The real impact of high transportation costs

During the 1990s and the first part of the 21st century, the high availability and low cost of transportation services relative to the cost of holding inventory encouraged organizations to emphasize fast, frequent delivery to customers through such means as just-in-time delivery. But things have changed dramatically in the last decade, and companies increasingly are calling such long-standing strategies into question. The "game changers" are volatile, escalating oil prices and an imbalance of supply and demand for freight transport services. These realities have led to high transportation costs—high enough to cause companies to make transport-driven shifts in their supply chain strategies.

Three such shifts are having a notable impact today. The first is a shift from offshoring to nearshoring sourcing strategies in an effort to reduce the number of miles shipments travel. The second is a shift from designing products and packaging for marketability and more efficient production toward designs that also incorporate "shipability" considerations. These include: customizing packaging for individual products' sizes and dimensions for space efficiency and easy handling; providing protection of goods in transit; and facilitating multiple processes of offloading, repackaging, and reloading. The third is a shift from lean inventory strategies to hybrid lean inventory/transportation strategies.

Article Figures

[Figure 1] World crude oil priceEnlarge this image

[Figure 2] Growth rates in U.S. import value from top trading regionsEnlarge this image

[Figure 3] Strategic profit modelEnlarge this image

[Figure 4] Transport-driven shifts in strategies and their connections to the boardroomEnlarge this image

These transport-driven shifts in supply chain strategies are designed to ameliorate transportation challenges, and they achieve those objectives. But it is not widely recognized that their benefits go well beyond that. As we will explain, they also contribute to improvement in an organization's broader supply chain and financial performance.

Why are prices high?
A conjunction of factors and economic developments lies behind rising transportation costs. At the center of today's transport challenges are oil prices. Freight movement in most modes remains largely dependent on ever-more expensive and finite fossil fuels, primarily diesel fuel. According to the U.S. Energy Information Administration, the price of crude oil is the dominant factor influencing changes in diesel prices.¹ As depicted in Figure 1, crude prices have risen significantly since the mid-2000s, but not in a predictable pattern.

An equally influential factor in transportation costs, the demand-supply imbalance of freight transport services, is a repercussion of trade growth that has outpaced the availability of transport services to such an extent that it has led to serious issues of congestion and capacity constraint in the United States. The remarkable growth in U.S. international trade in the last 10 years has resulted in rapid growth of traffic volumes throughout the nation's transport system. This is likely to get worse in the coming decades. Despite a significant drop in total freight volume during the depths of the 2008-2010 recession, economic conditions are improving, and it is projected that freight volume will grow 68 percent by 2040, with particularly strong growth in international freight.²

International trade growth places pressure not just on U.S. gateway ports but also on inland transportation systems and service availability. Simply put, more goods entering through the ports means more domestic moves to deliver these goods to their destinations. Moreover, as ships increase in size, demand for inland transportation services also grows. This becomes clearly evident when one considers that the average size of container ships calling at U.S. ports has grown rapidly in the past few years. To put this trend in perspective, the average size of container ships in 1997 was 1,581 TEUs (20-foot equivalent units). By 2007, the average had grown to 2,417 TEUs, and in early 2012, it reached 3,074 TEUs. More telling, perhaps, is that by that point, containerships of more than 18,000 TEUs were already on order, and 22,000-TEU ships were being discussed.³ Thus, whereas in the past a single ship might have discharged 2,000 or so containers to be moved via truck and rail to inland destinations, today the number of inland moves generated by a single ship can be more than five times as large. It is no surprise, therefore, that capacity constraints are particularly severe at major truck and freight rail corridors linking major seaports to inland destinations.⁴

This supply constraint is compounded by the fact that resources for investment in transportation infrastructure are limited. The end-of-year balance of the Highway Trust Fund (HTF) is declining. The HTF is a U.S. federal government program that is funded by a variety of transportation-related taxes, such as those on fuel, tires, heavy vehicle use, truck and trailer sales, and so forth. The money is distributed among the U.S. states to help pay for highway construction and maintenance. It is estimated that the HTF will experience a deficit sometime in fiscal year 2015, and that it will suffer an estimated cumulative shortfall of about US $92 billion by 2023.⁵ The dominant mode of U.S. freight transportation—truck transportation—inevitably will be adversely affected by such shortfalls.

In essence, persistent oil price volatility and capacity constraints mean that high-priced transportation is here to stay. As a result, managing transportation costs is more important than ever for preserving margins and profitability as well as improving supply chain performance.

The effect on strategy
A business environment that is being strangled by volatile oil prices and high-cost transportation solutions has prompted organizations to rethink their supply chain strategies. Three transport-driven shifts in supply chain strategy in particular have emerged and are gaining ground:

1. A shift from offshoring to nearshoring
2. A shift from product design for marketability and production to design for "shipability"
3. A shift from lean inventory policies to hybrid lean transport/inventory policies

The results we have observed at several companies that have adopted these shifts in strategy indicate that their benefits go beyond ameliorating transportation challenges. These shifts also help to improve both supply chain and financial performance due to lower costs and more productive investments. The following is a brief description of each of these strategic shifts and its impact on supply chain and financial performance.

Shift 1: From offshoring to nearshoring sourcing strategies to reduce the number of miles traveled
Observation: This shift is driving a change in sourcing strategy. Instead of procuring supplies and outsourcing manufacturing wherever it is cheapest to do so, more companies are now concentrating on performing those activities as close to end markets as possible. The growing attraction of sources in the United States, for example, can be gauged from the recent changes in U.S. imports depicted in Figure 2. Year-to-year growth rates of imports from low-cost, long-distance sources in Asia dropped sharply around the time of the oil-price peak in 2008. This is in noticeable contrast to the sharp increase in imports from near-shore sources in North America, Latin America, and the Caribbean during the same time period.

Supply chain impact: With supply sources moving closer to end consumers, the international transportation component of a supply chain is shortened, and distance-driven costs are reduced. Moreover, sourcing from near-shore sources—in the case of the United States, from North America, Latin America, and the Caribbean—offers other advantages. For example, by bringing imports from Latin America and the Caribbean through entry points on the U.S. East Coast, shippers not only can avoid the congestion on the U.S. West Coast that periodically affects inbound cargo from Asia, but they also can bypass the more expensive cross-country movements from West Coast ports to population centers in the east. The shortened distance and reduced risk of port congestion and associated delays also mean that companies can more quickly adjust freight movements to changes in customer demand. Overall, then, this shift is both cost-advantageous and beneficial to customer responsiveness.

Financial impact: Sourcing strategies that focus on nearshoring in an attempt to reduce the length of the transportation pipeline are positively impacting freight costs, revenue, and current assets pertinent to inventory. Freight costs are reduced because nearshoring means fewer miles traveled, and thus lower distance-driven transportation costs and less fossil fuel burned. Revenue is improved because nearshoring means being closer and more responsive to the market, allowing businesses to make adjustments to order fulfillment with shorter lead times than if they were sourcing from Asia. Current assets are reduced because nearshoring shortens lead times and the uncertainty associated with the lengthy ocean line haul for Asia-sourced goods. As a result, less in-transit inventory and safety stocks are required to buffer against that uncertainty.

Shift 2. From product and package designs for marketability and production toward designs that also incorporate "shipability" considerations
Observations: Many companies are revising package and product designs to reduce weight and increase shipment density. For instance, some have reformulated such products as laundry detergent, dishwashing liquid, dairy powder, and fruit juice to make them concentrated and physically more compact. Some manufacturers have redesigned rolled consumer products like aluminum foil and toilet paper so that the cardboard tube in the center is smaller, or they have even eliminated the tube altogether.

Like the products themselves, packaging is being redesigned to optimize package size and weight for the contents through package reconfiguration, the use of lighter-weight materials, and the elimination of unnecessary packaging layers, such as outer cartons and shrink-wrap film. More products in lighter, smaller package sizes are appearing in retail stores. There are many examples of this trend. The manufacturers of Windex and Method cleaning products, for instance, have introduced refills in flexible pouches, as opposed to the traditional hard-plastic bottles. Ragú and Bertolli now offer pasta sauces in flexible pouches as well as in the typical glass and plastic jars, and many manufacturers package soup in aseptic cartons in addition to metal cans. They are far from alone: According to a Grocery Manufacturers Association survey of its members, the number of packaging improvements implemented by companies in the consumer products industry has been increasing each year, resulting in more than 1.5 billion pounds of packaging avoided from 2005 to 2010.⁵

Supply chain impact: This "don't ship air, don't ship water" approach to package and product design helps to reduce shipping weight, size, and materials while maintaining the products' appeal and convenience for consumers. These changes translate into savings in freight costs, packaging costs, and space utilization.

Financial impact: Freight costs are reduced because the reduction in package size and weight, as well as the use of fewer packing materials, allow more goods to be shipped in one truck, container, or other conveyance. Moreover, a larger number of smaller-size containers, such as those described above, can fit within a manufacturer's allotted retail shelf space. Thus, revenue is enhanced through better utilization of valuable shelf space.

Shift 3: From lean inventory strategies to lean inventory-transport hybrid strategies
Observation: Lean theory and practice, which seek to reduce inventory costs, evolved back when oil, which accounts for 98 percent of energy consumption in transportation, was around US $25 per barrel. Common transportation strategies of companies that implement lean principles include just-in-time delivery; small, fast, and frequent shipments; and using a dedicated fleet—all of which depend on cheap transportation. However, as oil prices escalate, the importance of transportation economies of scale (achieved by making larger and less-frequent shipments) increases, and trade-offs between inventory and transportation costs become more important.⁶ As a result, companies have shifted to inventory/transport hybrid strategies that not only focus on safety-stock and cycle-stock policies but also consider the benefits of lower transportation costs.

A number of popular techniques corresponding to this shift have emerged. First, shippers are paying closer attention than ever to shipment consolidation. They are examining their own shipping patterns to find opportunities to consolidate their shipments, and are considering potential leverage to be gained from using a third-party logistics provider (3PL) as a matchmaker for shipments along shared routes. Second, they also are focusing on building consolidated, multiproduct containers, pallets, or cartons to optimize capacity utilization. And finally, shippers are becoming more astute in evaluating alternative modes of transportation to cope with high transportation costs. This means looking increasingly to intermodal rail services, instead of trucking services, for long-haul freight.⁷

Supply chain impact: These shifts toward shipment consolidation reflect lean inventory/transportation hybrid strategies in which lower transportation costs offset increased inventory carrying costs. Shipping larger loads translates into higher levels of inventory on hand, and the longer transit times associated with intermodal rail versus truck mean higher costs for in-transit inventory and safety stock. But these inventory-cost increases are offset by freight-cost reductions achieved through improved shipment economies, fewer empty runs, and better vehicle utilization.

Financial impact: Freight-cost reduction is made possible by trading off marginal transportation costs for inventory holding costs. At the same time, revenue is enhanced because more inventory is readily available to fill orders with shorter lead times. The substitution of inventory for transportation costs by no means suggests that inventory will become a less significant factor influencing total logistics costs. On the contrary, these hybrid strategies emphasize balancing the cost of transportation and the cost of carrying inventory, which includes interest, taxes, obsolescence, depreciation, and insurance. The fact that interest rates have followed a downward trend since the middle of 2000 and have remained essentially unchanged since 2008 contributes favorably to this shift in supply chain strategies.⁸

Key takeaways
In this article, we observe and highlight three shifts in supply chain strategy in response to higher costs of transportation. Based on this exercise, we underscore that those strategic shifts represent the manifestation of a renewed focus on the long-established principles of transportation management that distance, density, and shipment size are key drivers of transportation costs.

In considering distance, logistics and supply chain managers are exhibiting renewed interest in the extent to which components and finished goods travel along the supply chain. Sourcing strategies that focus on pursuing low costs for labor and raw materials from overseas sources have given way to strategies that consider sources in closer geographic proximity in order to reduce distance-driven transportation costs.

In terms of shipment density, previously overlooked density-dampening factors, such as unfilled space within packages (air) and volume-adding ingredients (water), have lately drawn shippers' attention relative to the impact they have on transportation costs. Managers now strive to avoid paying to ship air and water by focusing more on the designs of products and packaging for shipability, as opposed to designs for marketability and production alone.

Shippers are also controlling shipment size to reduce per-unit transportation costs. The widely practiced lean inventory approach favors minimizing inventory costs at the expense of transportation costs, due to the requirement for small and frequent shipments. In an environment where transportation costs are high, however, managers have become more astute in regard to shipment size, migrating from lean inventory to a hybrid transport/inventory strategy. They engage in freight consolidation (either among their own business units or by leveraging third parties), and select transportation modes that facilitate less-frequent, larger shipments of freight when it is appropriate.

While the direct benefits of the strategic shifts outlined in this article target reduced transportation costs, we articulate through the lenses of the Strategic Profit Model⁹ in Figure 3 that they also favorably contribute to other factors impacting supply chain and corporate financial performance (see Figure 4). Considering the long-established principles in transportation management through this new light, we recommend three simple rules for managers who are navigating the continuing challenges of high oil prices and transport service constraints: count the miles; don't ship air and water; and consolidate, consolidate, consolidate.

Notes:
1. U.S. Energy Information Administration, "Diesel Fuel Explained: Factors Affecting Diesel Prices,".
2. U.S. Federal Highway Administration, Freight Facts and Figures 2009 (issued 2010); Freight Facts and Figures 2010 (issued 2011).
3. United Nations Conference on Trade and Development (UNCTAD), Review of Maritime Transport 2012.
4. U.S. Federal Highway Administration (2011).
5. Sarah Puro, "Statement for the Record: Status of the Highway Trust Fund," prepared for the Committee on the Budget, U.S. House of Representatives, April 24, 2013.
5. GMA–Grocery Manufacturers Association, Reducing Our Footprint: The Food, Beverage and Consumer Products Industry's Progress in Sustainable Packaging, March 2011, p. 2.
6. David Simchi-Levi, "How Volatile Oil Prices Will Rock the Supply Chain," CSCMP's Supply Chain Quarterly, Quarter 4/2011, pp. 52-56.
7. Dan Gilmore, "Supply Chain News: Ideas for Reducing Transport Costs Given Rising Fuel Prices," Supply Chain Digest, May 12, 2011; Jane Gray, "A Transport of Delight: Reducing Costs in the Manufacturing Supply Chain," The Manufacturer, March 16, 2012.
8. FedPrimeRate.com, "Wall Street Journal Prime Interest Rate History," 2014.
9. J.J. Coyle, C.J. Langley Jr., B.J. Gibson, R.A. Novack, and E.J. Bardi, Supply Chain Management: A Logistics Perspective, 9th ed. (Mason, Ohio: South-Western Cengage Learning, 2013).