Damco eGuide

GOODS AND SERVICES TAX REFORM IN INDIA An opportunity for supply chain optimisation Nitesh Mandal, Regional SCD Consultant 1

Table of Contents 01. INTRODUCTION3 02. CURRENT TAX CODE DISTORTS SUPPLY CHAIN DECISIONS

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03. THE NEW GST SYSTEM

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04. GST EFFECTS ON THE SUPPLY CHAIN

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05. KEY CONSIDERATIONS

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06. POSSIBLE BENEFITS

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07. CASE STUDY

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08. DAMCO SUPPLY CHAIN DEVELOPMENT (SCD) APPROACH FOR NETWORK OPTIMISATION10

09. CONCLUSION10

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01. INTRODUCTION It seems certain that the new code covering the taxation of goods and services (GST) across India will be rolled out from April 2017. Legislation will go through Parliament and State assemblies over the winter, and details of tax rates and bands have now been announced, allowing companies to start detailed analysis of the fiscal and other impacts. Apart from any tax savings, which will vary by sector and location, it is evident that the new system will offer many firms the opportunity to reconsider their Sourcing and Distribution networks. This in turn will make it possible, where appropriate and applicable, to redesign Supply Chain networks leading towards far greater optimisation and efficiency than in many current practices. The introduction of the new GST system is said to be the most significant tax reform since Independence. After over ten years of research, negotiation, and institutional oversight, GST now forms one of the pillars of the Government’s 2014 ‘Made in India’ strategy, which aims to create proficient, leading edge and dynamic manufacturing sector for both domestic and export markets. Other targets to consider in this strategy include: land and labour reform, infrastructure (primarily transport) development, industrial automation and Information Technology (IT), and all with the objective of creating an ‘ease of doing business’ environment. Development in these areas will encourage additional supply chain optimisation strategies. In this paper we present Damco’s understanding of the changes that will happen once GST is implemented in India and their possible impact on supply chain networks. Furthermore, we analyse the emergent scenarios and provide an insight into potential action points for any organization currently in a post-GST scenario. The paper also provides a suggested methodology for optimising your supply chain network after the implementation of GST.

02. CURRENT TAX CODE DISTORTS SUPPLY CHAIN DECISIONS In common with most developing countries, Indian government at both national and state level is dependent on indirect taxation (of goods and services, as opposed to direct taxation of incomes and profits) contributing over a third of their annual revenues; a significantly higher proportion than is typical of larger developed countries. Historically, the 29 States have enjoyed considerable independence in tax matters and have held differing views on topics related to the economics and politics of taxation. The result has been the development of a complex and inconsistent series of indirect taxes. An interstate transaction could attract half a dozen or more taxes and duties, including entry taxes, octroi, state and national Value Added Tax (VAT), excise duties, and a variety of sales taxes. Tax rates and procedures may vary state by state, while goods may be exempt from a tax in one state but not in another. The extent to which manufacturers and traders can recover input taxes also varies. This has had several negative effects on supply chain development in India, not so much perhaps through firms seeking to reduce their overall tax bill, but because they seek to minimise delay, bureaucracy and the administrative burden of complying with complex tax codes. On the inbound side, parts and materials sourcing may be much more localised than

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would otherwise be the case (although there may also be sound operational reasons for this). There is a strong incentive for companies to do everything themselves where sourcing from external suppliers and contractors would otherwise make commercial sense. This has led to a depressing effect on the development of a strong supplier base in many industries. In distribution it has often been felt preferable for companies to maintain their own fully stocked warehouse or distribution centre(DC) in every state, rather than satisfy demand from a larger and more efficient DC in a neighbouring state (interstate ‘stock transfers’ do not attract Central Sales Tax, whereas a cross-border sale to a dealer does). Inventory levels tend to be higher than they should be, and transport utilisation lower. For smaller companies the complexity may be a real disincentive to expansion out of their home state. Meanwhile, greater space is available for operators in the ‘non-organised’ or informal economy, which reduces government tax revenues. The current arrangements are also unattractive to FDI (Foreign Direct Investment).

03. THE NEW GST SYSTEM The new GST code is inevitably complex, but its key points include the elimination of Central Sales Tax on the interstate movement of goods, and the creation of a uniform tax system across most of the country. It is essentially an extension of the value added taxation principle: central government taxation has been moving to a VAT model since 1986, with ‘MODVAT’, and later ‘CENVAT’, replacing central excise duties and sales tax. With the introduction of GST, India will for the first time operate and perform as a true ‘common market’, working on the principal that indirect taxation is ultimately paid by the end-user or consumer. Specific objectives towards the move to GST include: • Ensuring that input taxes are credited/reclaimed right through the value chain (a basic requirement for a VAT system) • Minimising the ‘cascade’ effect of taxation • Making tax administration and compliance simpler • Harmonising the tax base, laws and procedures across the country (this should also encourage the increased use of IT and automation in corporate tax affairs) • Minimising the number of tax rate ‘slabs’ to reduce disputes about the classification of goods • Preventing unhealthy competition between States (by, for example, offering tax exemptions to investors) • Increasing the tax base and raising compliance (by reducing the advantages of the ‘unorganised’ players). GST will operate in four tax bands or ‘slabs’, depending on the nature of the goods or services, set at 5%, 12%, 18%, and 28%. More essential items will attract the lower rates and indeed around half of the goods in the Consumer Price Index ‘basket’, including most foods, will enjoy a zero rate. On the other hand, luxury cars, tobacco, and aerated drinks fall in the highest band and for five years will attract an additional charge, which the government will use to compensate those States that would otherwise lose revenue from the changes. Importantly for business, taxation of petroleum and of electricity does not come under GST.

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GST is not intended to reduce overall taxation, although the overall effect is expected to be mildly deflationary. The expectation is that overall tax revenues will be constant or even rise as compliance improves and the informal sector is brought into the fold. Even if the ultimate tax paid on a product does fall, the effects on individual company finances may not be straightforward; to the extent that products formerly exempt will now incur a tax charge which will then be re-credited at a later date.

04. GST EFFECTS ON THE SUPPLY CHAIN The introduction of GST presents not just an opportunity but a commercial need for companies of all types to re-examine their supply chains in the light of the new situation. Every supply chain will face different impacts and opportunities from GST, depending in large measure on where they are starting from. This will not be just in terms of their physical networks but also the extent to which they previously enjoyed tax exemptions or alternatively, were unable to recover input taxes.

Six key Supply chain areas that are likely to be affected by the new GST system

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Consultants KPMG suggest that companies should be looking at six principal supply chain areas. They are of course interdependent, and should be reviewed in the broadest context, including the other elements of the ‘Made in India’ strategy (such as current and future availability of infrastructure, land, skilled labour and the like) and not just in terms of taxation. Warehouse locations, their geographical coverage, manufacturing locations, product-plant mapping, supplier networks and manufacturing architecture should be considered by the ‘normal’ criteria rather than against the rules of the tax regime. Criteria to look at include price, quality, speed to market, customer service and cost of service, and efficiencies in warehousing, procurement, distribution and manufacturing. Conclusions may range from the location of facilities and what operations are carried out in them to questions as to whether the company is actually the best entity to own and operate key sources or distribution channels. As India faces many of the same supply chain challenges as the rest of the world, from shorter product life cycles to more demanding customer service expectations and of course the whole Internet/ecommerce challenge, most companies ought to be reviewing their supply chain operations anyway. The new GST regime reinforces that requirement.

05. KEY CONSIDERATIONS Companies wishing to redesign their supply chain around real supply and demand signals and constraints need to address a number of key considerations. Prime locations for manufacturing or distribution facilities are a challenge to locate, particularly as India’s economy continues to expand. The policies of individual States have a significant impact on what is or is not possible and under what terms. Assured availability of resources such as water and electricity is of course critical. The condition of transport infrastructure, particularly roads but also rail, inland waterway and air, varies immensely. Companies will also need to consider whether suitably skilled labour is available, especially in the light of pending labour law reforms. The ability to hire key senior people, or to relocate existing staff, should be considered. The presence of a support base such as equipment maintenance companies, transport and logistics contractors, IT support and financial services, is also a significant factor. Early priorities for review and possible change include: • Realigning manufacturing and distribution networks with the aim of reducing costs while improving efficiency and customer service levels. This may create opportunities to use cheaper transport modes, to use larger trucks/containers and to reduce ‘empty running’, at least in some parts of the chain, although this may sometimes imply lower efficiencies in final distribution. • Potential changes in the manufacturing footprint also suggest the need to re-examine sourcing alternatives and current contracts. • Re-alignment of manufacturing and warehousing may create the potential for improved efficiencies through greater use of automation and technology. • A rigorous push down on the total inventory in the system should be a priority. The conclusions drawn from such reviews will vary across companies and sectors. Some companies may have an opportunity to close smaller warehouses and DCs and serve those markets from a distance, perhaps through new, larger DCs that can support high levels of

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automation. Other companies may see an opportunity to expand their markets and networks into areas hitherto seen as too costly or bothersome to serve. Some firms may choose to improve customer service by moving manufacturing elements, particularly final assembly and configuration, close to or even into the final distribution warehouse. These are the kinds of questions that industries in any country should be asking, although many don’t: but until now the need to ask the questions has to an extent been disguised by the tax situation. There is no ‘one size fits all’ solution and a sensible organisation will run several ‘what if’ scenarios to determine the best fit between business objectives and supply chain reality (and repeat the exercise every few years). Creating and analysing these scenarios is not however a trivial task, and many firms would be well advised to enlist the help of an experienced partner, such as the Supply Chain Development teams at Damco.

06. POSSIBLE BENEFITS Leaving aside any purely taxation-based benefits, the range of savings and efficiencies opened up by the GST tax reform is considerable. According to Chainalytics, typical companies could save between 2.2 and 8.5 per cent in logistics costs. Reductions in safety stocks through having fewer stocking locations could be between 3.5 and 10 per cent. Importantly, more of this stock should be held in direct response to a forward view of actual or forecast customer orders, rather than arriving at the DC on a backward-looking replenishment basis. According to a World Bank economist, the reduction or elimination of delays at interstate borders could be worth a 30 to 40 per cent improvement in lead times (other analysts put cross-border delays at anything up to 7-8 hours). Supply chain optimisation should also encourage efficiency through the use of technology and automation in warehouses, greater investment in efficiency by transport companies and 3PLs, and the development of more diverse and competitive source and supply industries. Against these potential savings (which it is only fair to say will require some significant investment) actual savings on the tax bill are relatively insignificant.

07. CASE STUDY Damco’s Supply Chain Development team (SCD) recently carried out an evaluation of the post-GST opportunities in the distribution chain of a major agrochemicals manufacturer. The customer sources from five of its own plants (82 per cent by volume) and six external sources, with 54 per cent of volume originating in Gujarat. Sales are delivered to over 10,000 customers across India, although with a concentration (31 per cent) in Andhra Pradesh and Telangana. Currently, distribution is through 40 DCs, 36 of which are company-owned. Our customer wanted to know how significant distribution savings could be made in the post-GST environment, while maintaining its customer service target of delivery within 48 hours. Damco noted the high number of warehouses and also the high level of stock, expressed as inventory days. (Demand is highly seasonal, so that was not too surprising). 7

SCD discussed strategic business objectives with the customer, and gathered data about the structure and operation of the current supply chain setup across India to create an ‘As is’ model. SCD then applied a demand and cost analysis to identify pain areas. SCD then modelled rigorous Centre of Gravity scenarios based around the various business constraints. Each scenarios was carefully evaluated by our warehousing and distribution experts, supply chain consultants and by the customer through their logistics team. Each scenario had its pros and cons but it was important to select scenarios that not only produce favourable financial and performance figures, but also are operationally implementable. After a lot of scrutiny two possible ‘to be’ scenarios remained that were achievable, produced good figures, and were in line with the customer’s strategic and tactical objectives In Scenario 1, the number of DCs was reduced to 18. This promised a service level at which around 86 percent of volume was within 300 km of a DC; almost the same as in the current, baseline case. A second setting, Scenario 2 was a much aggressive Hub and Spoke Network with a considerable reduction in DCs. Damco identified 2 ‘mother hubs’ (in Andhra Pradesh and Madhya Pradesh) and just eight further DCs. This would bring the service level down to 67 per cent within 300 km of a DC. 8

The next stage was for SCD to use ‘best in class’ optimisation tools, from Llamasoft, to run multi time period optimisation models of each scenario. This revealed the likely effects of each scenario on both costs and inventory levels. Looking purely at logistics costs, both ‘to be’ scenarios yielded significant savings, although not necessarily in the same areas. Both created small but significant savings in primary transportation (into the DCs), but higher costs on secondary legs – unsurprising as serving more customers over longer distances from the same truck is bound to increase part-loading and empty running. On the other hand, Scenario 2 eliminated the costs of inter-DC transfers. Both new scenarios showed useful contributions from savings in storage and in administration costs, but Scenario 2 significantly increased handling costs. With fewer DCs in the network, the inventory carrying costs in both cases were significantly lower than in the current ‘as is’ scenario. However given the maturity level of the customer’s current supply chain set up, successful implementation of Scenario 2 would require a revisit of the inventory management system. Considering only the logistics savings, Scenario 1 offered savings of 14.7 per cent (USD 625 thousand), and Scenario 2 a smaller but still impressive saving of 9.1 per cent (USD 388 thousand). But that is not the end of the story. When we looked at total inventory carrying cost, which was USD 1.907 million in the baseline case, Scenario 1 reduced this to USD 1.305 million and Scenario 2 to just USD 610 thousand, giving combined savings across both logistics and inventory of 20 per cent and 27.4 per cent respectively! The customer is currently evaluating Damco’s solutions through a pilot prior to scaling up.

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08. DAMCO SUPPLY CHAIN DEVELOPMENT (SCD) APPROACH FOR NETWORK OPTIMISATION Damco has a proven methodology in which SCD consultants integrate with our local operational experts to deliver network optimisation solutions Implementation Plan TO BE Scenario Optimisation and Recommendation TO BE Scenario Selection

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AS IS Baseline Model

• Gather Data

• Strategic Review

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SCD Team conducts joint qualitative review of the customer’s existing supply chain Qualitative analysis of key drivers, constraints, business goals and strategies in the customer’s supply chain. Gain comprehensive understanding of customer’s long term strategic growth plan

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Based on the strategic objectives, determine the information required. Identify, gather and collate sources of data (which may be distributed across the company) Clean and standardise data. Any assumptions made, such as wider economic trends, are detailed Assess and analyse data for gaps and omissions

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SCD experts define the scope of the models in terms of processes, facilities and products. A protocol for allocating costs in each Scenario is agreed

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The AS IS Baseline case is modelled Any variance between the model output and real performance is analysed, and if necessary the model and underlying assumptions are adjusted

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Request new data if required

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Map high level supply chain process(product, cash & information) flow

SCD models numerous Centre of Gravity scenarios, taking various business constraints into consideration The Project team (supply chain designers, solution engineers, warehouse and domestic distribution experts) drafts multiple possible future Scenarios, exploring the potential impact of changes

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Scenarios that clearly ‘fail’ on operational, cost or strategic grounds are discarded Out of the remaining viable scenarios, SCD revisits the customer the baseline assumptions, strategies and goals

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SCD applies state-ofthe-art tool, Llamasoft Supply Chain Guru to optimise each scenario

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Sensitivity analyses are carried out along with ‘what if’ exercises

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Promising models are run extensively under a wide range of input conditions to verify likely impacts on costs and services A detailed cost benefit and risk analysis is conducted for each scenario, highlighting impact of optimisation on different elements of the supply chain. For example: Shortened Lead time vs Total cost vs Customer Service Level

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Pilot project implementation in specific customer zones covering multistate supply chain network Joint steering team to be formed to monitor the implementation Implementation progress is reviewed on quarterly basis for at least a year; dedicated program managers streamline the process Robust Plan B in place for earlier identified challenging and crucial markets and/or demand points Annual Supply Chain Development workshops conducted to identify future strategic and tactical improvement areas

One or more Scenarios are presented to the customer with recommendations

A shortlist of viable models is taken forward for optimisation

Develop a conceptual model of what the supply chain is trying to achieve

09. CONCLUSION India’s GST tax reform offers great opportunities for companies to carry out a necessary re-evaluation of their supply chains based around commercial and supply chain drivers rather than around tax considerations. It is vital for businesses to identify and assess these opportunities and leverage them to reinvent their existing supply chain footprint. Companies, instead of investing their own time and money can rely on the expertise of Damco. With a team of consultants, implementers and operators across many countries and business sectors, Damco Supply Chain Development offers customers independent and unbiased solutions drawing on our deep knowledge and experience.

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About the author Nitesh Mandal is Supply Chain Development Consultant at Damco and is based in The Hague, Netherlands. As a supply chain professional with over seven years of experience, Nitesh has delivered complex supply chain optimization solutions across various parts of the world. His specialties are in network reengineering, inventory optimization, warehouse designing, and in managing warehouse operations. About Damco Damco, one of the world’s leading third party logistics providers, specialises in delivering customised freight forwarding and supply chain solutions. The company has more than 300 offices in over 100 countries and employs 11,000+ people. Damco is part of the Maersk Group. More information about Damco can be found on www.damco.com

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