics costs and customer service considerations and not on tax considerations. The firms can now have fewer and more strategically cognizant 20-20 insights

placed warehouses. The supply chain network can be made leaner and smarter so that the operational costs are minimized and efficiency is improved. With the provision of the input tax credit, each tax point in the supply chain will be required to record, maintain and file tax transactions happening at that point. It is probably fair to

suggest that the longer the supply chain, the more the tax points in the GST scheme of things and hence increased compliance costs. The challenge and the opportunity is thus to compress supply chains for GST efficiency while ensuring that the business objectives in and around supply chains are also met.

GST Impact on Warehousing

In todays context, a firm spends large sums of money in managing different warehouses to overcome the fiscal regime. The presence of these duplicate entities in the supply chain has added to the additional cost of administration, utility services and technology required to manage these entities. The effect on cost of goods sold (COGS) is further pronounced due to productivity

inefficiencies creeping into the system with the presence of many smaller stocking points. The logistics and inventory carrying cost of goods are very high as firms carry more inventory to fulfill demand and are handcuffed in selling products across states. The tax regime has also proved detrimental to the development of 3PL and 4PL providers in India, adding to the logistics woes of the country. India has one of the highest logistics cost as a ratio of GDP (see Figure 2) compared to other countries of the world. Also, transportation, inventory and warehousing contributes up to the 70% of the total spend on logistics in India. All of these costs are in some way impacted by a differential tax regime which promotes smaller and multiple stocking points.

Cross Country Logistics Cost Comparison

Country India, China US Europe Japan Logistics Cost/GDP 16-20% 9-10% 10% 11% Activities by 3PL/ Logistics Activities <10% 60% 30-40% 80%
11% 14% 25%

Elements of Logistics Cost1

9% 6% 35% Transportation Inventory Losses Packaging Warehousing Customers Shopping

Figure 2

From a technology perspective, the implementation of ERP at multiple warehouses is a costly affair, so most small to medium businesses in India have stayed away from technology implementations that can result in long-term profits. This has resulted in the proliferation of myriad technology implementations in warehouses and increased technology spends by firms. The non-standardized modus operandi in these warehouses also hampers the ability to bring efficiency in people-related processes. There are many more such inefficiencies that Indian firms are living with due to the differential tax regime. In a GST frame of things, logistics costs and not tax considerations will play an important role in determining the location of a warehouse. Firms will move towards fewer and more strategically located warehouses and this will entail combining the existing capacities of warehouses or creating new capacities. As simple as it sounds, the firm has to prepare for various impacts and challenges that this may bring.

First of all, fewer and larger warehouses may make it feasible to route plant production directly to warehouses rather than through hubs. Thus, the size and number of hubs could be affected. While consolidating the warehouses, the optimum path for moving current inventory to the newly located warehouses has to be worked out to reduce the cost of manufactured goods movement. An increase in inventory movement cost may impact the price of goods directly. Once the firm decides to move to fewer warehouses, the overall COGS will come down. At current price levels, this will entail more profits for the firm, and passing on this benefit to consumers will positively affect the demand for products. With increasing demand for products and services, the demand planning and management at newly constructed or consolidated warehouses will have to be reevaluated. Even if the demand planning is perfected, the logistics costs associated with delivery of goods will change. Firms have to

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look for new optimization techniques which can help them keep the current service levels and save on logistics costs. To maintain the current lead time with fewer warehouses, the firm has to redesign the network by factoring in various parameters that affect lead time. GST will foster growth of 3PL and 4PL providers, and firms will have to consider their services while designing the distribution networks of the future. Fewer and larger warehouses may even encourage adoption of cross docking that can alter the way products are handled in the warehouse. Advent of GST may even change the customer perception about a firms products. As the footprint (in terms of warehousing) required for operating in the Indian market will shrink, more foreign companies will enter the market to do business. The competition among foreign and national players will intensify, resulting in an upsurge in customers demand for high quality. A thorough look at various aspects of a firm shows that the impact of warehousing changes needs to be accessed not just from a supply chain perspectives but also from technology and people perspectives. IT systems would need to be migrated, aligned and upscaled for a robust performance in the new world of larger warehouses. With fewer warehouses to worry about, firms will be eager to implement ERP solutions to achieve greater efficiencies in operations. To enjoy economies of scale, the firms need to move towards fewer technologies and better application rationalization. Increasing scarcity of skilled labor and skyrocketing real estate prices will force firms to go for automated, efficient and vertical warehouses. The adoption of intelligent warehouse management systems and innovative technology (e.g., iPad applications for managing shelves and SKUs in a big warehouse) to reduce human effort will increase greatly. People will have to be retrained in various operating procedures of the firm and customer care has to be reevaluated during the initial days of transition to new warehouses. Organizations will have to undertake customer education initiatives to help them understand various changes brought about by GST. These changes will in turn alter the ways in which businesses are run. Moving different pieces of an existing supply chain, which has been perfected after several years of experience and optimization, seems to be a daunting task. Changes to a warehousing network impact both tangible and intangible aspects of a business. And a firm will be better

served in answering the following questions before embarking on such a journey.

What aspects of business, technology and people will get impacted? How to make sure that the future state fulfills the current business objectives as well? What external factors should one include in doing such an analysis? Once impacts are identified, how to drive them to their rightful conclusion in the organization?

Even though the impacts of GST on a firms business are numerous, a methodical approach can help in identifying and preparing for such challenges. Once the impacts are identified and core business objectives are known, the firm can use inputs from such an exercise to define and redesign the future distribution system.

Approach to Network Redesign

Its quite evident by now that firms in India have to consolidate their warehouses and redesign the distribution network to remain competitive and efficient with the advent of GST. As easy as it may sound, the impacts of such a process are manifold and ignoring any one of them may be detrimental for the distribution network and, in turn, for the firm. A company needs to follow a methodical approach for carrying out impact analysis on current supply chain points. Once such an analysis is done, a holistic solution can be built by keeping in mind the business, people and technology aspects of changes. The DOT Framework can help firms navigate through such challenges and redesign their distribution networks. The various phases, activities and output of each phase are shown in Figure 3. The three phases of this approach help in the qualitative and quantitative assessment of different aspects of a distribution network. At each point of assessment it is ensured that new design not only satisfies current business objectives but also generates a feedback mechanism for continuous improvement. The broad objectives of these three phases are as follows:

Discover: This phase helps in understanding a firms business, the external environment in which it operates and its capacity to make changes. Since each firm is unique in itself, this phase is a cornerstone for the other phases and defines the future course of action in a redesigning exercise. Another goal of this phase is to derive insights into current supply

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DOT Framework Redesigning the Distribution Network

Activity
Understand rms business requirements and vision. Gain insight into rms competition, vendors and consumers. Identify rms readiness for change and key stakeholders. Classify KPI/KPA and success factors that a rm identies with its distribution network. Benchmark success factors against industry best practices. Organize workshops to analyze: > Demand patterns, forecasting strategy and inventory management techniques used. > Customer SLAs and associated delivery (logistics) mechanisms in place. > Warehouse management techniques and supporting technology employed. > Criticality of a stocking point in supply chain with respect to distribution, taxation and capacity. Ascertain rms business processes affected by redesigning the distribution network. Build redesigned & optimized distribution network using inputs from rst phase. Generate rigorous what-if scenarios and network performance matrices. Create business process impact matrices and redesign process ows. Identify risk and associated mitigation plan to keep project on track. Create implementation road map and key metrics to measure performance. Produce detailed customer care and employee training manuals. Carry out necessary process & technology changes in accordance with implementation road map and redesigned distribution network blueprint. Run simulations on what-if scenarios and create performance matrices. Execute change management process. Implement user training and customer awareness programs. Monitor adoption & measure KPI/success factors continuously to ascertain solution effectiveness. Perform market scan/survey to identify effect on competition, customer SLAs and rms performance. Fine-tune solution using market scan and KPI data.

Outcome
Requirement & Scope Analysis Competition Analysis Industry Analysis Success Matrices Stakeholder Analysis Workshop Plan and Mind Maps Demand & Forecasting Analysis AS-IS Distribution Network Analysis Customer Analysis Skill Assessment Training Assessment TO-BE Distribution Network Blueprint What-if Scenarios Impact Analysis Risk and Mitigation Analysis Complete Implementation Road Map Training Manuals

5 Weeks

8 Weeks

4 Weeks

Optimize

Discover

Simulation Analysis Training Feedback Learning Document Change Management Analysis Performance Matrices Adoption Matrices ROI Document Market Scan Analysis

Figure 3

chain strategy and supporting processes. The aim is to highlight shortcomings, strengths and areas of improvement in the existing distribution network to better fulfill the future needs.

Transform

leads to further fine-tuning of the distribution network. The new network is continuously benchmarked against best practices to gain efficiency.

Optimize: The objective here is to create a blueprint of the future distribution network while keeping in mind factors such as efficiency, scalability and flexibility. Various parameters and what-if scenarios that characterize a distribution networks effectiveness are defined in this phase. No stone is left unturned in defining the future processes that will lead to employee and customer satisfaction. In short, the entire road map that defines the future state is built here. Transform: The intention here is to bring new business processes in practice and redesign the distribution network according to the implementation road map. This phase may involve shadowed phase-out, upgrade or replacement of current distribution network pieces. This phase also characterizes testing of what-if scenarios, measuring various KPIs and executing change management processes. Transformation is accompanied by the creation of a continuous feedback mechanism that

Conclusion
A common tax structure for goods and services in India is necessary for improving supply chain efficiencies and rationalizing business objectives. The only question that needs to be answered is when this will become a reality. Whenever it happens, it will come with a set of challenges that if addressed at the right time can take businesses to new heights. Our strong consulting expertise in the areas of supply chain sourcing, planning and execution can help firms in moving forward with confidence and embracing GST with ease. We can help with every aspect of distribution network redesign, from analyzing the existing supply chain points to designing an optimized network to implementing the new model. We also have vast experience in streamlining IT processes and creating future IT road maps for consumer goods firms. Our delivery model ensures that all three aspects process, people and technology are honored while driving change in the firm.

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Footnote
1

The Indian Logistics Industry 2006, N. Viswanadham, Center for Global Logistics and Manufacturing Strategies, Indian School of Business.

References
1. GST Reforms and Intergovernmental Considerations in India, March 2009, Department of Economic Affairs, Ministry of Finance, Government of India. 2. Goods and Service Tax: An Introductory Study, April 2007, Sudhir Halakhandi, The Charted Accountant. 3. How GST impacts Your Business, 2010, Ernst & Young. 4. Understanding GST, 2010, Ernst & Young. 5. The IT Strategy for GST, July 2010, Nandan Nilekani, Empowered Group on IT Infrastructure on GST, Government of India. 6. GST Alert: India Update, Dec 2009, KPMG. 7. Supply Chain & GST, Sept 2009, PriceWaterhouseCoopers. 8. GST: Impact on Supply Chain, Anil Rajpal, Sachin Jagtap, Technopack Consulting. 9. Supply Chains of Asia: Challenges & Opportunities, 2002, Accenture.

About the Authors

Chandrasekar Ranganathan is a Manager in the Consulting Group. Chandrasekar has over 17 years of experience with over 12 years in business/IT consulting including seven years of project/ delivery management. Some of Chandrasekars consulting assignments include business process reengineering, SAP and SOx solutions, business case validation for supply chain redesign, IT strategy and road maps for M&A, and business transformation planning. He has completed a certification program in global business leadership offered by U21 Global. He can be reached at ChandrasekarViswanathan.Ranganathan@cognizant.com. Jiten Jain is a Senior Consultant currently working in the Consumer Goods Department of Cognizant Business Consulting group. Jiten has expertise in claims and rebate management, order management and trade promotion management with an emphasis on supply chain planning and execution. He has consulted for Fortune 500 consumer goods and manufacturing clients in business blueprinting, business process reengineering, requirement analysis, portfolio rationalization and project execution. Jiten has an MBA in information management from the S. P. Jain Institute of Management and Research, Mumbai and a Bachelor of Engineering in computers from South Gujarat University. He can be reached at Jiten.Jain@cognizant.com.

About Cognizant
Cognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process outsourcing services, dedicated to helping the worlds leading companies build stronger businesses. Headquartered in Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industry and business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50 delivery centers worldwide and approximately 137,700 employees as of December 31, 2011, Cognizant is a member of the NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among the top performing and fastest growing companies in the world. Visit us online at www.cognizant.com or follow us on Twitter: Cognizant.

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