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Friday, Aug 27, 2004

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The hub and spoke of VAT

Abhijeet Virmani

Implementation of the Value Added Tax regime will, in no uncertain terms, change the logistics and supply chain management scene in the country.

VALUE-Added Tax is round the corner and there is significant publicity that the State governments are well prepared for its implementation as they have had an additional year to iron out issues and learnt significantly from the experience of Haryana, where VAT was enforced last year.

Does this imply that the transition will be easy? Are Indian corporates ready to embrace VAT even if the Government says it is? Most corporate personnel agree that the transition will present significant challenges. What is surprising, however, is that most companies continue to focus on legislation details, compliance and financial and tax issues. There is hardly any focus on the impact of VAT on their supply chains.

The implementation of VAT nationwide will, in no uncertain terms, change the logistics and supply chain management scene. Currently, most companies have to maintain warehouses for sales tax purposes in most or all States. As a result, each company has over 20 warehouses across the country.

The cost inefficiencies in such an arrangement are very high as companies must plan warehousing space, deploy manpower, ensure IT connectivity and maintain stocks at each location. In the new tax regime, the location of the stocking points will be governed by proximity to the consumers.

As a result, the number of stocking points is expected to fall substantially and, depending on the business model, companies will not require more than five to six stocking points across the country. Most FMCG and consumer durables companies will need to bring about a change in their supply chain operating models.

Companies would need to move to a hub-and-spoke model from the prevailing system that uses clearing and forwarding agents (C&FAs), distributors and stockists. This change is easier said than done and will take considerable time and effort.

Imagine the activities involved — terminating contracts with over 15 C&FAs, relocating company personnel and equipment (computers, VSATs) based at these sites, diverting inventory to alternative locations and communicating changes to various stakeholders (distributors, transporters, customers, and so on).

These would come into effect provided companies have a supply chain strategy and an alternative supply chain network in mind.

Having advised several companies in the last few years on VAT, it was evident that corporates were not prepared for such a change. With days to go for VAT to come into force, most corporates did not have a transition plan in place.

History seems to be repeating itself. Many companies continue to believe that this time too VAT will not see the light of day and that the Government will get pushed into another postponement. This could be true. But if not, the tactic is a ticking bomb which could go off and cause firms to lose out on significant cost reduction opportunities and the first-mover advantage.

The decision to move to an alternative system would be purely economic. It is expected that during the next three years, distribution costs as a percentage of selling costs may decline by 20 per cent for various manufacturing companies. At present, distribution costs, including inventory costs, account for 10-15 per cent of the total selling costs for the manufacturing sector.

Given the bottomline pressures that are affecting most FMCG and consumer durables companies, this would seem to be a godsend to many, provided they act now.

The current supply chain network in the country is geared to cater to the existing sales tax structure. As a result, most third-party logistics players have a number of small warehouses scattered across the country.

With the change in the tax regime, these players would find it extremely difficult and time-consuming to make the transition to a hub-and-spoke model where large warehousing space would be required in key logistics hubs and closer to demand points (the metros).

Hence, when companies contact their logistics partners asking for larger space in these logistics hubs and closer to demand centres, most warehousing companies will not be in a position to provide such a space. Many shippers would anyway want to carry out detailed analysis of whether to outsource such services or make use of the opportunity and carry out these activities in-house.

A small number of large capacity warehouses would allow companies to invest in the stocking points. Various services could be offered at these warehouses, including bar coding and computerised tracking of all merchandise, conveyer belts for movement of goods, loading and receiving docks that can simultaneously manage large movements, round the clock, 24x7, and so on. Logistics players could also make the most of this opportunity by investing in stocking points closer to the demand centres.

By doing so, some would not only be setting up a network for the proposed VAT regime but would also be able to get the first-mover advantage. This opportunity could be seen as an "inflection point" for the industry.

Post-VAT, various small logistics players and C&F agents will not be able to sustain their businesses. But the players who play their cards well can grow significantly and become really big. Some players, such as Safexpress and Gati, are ahead of the game. For them to succeed they would need to think big.

For instance, in the US, a distribution centre could be as large as 1 million square feet, could employ over 600 staff and could service over 200 trucks simultaneously. We might not need distribution centres that are as large, but even smaller centres will require serious investments.

While VAT has been postponed earlier, it should be introduced in the coming year. Since the changes required to transition to the new regime are great, proactive shippers and logistics providers should act now.

(The author is Director, Positron Advisory Services, focussing on supply chain management. He can be reached at

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