Cost Effectiveness in The e Grocery Business

International Journal of Retail & Distribution Management
Cost-effectiveness in the e-grocery business

Vesa KmrinenJohanna SmrosJan HolmstrmTomi Jaakola
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Vesa KmrinenJohanna SmrosJan HolmstrmTomi Jaakola, (2001),"Cost-effectiveness in the e-grocery business",
International Journal of Retail & Distribution Management, Vol. 29 Iss 1 pp. 41 - 48
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Introduction
Cost-effectiveness in
the e-grocery business
Home delivery as such is not a new service

model in the grocery business. However, it
did not get widely spread until the Internet
became popular in the mid-1990s. At that
time, when the first e-grocers started to
operate, they offered Internet as a new tool for
ordering. That is, the ordering channel for the
groceries was new, but the operational
activities of home delivery were not.
From the customer's point of view, home
delivery is a new service that makes life easier,
especially for people who have difficulties in
getting to a store or who do not have time for
shopping (see, for example, Morganosky and
Cude, 2000). Nowadays, e-grocers can also
offer other services, in addition to home
delivery. For example, it is possible to order
videos, dry cleaning or film processing in
addition to groceries (Ransdell, 1998).
Although e-grocery shopping has a lot to
offer, a problem is that consumer prices are
often higher than in traditional supermarkets.
This prevents fast growth and the creation of
an attractive and commercially profitable new
mass market. These high prices are a result of
inefficient home delivery and picking.
Some players, such as Streamline in the
USA and SOK in Finland, have developed a
solution for cutting delivery costs. The
groceries are delivered to locked reception
boxes, which are located in the customer's
garage or yard (Streamline, 2000; S-Kanava,
2000). This means that the customer
becomes independent of the delivery
timetable, i.e. that the customer does not
need to be at home to receive the goods. This
is also the most cost-effective home delivery
solution for the e-grocer. Results of an
analysis of home delivery in a suburban area
show a cost benefit of over 40 percent when
using reception boxes (Kamarainen et al.,
2000). The drawback is that this mode of
operation requires significant investment in
the reception boxes.
Tesco in the UK has attained near-national
coverage at a reasonable cost. It has chosen a
store-based fulfilment model that makes it
possible for the company to offer a full
product range and to use its existing assets to
the maximum (CIES, 2000). Tesco has a first
mover advantage in the UK and its model
allows it to quickly move into new areas and
cities. Thus, this is a fast way to increase the
sales volume. However, because products are
Vesa Kamarainen
Johanna Smaros
Tomi Jaakola and
Jan Holmstrom
The authors
Vesa Kamarainen and Johanna Smaros are
Researchers and Jan Holmstrom is a Senior Research
Fellow in the Department of Industrial Engineering and
Management, Helsinki University of Technology, Finland.
Tomi Jaakola is a Logistics Designer at S-Kanava Oy,
Helsinki, Finland.
Keywords
Grocery, Electronic commerce, Distribution centres,
Order picking
Abstract
In the grocery business online start-ups, e-grocers, have in
the last few years developed new business models to
challenge the traditional bricks-and-mortar supermarkets.
However, many of the big players in the e-grocery business,
such as Peapod and Webvan in the USA, still operate in the
red. They have financed rapid growth by collecting
hundreds of millions of dollars from investors. These huge
investments have enabled the e-grocers to enter the
grocery market but, on the other hand, ineffective
operations have used up capital on operating expenses. If
the e-grocers want to become serious challengers to the
traditional bricks-and-mortar business, they need to cut
operational costs dramatically and fast. This paper
illustrates some basic principles for cutting operational
costs in the e-grocery business. The focus is on picking
efficiency and order assembly costs. Solutions for achieving
better picking efficiency are discussed. In addition, one
detailed example of how a grocery distribution centre for
efficient picking could be designed is presented.
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Volume 29 . Number 1 . 2001 . pp. 4148
# MCB University Press . ISSN 0959-0552
41
Vesa Kamarainen, Johanna Smaros, Tomi Jaakola and Jan Holmstrom

Volume 29 . Number 1 . 2001 . 4148
new specialist, the distribution centre. Using a

distribution centre rather than picking the
orders from conventional stores or wholesale
stores is potentially much more efficient.
Table I shows a comparison between a typical
supermarket and the e-grocery company
Streamline's financial figures (assuming high
capacity utilisation for Streamline). The
distribution centre is essential for the
potential advantages of Streamline's
operational model. Similar figures have also
been presented by, for example, Jaakola (1999).
Replacing stores with distribution centres
is potentially more efficient for several
reasons. First, picking the orders in
distribution centres rather than in stores
increases picking speed. This is because the
distribution centre can be especially designed
for picking efficiency, whereas the
supermarket's main concern is displaying the
products in an appealing way. In addition,
consumers doing their shopping do not get in
the way when the picking is done in a
distribution centre. Second, the labour costs
of a distribution centre are likely to be lower
than those of a supermarket. Finally, the
distribution centre allows for more efficient
space utilisation (Jaakola, 1999). There are,
however, significant differences in costeffectiveness between different distribution
centres.
The second key factor to consider is the
level of automation. The level of automation
is important because by improving picking
speed it is possible to attain savings in
operating costs such as the salaries of the
picking personnel. At the moment, in egrocery companies the picking speed varies
between 100 and 450 lines per hour per
worker. The 100 lines per hour are picked
picked from existing supermarkets, operating

costs tend to increase faster than revenues at
high volumes. The issue is picking efficiency.
Webvan in the USA has improved picking
efficiency by investing in highly automated
distribution centres (Cuglielmo, 2000). Many
other e-grocery companies as well have
abandoned the early operating model of
picking from supermarkets and switched to
picking from special warehouses, so-called
distribution centres. The reason for this is
that picking is expensive when done in
conventional stores customers are in the way
and the store layout is designed for displaying
products, not for picking efficiency. Existing
conventional stores' structures have to be
significantly altered for attaining the efficient
picking and delivery mechanism that egrocery requires.
The distribution centre model requires
substantial investments, but also offers
opportunities to radically improve picking
efficiency and space utilisation as well as to
reduce loss due to pilferage or spoilage
(Kamarainen, 2000). However, despite this,
most e-grocers still have trouble reducing
picking costs in practice. The problem is low
capacity utilisation, which means that the
overall operational efficiency remains poor.
This, in turn, means that the e-grocers cannot
provide competitive prices for the customers.
Furthermore, the service level offered by egrocers cannot improve radically before
resolving the operational issue of efficient
order picking. One of the e-grocer's main
challenges is, therefore, improving overall
picking efficiency.
Cost-effectiveness through increased

picking efficiency
Table I Comparison of Streamline and a typical

superstore
Order picking is one of the biggest cost drivers

in the e-grocery business. In bricks-andmortar supermarkets, the customers do their
own picking free of charge. The e-grocer,
however, has to pick the items for their
customers. This means that one of the biggest
e-grocery challenges is to increase picking
speed and, in this way, reduce the labour
costs of picking. Better picking speed can be
achieved by paying attention to who does the
picking as well as to the level of automation
(Reda, 1998).
First, who does the picking? There are two
alternatives: the existing supermarket or a
Typical
supermarket* Streamline
(%)
(%)
Cost of goods sold
Operating costs
Distribution
Corporate overheads
Net profit (%)
75
17
4
3
1
72
13
6
3
6
Note: * Figures compiled by Smart Store, a researchand-development initiative at Andersen Consulting

Source: Macht (1996)
42
where T the amount of working hours
from a conventional store without any

automation (Kamarainen, 2000), and the 450
lines per hour is a benchmark figure from
Webvan, which uses highly automated
distribution centres (Anders, 1999).
However, a high level of automation also
requires significant investments. For example,
Webvan's distribution centres cost from $25
million to $35 million each, while less
automated distribution centres cost between
$ 4 million and $6 million (Cuglielmo, 2000).
At a capacity of 8,000 orders per day, seven
days per week, with an average order size of
about $103, Webvan could achieve an
operating margin of 12 per cent compared to
a 4 per cent margin for a traditional
supermarket. In reality, however, Webvan's
distribution centre operated at a loss with a
less than 20 per cent capacity load, i.e. less
than 1,600 orders per day, five days a week in
the end of 1999 (Cuglielmo, 2000). The
example illustrates that efficient order picking
alone is not enough to make the e-grocery
business model cost-effective.
The main benefit of automation is the
reduced labour requirements, and thus
reduced labour costs. Next, we will
demonstrate how the maximum justifiable
investment in improving picking efficiency in
different situations can be calculated. As an
example, we will look at a situation where we
have a distribution centre with the current
picking speed of 200 lines per worker per
hour. We would like to increase the picking
speed and are considering an investment to
increase the speed by 250 lines to 450 lines
per worker per hour. The employment cost is
$20 per hour. The expected lifespan of the
investment is eight years and the applied
discount rate 15 per cent.
In order for the investment to be profitable,
or at least not unprofitable, the savings it
causes have to at least equal the investment.
This means that the break-even point can be
expressed as follows:
Itot Stot ;
per worker per year,p

per hour,
W1 the number of workers needed
without the investment,
W2 the number of workers needed
after the investment.
The required number of workers can be
calculated by comparing the total picking
capacity needed to the picking capacity of
each individual worker:
Ctot
Ctot
W
;
3
Cind T x
where Ctot the total picking capacity
needed (lines per year),
Cind the picking capacity of each
worker (lines per year per
worker),
x the picking speed (lines per
hour per worker).
The total capacity needed depends on the
amount of lines that need to be picked as well
as the capacity utilisation rate:
L
Ctot ;
4
U
where L the amount of lines that need to
be picked (lines per year);
U the capacity utilisation rate.
The net present value of the annual savings
during the lifespan of the investment can be
expressed as follows:
n
X
Sannual
stot
;
5
i
i1 1 r
where r the discount rate,
n the expected lifespan of the
investment (years).
By combining formulae 1-5, we get the
following expression for the maximum total
investment that can be justified:
n
X
Sannual
Itot Stot
i
i1 1 r
6

n
X
1 pL x2 x1
:
i U
x1 x2
i1 1 r
where
Itot the maximum total investment;
Stot the total savings during the lifespan
of the investment.
The annual savings, i.e. the annual reduction
in labour costs can be expressed as follows:
Sannual T p W1
W2 ;

Volume 29 . Number 1 . 2001 . 4148
In this case, if we make the simplifying

assumption that the capacity utilisation rate is
2
43

n
Itot X
1
p
U 2 x2 U 1 x1
; 7
iU U
L
x1 x2
1 2
i1 1 r
1, the cost savings per line to be picked, i.e.

maximum investment per line, is therefore:

8
200
20 450
Itot X
200450
$0:25=line
i
L
i1 1 0:15

Volume 29 . Number 1 . 2001 . 4148
where U1 the capacity utilisation rate

before the investment,
U2 the capacity utilisation rate after
The result shows that the maximum

investment in automation is $0.25 per line to
be picked provided that capacity utilisation
is 100 per cent both before the investment
and after it. However, a 100 per cent capacity
utilisation rate is not realistic. Capacity
utilisation varies a lot depending on how
demand fluctuates over the week and during
the day. For example, in Finland about 40 per
cent of the grocery demand is concentrated to
Fridays and Saturdays (LTT, 1995). This
means that, if our capacity is inflexible, i.e. if
we use a lot of machines and automation, we
have to set the average capacity level
according to the peaks in demand, which
means that capacity utilisation is poor in the
beginning of the week. On the other hand, if
our capacity is flexible, i.e. if we use mainly
manual labour that only works and is paid
when it is needed, we can lower the average
capacity level needed (see Figure 1).
The capacity utilisation rate is, thus,
different in different situations and has to be
taken into account when considering the
profitability of an investment. When
calculating the maximum justifiable
investment, the same logic as presented above
can be used. However, the situation before
the investment is given a different capacity
utilisation rate than the situation after it. This
means that formula (6) changes as follows:
the investment.
Figure 2 illustrates how the difference in
utilisation rates affects the value of the
investment. In the illustration, the capacity
utilisation rate before the investment is
assumed to be 1 a simplification that makes
it easier to illustrate the changes. The original
picking speed is assumed to be 200 lines per
hour.
As we can see, capacity utilisation has a
significant effect on cost savings. When
capacity utilisation increases, cost savings also
increase rapidly. To respond to the demand in
Figure 1 with same-day deliveries, a realistic
utilisation rate relying on a highly automated
solution is only 50 per cent (in a more manual
solution, workers can more easily be added to
meet peak demand than in a highly
automated one). In our example, the original
picking speed of 200 lines per hour needs to
be doubled to reduce the cost per order line at
a utilisation rate of 50 per cent. However,
with a utilisation of 60 per cent, a doubling of
the picking speed already yields a cost saving
in labour of $0.07 per line, and at utilisation
of 70 per cent the cost saving is $0.13 per
order line.
To summarise, automation is a solution for
achieving better picking efficiency in the egrocery business. However, if the e-grocery
Figure 1 Average weekly fluctuation in store visits in Finland in 1994
44

Volume 29 . Number 1 . 2001 . 4148
Figure 2 Total cost of savings per line, i.e. the value of the investment, at different rates of capacity utilisation
products. This information can be obtained

by analysing consumer orders and
establishing in how many of the orders a
certain stock-keeping unit (SKU) appears.
Frequency of occurrence is more important
than volume because it directly affects the
amount of picking that has to be done if
every order contains a certain item, it causes
more work than if every tenth order were to
contain ten pieces of this same item.
Smaros et al. (2000) have presented a
model for consumer demand segmentation
(Figure 3) in which three demand segments
are used:
(1) continuous demand;
(2) occasional demand; and
(3) single purchase type of demand.
companies fail to consider automation from a

capacity utilisation point of view, projected
cost savings will not be realised. Rather than
simply investing in automation, the e-grocers
also need to pay attention to the design
principles of the distribution centre. Special
attention must be given to the planning of the
order assembly process in the distribution
centre.
Design principles for better picking

efficiency
The distribution centre should be seen as a
factory that assembles grocery orders rather
than a warehouse for storing goods. This
means that production principles
(Schonberger, 1982) such as just-in-time
(JIT) and lean manufacturing can be applied
in distribution centre design (Harmon, 1993).
Minimising handling and waste are powerful
concepts when making order picking more
efficient.
When planning an e-grocery distribution
centre, the main goal should be to create an
efficient flow of products through the centre.
To obtain efficiency and not, for example,
allow slower-moving products to be in the
way when handling faster-moving products,
differences in product group characteristics
have to be considered when designing the
product flows and the layout of the
distribution centre.
The most important factor to consider is
the frequency of occurrence of different
The model and its three segments can also be

used to describe how products, or SKUs, with
different frequencies of occurrence can be
grouped. Items with high frequency and
Figure 3 Demand segmentation of products
45
relatively stable demand belong to the

continuous demand group. Items that have a
lower frequency of occurrence belong to the
occasional demand group. Finally, items that
only rarely appear in the consumers' orders
belong to the group called single purchase.
The layout of the distribution centre should
take these groups into consideration.
Handling and movement of the continuous
demand products must be minimised. Ideally,
the products are cross-docked in the
distribution centre. There is no need to store
these items on the shelf. Products that belong
to this group must be placed near to inbound
and outbound areas. In Figure 4, a layout
solution for these items is presented.
Products that belong to the occasional
demand group are unpacked from pallets
(wholesale packages) to smaller units. This
makes it possible to save space. Items are
stored in flow racks and on open shelves. Ushaped picking cells (Schonberger, 1982) of
compatible products can be formed to
increase picking efficiency (Figure 5). To
avoid crossing paths, the shelves are loaded
and unloaded from different sides. The aim is
to get these items to flow through the
distribution centre.
There is no need for forming cells for
products that demonstrate single purchase
type of demand, due to their rare occurrence
in the orders. The most important thing as far
as this group is concerned is to minimise the
risk of stock-outs it is important that the
customers' orders can be filled completely in
order to attain good service quality (Sakki,
1999). In Figure 6, the solution for storing
items that have low frequency of occurrence is
presented.

Volume 29 . Number 1 . 2001 . 4148
Although frequency of occurrence forms

the basis for the product flow and layout
design, there are also other factors, such as
the preservation temperatures and physical
characteristics of the products to consider.
When dealing with groceries, preservation
temperatures are crucial. In the distribution
centre, proper preservation of the goods
requires that there should be at least three
different temperatures in use:
(1) room temperature;
(2) chilled; and
(3) frozen.
This increases the complexity of grouping and
layout planning. For instance, items that
belong to the continuous demand group have
to be placed in at least three different places
because of preservation temperatures. The
temperature aspect also affects what shelf and
technology solutions can be used. For
example, frozen items may need to be placed
so that the picker does not have to do the
picking inside a freezer. Picking should be
possible to do outside the freezer, through
special Plexiglas doors.
Furthermore, the physical characteristics of
the products have to be taken into account.
Some items, such as meat and detergents,
may not be stored in the same place. The
weights, dimensions and durability of the
products also affect layout planning. By
placing items that have similar properties in
the same area, the picking routes can be
planned so that heavy items are picked first
and fragile items will be situated on top of the
picking tote.
Picking the products is, however, just one of
the distribution centre's functions. The
products also have to be assembled into
Figure 4 Solution for continuous demand products
46
codes, it is possible to simplify the final

assembly process (Harmon, 1993).
The distribution centre does not need any
extraordinary technology to be effective. The
most important point to understand when
improving picking efficiency is to realise that
shelves and other facilities do not need to be
automated. The first priority is not
automation, but organising the distribution
centre material flows and layout for efficient
order assembly. The proper reference point
for designing a distribution centre for home
delivery is not a wholesaler or grocery
manufacturer distribution centre, but an
assembly plant for make-to-order PCs or
automobiles.
Segmenting products according to the
frequency in the shopping baskets of the
consumer makes it possible to significantly
improve efficiency using only ordinary picking
shelves and gravitation flow racks. The next
level of improvement is achieved by using barcodes, pick-to-light systems and a warehouse
management system. With investments in
technologies that frees both hands of the
picker, it is possible to make the picking
process much more efficient, again without
investment in automatic handling systems.
Figure 5 Picking cells for occasional demand items
Figure 6 Solution for single purchase products


Volume 29 . Number 1 . 2001 . 4148
complete orders. Figure 7 presents how

assembly can be arranged efficiently. Items
are moved to the assembly area just before
delivery in order to maintain the appropriate
preservation temperature as long as possible.
By arranging picked order totes according to
customers' locations, for example postal
Conclusions
E-grocers try to challenge the traditional
bricks-and-mortar grocery business, but their
operational costs are still too high. In addition
to home delivery, order picking is currently
Figure 7 Order assembly solution
47

Volume 29 . Number 1 . 2001 . 4148
can be effective to level demand during the

week. This way, changing the service model
to level demand can make investment in
improving picking speed more attractive. The
result is that service and cost-effectiveness can
be developed simultaneously.
far too inefficient and expensive. One of the

main e-grocery challenges of today is,
therefore, to increase picking speed.
Questions that need to be addressed are: who
performs the picking (existing supermarkets
or new specialists, distribution centres) and
what level of automation is desired?
In this paper, we have shown that, when
volumes are sufficient, distribution centres
become more efficient than supermarkets for
several reasons. One of the main benefits of
the distribution centres is the opportunity to
significantly increase the picking speed.
Automation is the obvious solution for
further increasing the picking speed. This,
however, requires significant investments. In
addition, as we have shown is this paper,
projected savings may not be realised if the
full capacity of the distribution centre is not
efficiently utilised. Unfortunately, due to
fluctuating demand, the capacity utilisation is
often rather poor in the grocery business. This
diminishes the attractiveness of investing in
automation.
Therefore creating flexible and expandable
product flow and layout designs should be
regarded as more important than rapidly
increasing the level of automation. The goal
should be a distribution centre through which
the products flow efficiently and without
stopping unnecessarily, and in which changes
and adjustments, such as changes in the
placements of the products or in the size of
the operation, can be made continuously as
the business develops. Instead of taking the
risk of tying a lot of money to automation that
we cannot fully exploit, we should create an
opportunity to take smaller steps as the
business grows.
Finally, before embarking on automating
order assembly, there is much to do for egrocers in developing the service model. The
point is that the potential utilisation rate for
automated solutions can be improved by
levelling the demand. Changing the service
model can level demand for grocery products
in several ways. For example, to level the
demand during the day a reception box in the
garage or front yard of the consumer is useful.
The e-grocer can level the load on the
distribution centre by delivering orders to the
reception box before the peak hours in the
afternoon when people return from work.
Also, replenishing automatically the
household with continuous demand products
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Cost Effectiveness in The e Grocery Business

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International Journal of Retail & Distribution Management