CASE STUDY:                                               
Self-distribution vs. Partnering With a 3PL

CASE STUDY: Self-distribution vs. Partnering With a 3PL

Ali Lepech

Summary
As California’s legal cannabis market grows, the distribution network needed to meet the demands of the market grows with it. Currently, the cannabis supply chain landscape is fragmented between brands working with third party distributors and those opting for self-distribution. A comparison of costs and logistical challenges reveal using a third party distribution partner is cost-effective and frees up resources for other growth-oriented initiatives.

Self-Distribution Costs
A conservative estimate of the capital necessary to establish a viable state-wide distribution network in  California includes:

While self-distribution costs can quickly surpass $1 million, several of the assets purchased at the start of distribution will depreciate in value over time and require substantial upgrades; Vehicle deterioration and the emergence of new facility compliance regulations are likely to occur within the first two years of purchase.  Further, multiple facilities will likely become necessary to achieve effective state-wide product reach. These costs will increase as a company scales and expands its distribution footprint, making it compulsory for brands to continually source manpower and invest in resources to maintain compliant growth.

Third Party Distribution Costs
The majority of third party cannabis distributors charge fees as a % of Gross Merchandise Value (GMV) shipped. The table below illustrates how working with a 3PL offers cost savings relative to self-distribution:

A brand shipping $500K GMV per month while working with a third party logistics partner would pay substantially less than the average costs of self-distribution. This cost estimate does not include the drastically reduced management overhead and risks associated with operating a state-wide distribution service. These risk-associated challenges exist before and after establishing distribution capabilities, and are discussed in detail below.

Challenges Before Distribution

Prior to order fulfillment, time and resources are required to minimize the risk of making a noncompliant sale. California has some of the strictest cannabis compliance requirements in the U.S., and penalties for violations can be severe.

Noncompliant sales can occur when a brand or manufacturer fails to:

Meet the BCC’s packaging requirements
In 2018, label requirements resulted in a near industry-wide overhaul of cannabis product packaging, but brands and manufacturers were often unaware their labels fell short of BCC requirements until a delivery was rejected. Third party distributors help oversee packaging specifications and can notify brands of issues before orders are rejected.

Ensure products are tested in a licensed lab
California labs are required to test cannabis products for residual pesticides, residual solvents and processing chemicals, and heavy metals to ensure they are safe for consumption. The industry has been plagued with noncompliant labs falsifying data, which put brands at risk of major product recalls. Working with a lab that produces consistent results on fast turnaround time is critical, and many third party distributors have established relationships with compliant labs.

Ensure product is delivered to a licensed dispensary
With over 1,000 unlicensed dispensaries in L.A. County alone, it’s imperative that manufacturers and brands verify a retailer’s licensing information before agreeing to a sale. If a noncompliant dispensary is raided by the BCC, all products being sold there are subject to loss of license. As a brand scales, the overhead of monitoring thousands of sales can become overwhelming. Third party distributors work with hundreds of retailers each week, and can help reduce the risk of working with unlicensed retailers through regular license verification checks.

Challenges During Distribution

Unviable unit economics
A major challenge of self-distribution is reaching an order volume large enough to achieve viable unit economics on deliveries. Brands making in-house deliveries are inherently constrained to a single order per trip, which makes it difficult to justify smaller sales with a high cost of delivery. Overtime costs also accumulate with a smaller fleet and fewer drivers to spread deliveries across- these costs increase when expanding coverage to target new customers in more remote areas.

Third party distributors are better equipped to handle these challenges and perform deliveries more efficiently. The ability to layer deliveries with multiple orders, increase the number of deliveries per route, and establish consistent routes across California allows them to drive the cost of delivery much lower than a single brand could achieve.

Unsuccessful deliveries
With rapidly evolving regulations and unique delivery requirements across hundreds of retailers, the risk of product and order rejections is substantial. In a recent survey of cannabis retailers, respondents highlighted two key causes for rejection: miscommunication with distributors and noncompliant paperwork/packaging.

Miscommunication
Order miscoordination was listed as the single most common cause for order rejection. Many dispensaries have specialized instructions for deliveries (e.g. specific windows of time for product intake, appointments scheduled in advance, paperwork emailed before delivery). Substantial overhead is required to manage these special requests as an operator scales to avoid rejected deliveries.

Noncompliant paperwork/packaging
As previously referenced, compliance requirements vastly increase the complexity and management overhead of cannabis distribution. A compliant shipping manifest must be prepared and printed for every single order with a host of data requirements, and product packaging must adhere to strict guidelines laid out by the BCC. If any of these standards are missed, retailers can reject the entire order - a costly mistake in both lost revenue and expenses related to delivery.

Time-of-delivery manifest updates
Orders often change upon delivery for a number of reasons: partial SKU rejection, incorrect manifest information, mis-packing, etc. When this occurs, the distributor must make real-time adjustments in order to accurately reflect the transaction for California’s track and trace program. As an operator scales, the frequency of these updates can quickly become overwhelming for a small team.

Challenges After Distribution

Payment collection
No transaction is complete until payment is collected. On average, more than 40% of all orders are placed on net payment terms as opposed to cash on delivery (COD). This effectively doubles the logistical challenges for operators, as they must coordinate return trips for collections. They must also manage all outstanding invoices and keep track of payments as they are collected to ensure cash amounts match invoices. As volume grows, the associated risks and costs increase as secure storage in transit and in distribution facilities becomes imperative.

Tax collection
As California cracks down on illegitimate operators, collection and remittance of excise taxes only grow more important for operators that look to remain in good legal standing. So far, data from the IRS reveals current efforts are falling short. The government’s reported collection of $355 million in excise taxes is less than half of what was expected after legalization, meaning that a large portion of California cannabis businesses are operating in a noncompliant manner. Since 70% of legal cannabis businesses operate without using banks, the prevalence of cash transactions adds another layer to the intricacies of tax collection.

Advantages of a 3rd Party Distributor

Cost-Savings
Working with a third party logistics partner should not only reduce the management overhead and risk of operations, but also improve the bottom line. The cost comparison above describes how, even by conservative estimates, the economics of third party solutions quickly become attractive as a brand scales.

Technology
Third party distributors can invest heavily in developing cannabis logistics software, tailored for the industry and the unique compliance requirements. By hiring a team of dedicated engineers and leveraging operational expertise, the pace of development increases dramatically and is specialized for cannabis distribution. Features around order tracking, inventory management, and accounting provide the level of transparency that a brand would seek through self-distribution. This type of tech focus is not always feasible for self-distributing brands, as engineering resources (if available) are typically dedicated to other growth-related initiatives.

Workforce
While a cannabis brand could hire additional employees to manage internal logistics, the number of people required to effectively manage a state-wide supply chain puts a substantial strain on capital. The average California distributor has between 10 and 30 employees, all of whom are dedicated to ensuring that deliveries are completed on time and compliantly. Since brands typically pay distribution fees as a % of GMV, they benefit from this larger and more specialized workforce for a fraction of the cost.

Specialized and standardized operations
Third party distributors can leverage the wealth of operational information to improve service quality to retailers and optimize routing. Over time, delivery preferences and other important information is captured, processed, and communicated to brands as distributors interface with retailers. Third party distributors can use this aforementioned wealth of data to streamline their supply chain and make necessary operational adjustments. They can dedicate resources to best-in-class supply chain systems and processes and ensure consistency within distribution facilities and during deliveries at retailers.

Conclusion

Analysis of costs and other operational considerations associated with establishing  a distribution network reveal a third party distributor can absorb the majority of expenses required to deliver product while also offering superior service. Capital can be re-allocated towards hiring, sales, and marketing, and management can focus on other critical growth-oriented initiatives


Sources
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CALCULATIONS

Warehouse price was calculated using average prices in the industry along with average warehouse size according to California Industrial Warehousing Studies.
Johnson, Julie. (2017 September 17) Pot Businesses Rush to Fill Santa Rosa Industrial Buildings. Retrieved from www.northbaybusinessjournal.com

LA Cannabis Growers in Bidding War for Warehouse Space. ( 2018 April 3) https://www.emeraldreport.com/los-angeles-cannabis-warehouse-prices/

Southern California Association of Governments Industrial Warehousing Study. (2018 April). Retrieved from http://www.scag.ca.gov/Documents/Task3_2_FreightStakeholderInterview.pdf

Vehicle price was calculated using average prices of comparable distribution vehicles industry along with internal data on vehicle expenses.
DeMuro, Doug. (2014 June) The 6 Best Cargo Vans for Your Business. Retrieved from www.autotrader.com
Upfitting price was calculated using numbers from industry experts along with published BCC distribution vehicle requirements.
Brown, Chris. (2019 January 19) Hauling Cannabis and Cash: New Fleets Serve Exploding Industry. Retrieved from www.businessfleet.com
Ajax, Laurie. (2019) Regulations for Commercial Cannabis Distributors, Retailers, Microbusinesses, Temporary Cannabis Events, and Testing Laboratories. Retrieved from https://www.bcc.ca.gov/

Auto insurance price was calculated using numbers from cannabis and insurance industry experts along with internal data tracking insurance rates.
Brown, Chris. (2019 January 19) Hauling Cannabis and Cash: New Fleets Serve Exploding Industry. Retrieved from www.businessfleet.com

(2019) Product Liability Insurance Cost. Retrieved from www.howmuch.net

Cost of labor was calculated using data from industry job board postings along with internal data from employee pay rates. Amount of time worked was calculated using data from Pew analysis of Labor Department Data.
Backman, Maurie. (2019 January 19) Here’s How Many Hours the Average American Works Per Year. Retrieved from www.themotleyfool.com
Brown, Chris. (2019 January 19) Hauling Cannabis and Cash: New Fleets Serve Exploding Industry. Retrieved from www.businessfleet.com
Cannabis Delivery Driving Jobs (2019 February) Retrieved from www.google.com
Cost of fuel was calculated using data from US News & World Report combined with internal data on vehicle mileage and number of fuel refills tracked throughout the quarter. Amount of time vehicles were mobile and in need of gas was calculated using data from Pew analysis of Labor Department Data.
Brown, Chris. (2019 January 19) Hauling Cannabis and Cash: New Fleets Serve Exploding Industry. Retrieved from www.businessfleet.com
The 10 States with the Highest Average Gas Prices (2018) Retrieved from www.usnews.com
Miscellaneous costs were calculated using internal data of expenses from previous quarters along with market data on current average vehicle maintenance pricing.