Lego Case Study MKTG 210 20211LEGO: Consolidating DistributionEdwin WeMan, Carlos Cordon and Ralf W. SeifertIt was November 2006 and Egil Moller Nielsen, senior director of European/Asianlogistics for the LEGO Group, was undertaking a very challenging logistics transformation.Earlier in the year the company had consolidated distribution from seven operations into asingle European distribution center in the Czech Republic. The center was based in Jirny,10 kilometers outside Prague, and was operated by DHL, the global logistics company.This had been a stressful year for Møller Nielsen, the Logistics Strategy Director and his team.The implementation had not gone smoothly and there was still much left to do. Fortunately,the ‘high season’ was over, giving Møller Nielsen some time to breathe and plan his nextmove. The next phase — the transfer of the remaining operations to Jirny — was meant tostart early the following year. But was this still the right thing to do? Should he revise hisstrategy?Møller Nielsen had just come out of a meeting with senior executives for a go/ no-go decisionon the next phase. He was told: ‘Our business is back on track, so we are actually OK if youstop or slow down further consolidation — what do you recommend?’The company’s leadership was looking to Møller Nielsen for a strong recommendation.Should he push his initial, ambitious plan of using a single outsourced central distributioncenter (DC) in Europe? He had three options:1 Continue as planned.2 Keep the status quo — operate with several DCs for a few more years.3 Explore other alternatives.Whatever the decision, he would have to move quickly to be ready before the start of thenext peak period in about half a year from now.Financial Crisis at the LEGO GroupThe LEGO Group was established in 1932 by Ole Kirk Kristiansen in his carpenter shopin Billund, Denmark. For almost 70 years it saw steady growth in both sales and profitsuntil, in 1998, this successful streak came to an abrupt end and the company started losingmoney. Staff reductions followed for thefirst time in its history, and LEGO set out on apath of innovative new product development.By the end of 2002 the company appeared to have turned the corner — net cash flowwas positive once again and sales reached record highs. But inventory and receivables werealso up, and when retailers’ Christmas sales proved to be disappointing — especially in itslargest markets — LEGO braced18 itself for another difficult year. What happened nextexceeded even the company’s own worst case scenario. Sales dropped 26% in 2003 aloneand another 20% in 2004. This resulted in the largest losses in the company’s history overtwo successive years (refer to Exhibit 1 for a financial overview), calling into question theeffectiveness of the measures taken in response to the 1998 loss.Lego Case Study MKTG 210 202122004: A Costly and Complex Supply ChainThe company’s leadership knew that the supply chain posed the most immediateopportunity for significant improvements. It was selling creative toy products in acompetitive and highly seasonal global marketplace. But it did not have aflexible enoughsupply chain to deal with these great fluctuations. The company’s focus on creativity,innovation and superior quality had, over time, created high complexity in the supplychain. LEGO’s motto — ‘Only the best is good enough’ — had contributed to an emphasison creating, selling and delivering toys at any cost, without regard for practicalities. Torebuild profitability, the company had to re-engineer its supply chain.Bottlenecks in the Supply ChainThe company ran one of the largest injection-molding operations in the world, with its ownproduction sites in Denmark and Switzerland, and packing and other facilities in the CzechRepublic, the US and Korea. The fully automated factory in Denmark alone had more than800 machines. Its production people would proudly tell you that LEGO was the largestproducer of (toy) tyres in the world! The factories produced a staggering 20 billion bricks peryear; separate packing facilities assembled them into finished LEGO sets. The logistics flowbetween each factory and packing location was managed through a complex structure ofmultiple DCs and warehouses.Planning remained a constant challenge for LEGO, even after 50 years of experiencemolding bricks. Sales forecasting was so inaccurate that capacity utilization was just 70%.The company also had to manage a supply chain of over 11,000 suppliers that had grownover time as LEGO sets had become more elaborate, with multiple combinations for theface, body and legs of the main action figures — adding up to a total of 12,500 SKUs in over100 different colours.LEGO tried to establish itself as a just-in-time delivery company, but at a cost to itself. Itaccepted customer orders with immediate or next day delivery. Of these orders, 67%were for less than a full carton and only 62% could actually be delivered ‘on time’.A Complex Three-Level DC Structure in EuropeAs Exhibit 2 shows, to be close to the customer, LEGO used four regional DCs: two in France(Dunkerque and Lyon), operated by a third-party logistics provider and serving primarilythe UK and southern European markets; one in Germany (Hohenwestedt) for the Central andEast European markets; and one in Denmark (Billund) for Scandinavia and Benelux. Thelast two, also the largest, were operated by LEGO and employed just over 200 people. Almost14,000 customers received direct deliveries from these four DCs.The finished LEGO products were stored in a 30,000m2 central warehouse in Germany,operated by a third party. Products from this warehouse were delivered on demand to thefour regional DCs, two dedicated assortment product lines (Lego X-tended Line, Denmark andLego Education, Denmark) and LEGO’s Shop@Home operation in Denmark as well as DCslocated overseas for non-European customers.Lego Case Study MKTG 210 20213The factories in Denmark and Switzerland operated their own logistics and distributioncenters, storing and consolidating goods from their own production sites as well as fromthe packing facility in the Czech Republic and other third party suppliers. From the Denmarkand Switzerland central DCs, finished and complete sets were delivered to the centralwarehouse in Germany.Including a separate warehouse and operation for its ‘assortment packs’, LEGO used 11different European logistics operations to manage the flow of products, with more than 60suppliers of logistics and transport services.Project Shared VisionLEGO needed a turnaround. In 2003 and 2004, Kjeld Kirk Kristiansen, CEO and majorityshareholder, brought in outsiders and some recent recruits to execute the company’stransformation. Jesper Ovesen, from Danske Bank, became the new CFO; Bali Padda, whojoined LEGO in 2002, was promoted to VP Global Logistics and Jurgen Vig Knudstorp, whojoined LEGO in 2001 as a director of strategic development, was tasked with developing arescue plan. Vig Knudstorp gathered a diverse group of senior executives to develop thestrategy and set up a ‘war room’. The war room was decorated with process charts,performance data and other project tracking sheets, where senior management andspecialists analysed the company’s product development, sourcing, manufacturing andlogistics process. It was here that LEGO’s new ‘Shared Vision’ strategic plan took shape. InOctober 2004, Vig Knudstorp replaced Kirk Kristiansen as president and CEO of LEGO,receiving a clear mandate from the company’s board to execute this plan. Kirk Kristianseninjected some more of his own cash into the group ‘for the last time’, but otherwise took abackseat role.Action Plan for SurvivalThe first phase of Shared Vision — ‘Stabilize for Survival’ — focused on reducing costs,eliminating debt and returning the company to profitability. LEGO sold a 70% share of itsfour LEGOLAND theme parks to the Blackstone Group in 2004, clearing its debt and reducingdirect headcount by approximately 30%. Other assets were also sold or outsourced, such asbuildings, land, its own mold-making factory, the Korean packing facility and the corporate jet.The first phase of Shared Vision was achieved in 2005, a year in which LEGO returned toprofit. Sales increased also, but this was largely driven by the success of the sixth and finalStar WarsTM movie: Revenge of the Sith. The second phase — ‘Profit from the Core’ — wouldfocus on sustainably improving the company’s profitability and growth.Reducing Complexity: Breaking with the PastMøller Nielsen had joined LEGO in January 2004 as Logistics Strategy Director, tasked withdeveloping a strategic turnaround plan for the global distribution process. Initially he wasgiven a full year ‘away from the frontline’ to develop a plan, but this relative period ofpeace was disturbed after four months, when LEGO made him also responsible for all logisticsheadcount in Europe and Asia. Managing the seasonality of LEGO products would be hiskey challenge. Demand roughly doubled between September and November and so hehad to manage almost twice the number of blue-collar workers for a short period of time. Hismain job would be to find a way to get the right product to the right place, in time —something LEGO had been struggling with for a while. As Padda put it: `Too much time wasspent finding out where a product was at any given time.’Defining Cost Drivers and Establishing a Cost BaselineOne of Møller Nielsen’s first tasks was to establish a solid logistics cost baseline. It tookalmost four months to do so and to define key cost drivers and cost ownership. TotalLego Case Study MKTG 210 20214yearly costs were estimated at DICK 650 million, 25 or more than 10% of sales. Transportationcosts were more than half of total costs.Understanding the Real Customer RequirementsAnother challenge was to convince the people in sales that any cost-cutting changes in thelogistics process would not automatically lead to customer dissatisfaction or loss of business.Møller Nielsen knew that he had to establish a direct communication link with LEGO’s keycustomer base, to understand their real — not perceived — requirements. He had aquestionnaire sent to the top 20 companies, representing 70% of LEGO’s total business,followed by interviews and personal visits. Møller Nielsen learned one very important thing:Most customers did not require daily or next-day deliveries. This was contrary to what hehad been told by some of his colleagues. Arguments in favour of immediate delivery wereused to justify higher inventory levels and having DCs close to the customer. The direct customerfeedback would give Møller Nielsen more credibility in designing the ideal process.Defining Key Objectives and Targets and Developing a High-Level StrategyOne of the key corporate drivers — to build a sustainable profitable platform — was tomake the company more asset light. This was to be achieved through outsourcing andsimplified processes. In 2004 LEGO had given its management team a target to cut costsby 20% by the end of 2008. To meet this objective and achieve the cost savings target,Møller Nielsen proposed consolidating all logistics and distribution operations to a singlecentral DC, managed by a third party. This proposal was accepted by the managementteam at the end of 2004. For economic reasons, this central DC needed to be close” toLEGO’S main production facilities and largest single markets (Germany and the UK).Selecting New Partners: Global TenderingIn early 2005 a global tendering process started with the company’s existing logisticsservice providers, as well as some new ones. In total, LEGO invited 22 companies to bidon part or all of its global logistics process. The goal was to reduce its 55+ transportationcompanies to a maximum of 7 global suppliers, bring all finished goods in Europe underone roof and to cut costs by DKK 130 million — including DKK 45 million on transportation.The central European DC (EDC) would have to have an initial total capacity of 51,000m2 —with an option to extend to 62,000m2 — and the provider would have to be able to managethe level of the workforce during peak and off seasons. A model created to calculate the ideallocation showed that Prague in the Czech Republic was the most central place. However,a distribution center on such a scale ‘had never been done before’ in an East Europeancountry. Møller Nielsen left the choice of final location open, enabling him to evaluatedifferent options, but he urged ‘preferred’ providers to base their quotation on theassumption that the EDC would be in the Czech Republic.DHL won the tender. The deciding factor was that DHL, through its global relationship with ProLogis— the world’s largest developer of distribution facilities – was the only company that could quicklyconstruct a facility of the required size close to Prague. DHL-Exel in the Czech Republic, responsiblefor this EDC, had yearly revenues in 2005 of approximately €30 million (DKK 200 million). The LEGOcontract would almost double its annual revenues, so this was ‘a big fish’ for the company. Building acentral DC of this size in the Czech Republic would break new ground, not only for DHL but also forLEGO. The new DHL building in Jirny was intended to be a multi-client operation, with extra officespace for DHL’s Czech operations.Lego Case Study MKTG 210 20215The contract with DHL was signed for five and a half years and was communicatedto all LEGO employees worldwide and to third parties on August 30, 2005. Thecontractual cost savings were considerable. Reducing the number of transportationcompanies to seven would result in DKK 40 million savings per year and theconsolidation of 10 operations into one another DKK 75 million.Other Changes Impacting DistributionAlso on August 30, 2005, LEGO announced that it would outsource production from itsfactory in Switzerland to a contract manufacturer (CM). The same CM would also take overthe management and control of LEGO’s packing facility in Kladno, in the Czech Republic,which would further be expanded to meet roughly half of the total demand. The Swissplant mainly produced LEGO’s Duplo products and employed 239 people. Production wouldbe transferred to the CM’s facility in Hungary during 2006. Other changes were also happeningfast on different fronts in an attempt to reduce complexity: The number of different colourswas cut by half and SKUs were reduced to 6,500. Of course, the challenge was to reap the fullbenefit of these changes through excellent execution.Building the infrastructurePlanning, Construction and IT ChangesMøller Nielsen and his team had developed a very detailed project plan, but this was tossed outof the window as soon as the team began facing the real day-to-day issues. The construction ofthe building in Jirny started at the end of 2005, new transport suppliers were introduced, andsystem changes and transfer to a new SAP Enterprise Resource Planning platform (software)were in progress, enabling future electronic linkages to DHL’s warehouse system.Implementation was planned in a phased approach (refer to Exhibit 3). During 2006,before the start of the peak season, responsibility for the two DCs in France would betransferred to DHL in Jirny. This represented around half of the European sales volume. Goodsand responsibilities from the central warehouse in Germany, the two logistics operationsmanaged by the plants in Denmark and Switzerland, and the two Danish assembly lineswould transfer the same year as well. During 2007, the remaining two DCs in Billund(Denmark) and Hohenwestedt (Germany) would follow, and the assortment pack facility inBillund, would be phased out completely.Organization ChangesBeyond the standard storage and pick services, DHL also managed the LEGO assortmentpacks, assembled customer value packs and prepared customized deliveries, describedin the ‘customer brief’. Having these services under one roof was unique for most large DCs,and to allow it to focus properly on each service, DHL split its organization into three parts:(1) standard orders; (2) value-add services; and (3) customized orders. Not all specificcustomer requirements were known during 2004 and 2005 and thus could not bespelled out in the requirements document. It was, however, mutually agreed betweenthe LEGO Group and DHL that DHL would have to be flexible in adapting to customers’requirements as soon as they became known.Møller Nielsen created a new ‘customer logistics’ team. It was his organization’s direct linkwith the customers and responsible for reducing the complexity of customized orders,while also focusing on improving customer delivery satisfaction.The First Warning Signs: Cost Drivers or Cost Behaviours?To simplify the process of accurately allocating the total logistics costs to profit centers,LEGO used ‘costs per order’ as the main cost driver for logistics. During the tenderingprocess, providers had been asked to quote their prices at the order level, making it easierLego Case Study MKTG 210 20216for LEGO to reallocate their total costs. What DHL did not know at that time was that LEGOwas undergoing major changes in its customer ordering process. Large retailers, which hadinitially placed small daily orders, were requested to place larger orders, at least twomonths in advance. Most retailers were surprisingly cooperative and in favour of thischange; they were used to long lead times from other toy manufacturers, as most toyproducts arrived by sea from Asia. They preferred to wait for two months, knowing thatthe LEGO products would at least be delivered within the requested delivery date.Changes in the cost drivers also changed the behavior of some of the sales offices. Withlogistics costs allocated at order level, some of them saw this as a reason to shift their focusfrom smaller to larger retailers. Obviously, as DHL had calculated all costs at the order level,it would lose out when the number of orders started to drop significantly.2006 ImplementationA Steep Learning CurveDuring the first transitions before the summer, there were more than the usual start-upissues. The Czech DHL team had never managed an operation of this size before. For starters,there were not enough trained people: ‘We even had to teach them how to drive a forklift…’DHL’s main IT system turned into a bottleneck. It was not designed to handle so many differentcustomer delivery ‘rules’ and also could not cope with the volume of transactions providedby LEGO. The system ground to a halt more than once, and additional people had to be hiredto produce and manually print the different customer labels and shipping instructions.Also, it took longer than expected to find a big enough skilled temporary workforce foronly four or five months. Most of them had to be recruited from Ukraine, but not manyspoke English, so they had to be taught how to read the information on the scanners andsystems.LEGO sales teams, anticipating delays and shortages during the transition, had pushed theircustomers for advance orders. As a result, demand started increasing as early as August,catching everyone ‘off-guard’, including Møller Nielsen and his team. The first crisesstarted to occur and from then on the teams were in constant firefighting mode.Soon after it became apparent that DHL did not have the capability to control the flow andcommunication with the carriers — ‘They were not aware that there was a truck-load waitingfor 24 hours inside the warehouse’ — LEGO decided to take back the management andcontrol of the carriers. To improve this process, it designed and implemented a new webbased tool in less than three weeks.33Misunderstandings and Cultural IssuesCultural clashes played an important role, creating an atmosphere of mistrust betweenboth parties. LEGO people blamed the ‘Czechs’ (i.e. DHL) for not taking enoughresponsibility, and the Czechs had problems with the Danes’ direct approach and theirconstantly changing requirements. LEGO then started bringing more of its own people intoJirny, something that DHL at first perceived as ‘an intrusion on its own territory’. Blamegames would start whenever there were issues with deliveries, which were largelycaused by the carriers. This situation further escalated when Møller Nielsen was brieflyintroduced to Leigh Pomlett, the new regional head of DHL-Excel, in August 2006. Pomletthad just come out of a meeting with his Czech team, believing that everything was goingsmoothly and was in good spirits. This changed abruptly when Møller Nielsen told himprovocatively, ‘Your people have no clue how to run this warehouse.’ Perhaps it was blunt,but Pomlett took the criticism seriously; from then on key issues were addressed and resolvedin a more constructive way and a new head of operations, from Pomlett’s old team in the UK,Lego Case Study MKTG 210 20217was transferred to Jirny two months later.Misunderstandings and disagreements on the commercial contract agreement became themain obstacle to establishing a sustainable partnership. LEGO’s perspective was that thecontract had been signed and it was up to DHL to deliver as promised. In fact, frequentlychallenged by LEGO on the validity of its quotation, DHL European managementconfirmed in writing in 2005 in that they were comfortable with their calculations and woulddeliver as promised. In DHL’s view, the contract was very complex and not easy tounderstand. Long hours were spent arguing over the agreement, as it started to becomeclear that DHL had underestimated the requirements — especially with regard to the highfluctuations between low and peak periods. For example, in its quotation, DHL estimated ayearly average of 180 full-time equivalent (FTE) employees for 2006, not really believing theprojected volume provided by LEGO. The actual average number needed was closer to 500FTE. DHL was going to pay a high price for the extra costs, which Møller Nielsen was not yetprepared to share, given the initial cost pressure within LEGO.Capacity ConstraintsIn addition, the warehouse was getting full. It was supposed to be large enough to managethe total European capacity for the next five years, so what had happened?In June 2006 LEGO announced to employees that most of its production would beoutsourced to the Contract Manufacturer that had already taken over theproduction from Switzerland and was also responsible for the packing facility in Kladno.Production at the US-based plant would be phased out completely and relocated to Mexico,affecting about 300 people. Production of the more technically demanding products, such asLEGO Bionicle and LEGO Technic, would stay in Billund, whereas production of the morestandard and high volume products would move to Hungary and the Czech Republic. Up to900 of the 1,200 jobs in Billund would be affected. The relocation would take place between2006 and 2010. Related to this outsourcing, key changes were made. To mitigate thetransition of production from Denmark to Hungary or the Czech Republic, production wasramped up temporarily. Furthermore, the packaging for finished LEGO sets was changed,which decreased the number of sets that could fit on a pallet by almost 20%.These changes — neither of which was communicated to logistics — created asignificantly higher inventory level in terms of pallet positions, not only impactingspace but also driving transport and storage costs higher. DHL quickly expanded to use themaximum of the available 62,000m2 space, but this was still not enough. With the help ofProLogis, more space would ultimately be found in nine additional smaller depots in andaround Jirny. The EDC had been built to store 76,000 pallets, but by November 155,000pallets were being stored in 10 different locations. Once inventory dropped to normallevels again, Møller Nielsen estimated that space for 120,000 pallets — or almost double thesize of the current EDC — would be needed.Assessing the Scale of the ProblemEven with frequent delivery issues and the tracking of goods seemingly out of control,delivery delays were kept to a minimum. On average, they were limited to less than two days,but only through constant firefighting and long working hours.By November 2006, it was clear that DHL, which expected to break even during the first year,would finish 2006 with a loss of approximately €3.5 million (DKK 25 million). Møller Nielsenknew that he could not let DHL pick up the whole tab and that he would ultimately haveto change the cost drivers in the contract. But how would he explain these increased coststo his management? Perhaps the changes in production and consequent increase inwarehouse space would create the opportunity he needed to break this deadlock situation.Lego Case Study MKTG 210 20218Future ChallengesThe sales organization in Germany was especially critical and vocal as their local DC inHohenwestedt, managed by the LEGO Group and serving their customers, was next in line tobe closed down. They played a large role in trying to convince Vig Knudstorp that this was abad idea. Vig Knudstorp in return leaned hard on Møller Nielsen and his team, who hadexpected more support from management back in Billund, but often felt let down by their‘unfair’ behavior. Yes, there were many issues related to this transition, but the expectednegative customer impact had been marginal.DHL was losing a lot of money. It was blaming LEGO for a large part and was seekingcompensation. DHL and LEGO, despite the fact that they both wanted to make this work,did not trust each other enough and were arguing constantly. The warehouse was full andthe situation of using nine additional depots was obviously not an efficient short-termsolution. Something had to be done quickly. But what? Build a new warehouse? Where?Of what size and what about the current lease contract?For the LEGO Group as a whole, sales were up again, and 2006 promised to be the mostprofitable year of the last decade, so the pressure for massive cost reductions wastemporarily off. It was now up to Møller Nielsen to make a decision. Either he should: (1)stick to the original concept – transfer the remaining two DCs (Billand, Denmark andHohenwestedt, Germany) as planned during 2007 and continue to work with DHL as itsmain partner, while seeking a larger warehouse. Or (2), stop further transitions and managethe distribution through three remaining centers operated by DHL and the LEGO Groupin Denmark (Scandinavia and Benelux), Germany (Central Europe) and the Czech Republic(rest of Europe and Asia). There were two other alternatives he could explore, like (3) takingover the management from DHL at Jirny or (4) cancelling the DHL contract and finding analternative partner, but would this really solve anything?For Møller Nielsen the answer was clear, but what would you do?Lego Case Study MKTG 210 20219Exhibit 1: Lego Financial Results 1998 – 2006Lego Case Study MKTG 210 202110Exhibit 2: Three Tier Distribution Centre Structure 2004-2005Lego Case Study MKTG 210 202111Exhibit 3: DC Structure Europe: 2006 Jirny Phase 1
