Deflation strikes logistics
The annual State of Logistics Report shows that deflation is putting pressure on distribution managers to find bold new approaches to curtailing supply chain costs.
By James A. Cooke Executive Editor -- Logistics Management, 7/1/2003
Deflation has taken the wind out of the sails for logistics. Total U.S. logistics costs fell last year to $910 billion as declining interest rates drove down the cost of managing the nation's devalued inventory. Indeed, logistics costs represented the lowest percentage of the gross domestic product (GDP) in the 14-year history of the State of Logistics Report, a major study that quantifies the value of logistics to the national economy. The report is authored by Robert V. Delaney, a vice president of Cass Information Systems, and Rosalyn A. Wilson, a consultant with more than two decades of transportation experience. It is currently sponsored by Cass, which has businesses in freight bill auditing and payment and commercial banking, and ProLogis, the nation's largest provider of distribution facilities and services.
This year's State of Logistics Report underscored the Federal Reserve Board's growing concerns about the impact of declining monetary values on the U.S economy. Delaney and Wilson pegged last year's total logistics cost at $910 billion, down from $957 billion in 2001 and $1.003 trillion in 2000—the record high in the report's history. Last year's total, moreover, accounted for only 8.7 percent of the $10.47 trillion GDP. The previous year, logistics accounted for 9.5 percent of GDP; in 2000, it was 10.2 percent. (See Figure 1.) In 1981, when the study began, logistics amounted to some 16.2 percent of GDP.
As Delaney and Wilson note, that decline in logistics costs did not result from distribution efficiencies, but rather from an attenuating economy. For logistics managers, the study's results signal that next year could pose an even greater challenge than they've faced in the past as companies look to cut back on supply chain expenses in a deflationary environment.
A Metric for Efficiency
Delaney initiated the State of Logistics Report more than a decade ago to measure logistics efficiency following transportation deregulation. Over the years, the report has taken on near-oracular status, and its statistics often make their way into government reports that define national transportation policy. This year's update, like its predecessors, should provide plenty of data for policymakers to ponder.
Delaney and Wilson's report breaks down logistics expenditures into three key categories: inventory-carrying costs, transportation, and administration. (See Figure 2.) The drop relative to GDP, the authors say, can be attributed in large part to a deflation-induced reduction in carrying costs—the expenses associated with holding goods in storage. The $298 billion figure for carrying costs represents the sum of three components: $23 billion for interest; $197 billion for taxes, obsolescence, depreciation, and insurance; and $78 billion for warehousing.
To calculate interest expense, Delaney and Wilson multiplied the value of the nation's inventory—$1.44 trillion—by the commercial paper rate that banks charge businesses for loans. Two factors influenced last year's precipitous decline in interest expenses from $57 billion to $23 billion. First, inventory investment itself fell last year by $42 billion, reflecting falling goods prices. But the more significant factor was the plummeting commercial paper rate. Throughout the 1990s, that rate hovered around 5.3 percent. It fell to 3.8 percent in 2001, and last year hit 1.6 percent.
In addition, the cost of warehousing has remained flat over the past three years. Total warehousing expense has been estimated at $78 billion each year since 2000. That number reflects both the private and public segments of that industry, estimated at $64 billion and $14 billion, respectively.
Transportation Limps Along
Freight transportation constituted the second major component of overall logistics costs. For this part of the report, the authors relied on preliminary estimates that are to be published later this year by the Eno Transportation Foundation.
This year's estimated transportation expenses—$571 billion—also declined in relation to GDP. During the 1990s, transportation costs stood at around 6 percent of GDP. In 2001, those costs fell to 5.8 percent. Last year, they slipped even further, accounting for 5.5 percent of the gross domestic product.
That decline hinged on the performance of the trucking industry—at $462 billion, the largest portion of transportation costs. In 2000, spending on motor carrier services reflected 5 percent of GDP. In 2001, that number fell to 4.6 percent, then slipped to 4.4 percent in 2002.
The drop in trucking expenses reflects several problems afflicting that industry. Although truckload carriers saw their income rise in 2002, revenue for less-than-truckload (LTL) carriers fell. Local trucking, dry van service, and refrigerated carriage all reported either flat or declining revenues.
A more telling sign of the industry's woes is the continued spate of motor carrier bankruptcies. In their report, the authors cited the work of analyst Donald A. Broughton of A.G. Edwards & Sons, who has reported that the trucking industry witnessed 2,345 business failures in 2002. Such notable carriers as Consolidated Freightways, A-P-A Transport, and Dick Simon Trucking closed their doors last year.
Higher insurance costs, along with volatile diesel fuel prices, contributed to the demise of many motor carriers. Since last fall, moreover, carriers must buy trucks with cleaner-burning engines, even though those engines are 5 to 9 percent less fuel efficient than current models. Delaney and Wilson also said that the government's new hours-of-service rules, which determine how long a driver can stay behind the wheel, could add $611 million in increased operating costs and force motor carriers to hire 84,300 more drivers. "When it comes to the trucking industry, the hits just keep on coming," they wrote.
Other modes of transportation continued to limp along, accounting for $109 billion of the nation's freight bill. The report noted that railroad revenues—some $37 billion—were flat in 2002. Airfreight revenues, on the other hand, rose from $26 billion in 2001 to $27 billion last year. Likewise, freight forwarders witnessed an increase, from $8 billion in 2001 to $9 billion in 2002. Water carriers' revenues, however, fell $1 billion to $27 billion between 2001 and 2002.
Delaney and Wilson calculated the third component of logistics costs, for logistics administration and other related expenses, at $41 billion. In keeping with the Alford-Bangs Production Formula that has provided the methodology for computing costs since the report began, the authors used a constant of .04 in calculating administrative costs. Specifically, they multiplied the sum of inventory carrying costs ($298 billion) and transportation costs ($571 billion) by 4 percent to reach $35 billion.
Although third-party logistics (3PL) costs are included in the $910 billion total, Delaney and Wilson for the past decade have also provided separate estimates for the contract distribution industry. For that data, they relied on research by Richard Armstrong, the author of Who's Who in Logistics? Armstrong's Guide to Global Supply Chain Management. For 2002, Armstrong pegged the contract logistics market at $65 billion, a significant increase from the previous year's $60.8 billion estimate.
Delaney believes that growth in spending on third-party logistics resulted from shippers hiring non-asset based logistics services. He cautioned, however, that some of that spending on 3PL services went to transportation providers with long histories in traditional businesses that have merely recast themselves as third-party logistics companies to ingratiate themselves with Wall Street. Observed Delaney and Wilson: "Foreign freight forwarders, customhouse brokers, and transportation brokers with 100 years of experience are now described as non-asset based 3PLs in order to support extraordinary price-earnings ratios."
Price Deflation Hits Home
The report also looked at inventory efficiency in the economy. In this regard, the authors took note of recent research by the Ohio State University Supply Chain Management Research Group. In 9 of 14 industries studied, the ratio of finished goods inventory to the cost of goods sold either increased or did not change over two decades. Indeed, the report noted that there has been "no significant improvement" in inventory levels for those industries. In Delaney's view, the problem stems from product proliferation, which has encouraged companies to accumulate stock and tie up working capital. "We have brand proliferation. And too much attention is paid to software and collaboration and not enough paid to value analysis and working capital implications of excessive inventory. It's costing money," he said in an interview.
Although product proliferation may be causing inventory pileups, price deflation could provide a more powerful drag on the U.S. economy and on logistics operations. The authors noted that the U.S. price index for durable goods has returned to 1993 levels. Since prices peaked in 1996, moreover, durable goods prices deflated by 0.75 percent annually between 1997 and 2000. During the past three years, the deflation rate picked up, with durable goods declining 0.2 percent annually. "The trend suggests that these prices may fall even further," they wrote.
In looking for the reasons behind that deflation, Delaney and Wilson cited research by Roger Urban of Urban Wallace Associates, a business strategy and marketing firm. Urban attributes the deflation in durable-goods prices between 1997 to 2000 to imports from Mexican maquiladoras. Since 2001, Urban has said, the culprit has been Chinese imports. China's share of the U.S. import market has increased from 2 percent in 1988 to 12.3 percent in 2002, according to Urban.
Pressure on Logistics
The study's results are especially meaningful for logistics and supply chain managers. Price deflation pushes manufacturers and retailers to reduce inventory and lower their operating costs. When prices fall, therefore, earnings improvements must come from supply chain operating efficiencies. "Thus the pressure to reduce inventory, particularly finished-goods inventory, is especially high," Delaney and Wilson concluded. "This supports the case for reconfiguration of product lines, production and distribution networks, and operating systems."
What will be the near-term impact of today's deflationary environment? Delaney and Wilson forecast that logistics managers will soon find themselves on the frontlines of corporate initiatives to restructure operations to slash costs. "We think that today's successful logistics manager must reconfigure excess capacity and drive it out of the production and distribution system," they wrote. "The successful logistics manager must reconfigure brands and slash finished-goods inventory … we are in a brand new ballgame. You've got too much inventory and the value is going down before your eyes."
LTL
Life after CF
Both nature and LTL carriers abhor a vacuum, so when Consolidated Freightways went out of business, carriers acted quickly to fill the huge hole that was left in the trucking marketplace.
After the venerable motor carrier's September 2002 demise left some shippers temporarily stranded, competitors scrambled to grab a share of several billion dollars' worth of business—business they'd been denied thanks to CF's notoriously discounted pricing.
When the dust settled, there were stronger profits for the survivors. "The first quarter of 2003 showed very good earnings compared to last year," says transportation consultant Ray Bohman. "Much of that is attributable to companies picking up CF's business." Bohman notes that revenues for publicly traded LTL carriers on average rose about $34 million to $252 million in the first quarter of this year, up from $218 million during that same period in 2002. Naturally, the bigger companies had the strongest numbers, with the top five—Roadway, Yellow, Con-Way, FedEx Freight, and ABF Freight System—posting average revenues of $550 million in the first quarter of 2003, compared to $469 million for the same period a year earlier.
CF's bankruptcy and the resulting feeding frenzy did more than redistribute capacity and pump up carriers' bottom lines, however. For many, the LTL giant's demise was a wake-up call. "Seeing a company of that size go out of business really stressed the overall vulnerability of the industry," says Bill Rennicke, managing director with Mercer Management Consulting in Lexington, Mass. "Even though the business was picked up quickly, this was a signal to the shippers and the carriers themselves that the industry is still in a very precarious position."
Rennicke predicts that LTL carriers will have to contend with rising costs for a while. Fuel prices are coming down, but there was a high spike this year, he points out. The cost of insurance, moreover, is up—and it's likely to stay up.
"In the long run, companies with operating ratios above 95 can't be expected to provide a continuing and sustainable part of the transportation capacity," he says. (The operating ratio or O/R, a general indicator of a carrier's financial health, measures the ratio of revenues to expenditures.)
Changing Expectations
CF may have been the largest company to go under in 2002, but it certainly wasn't the only one. Donald A. Broughton, a financial analyst at A.G. Edwards & Sons in St. Louis, has identified 2,345 trucking companies that failed in 2002, most with revenues between $5 million and $20 million. Other large carriers that filed for bankruptcy in the past year included Rocor International, Dick Simon Trucking, and A-P-A Transport.
Rennicke believes that LTL carriers will encounter further difficulties if shippers don't change the way they view that market. "They're going to come to a point where, as much as they want to keep their costs low, they have to look at the overall health of the industry," he says. "Shippers can't expect that the big companies that are the core providers of service today can continually operate in these kinds of O/R ranges and cash-flow ranges and still be vigorous, vibrant companies that can provide the kind of services shippers need."
Still, it's in the nature of the beast to look for ways to cut costs, and pricing is a matter of what the market will bear. "With the heavy discounter gone, some carriers are a little more responsible in their pricing, since they don't have to meet that low-price competition," says Bohman. "But there will always be some out there who'll be pushing to get the lowest price."
TRUCKLOAD
In the driver's seat
The bad news for truckload carriers in 2002 was that costs were up. Insurance premiums continued their skyward climb and fuel prices reached record levels. The good news was that despite those problems, many truckload carriers made the past year work for them and posted increased revenues.
Unfortunately, in order for some to succeed, others had to fail. "One of the things we've seen over the past two years is 10 percent of capacity exiting the business each year," observes Michael LaTronica, managing director for investment bankers Morgan Joseph & Co. in New York City.
Typically, it's the smaller truckload operators that have been forced out by rising costs, he says. "The smaller operations that were running right on the financial edge as fuel and insurance costs went up weren't able to make their truck payments, they were running for payroll, and they were willing to take loads at any cost just to try to meet those [obligations]. And it didn't work out for many of them," he explains.
As the smaller truckload operators have pulled out, larger companies have moved in and absorbed their business. "Large, well-capitalized, premium companies that offer shippers guaranteed capacity and service are positioned to benefit from this [shakeout]," says Daniel C. Moore, senior transportation analyst and vice president with Stephens Inc., an investment bank in Little Rock, Ark. "They've been picking up market share although volumes have remained relatively lackluster," he adds.
With the economy still on the mushy side, though, motor carriers aren't hurrying to add more capital equipment and capacity. "The bigger carriers have been reluctant to add to their capacity because they want strong confirmation that they can earn a reasonable return on investment," says LaTronica. Moore agrees, noting that the major truckload carriers aren't as focused on top-line growth as they were in the 1990s. "If you can't earn your cost of capital, why would you add more to your fleet?" he asks.
Sitting Pretty
When the economy revives, though, the remaining truckload carriers may find themselves sitting in the driver's seat. Inventories will start to build, and motor carriers that can guarantee capacity for their customers will be holding all the cards.
"As contracts renew, shippers will be looking into this capacity abyss and thinking, 'I need to lock up the ability to move freight'," says LaTronica. When that happens, he predicts, truckload carriers will be able to negotiate higher rates.
Indeed, truckload rates already are on the rise. "We've seen steady improvement in rates out of the truckload group since the second half of last year," Moore notes. "I expect that trend to continue. [Shippers] want guaranteed capacity and service because their supply chain is the most critical component of their business," he observes. "And because the large carriers haven't added any significant capacity, they've been winning the war [on pricing]."
Still, analysts predict the truckload market will continue to shrink. "In a supply-and-demand situation, you'd expect that as freight started to pick up and rates began to firm, you'd see competition come back," LaTronica says. "But you're not seeing it now because the [costs of doing business] are so high. The freight is migrating toward the large core carriers."
RAILROADS
Staying on track
Former Surface Transportation Board (STB) head Linda Morgan believes that the railroad industry should keep three words in mind: growth, cost, and—perhaps most importantly—service. Those words, she says, are the keys to success for an industry that's just starting to think about how to improve what it does.
To be successful, she believes, the railroad industry must continually focus on improving service and maintaining better relations with customers. "It's got to look for different and creative ways of providing service," she suggests. "To compete with trucks, service has got to be reliable and consistent."
That's true now more than ever, says Thomas White, director of editorial services for the Association of American Railroads (AAR). Railroads have indeed become more aware of the importance of service, to the point that some carriers are offering money-back guarantees if they fail to meet specific targets. Still, White says, the industry as a whole has a ways to go before service equates to profits. "We have to be able to provide consistent service in a way that allows us to see adequate earnings," he says. "Our earnings have been below the cost of capital. And if you're not earning that, it's difficult to raise the funds you need to make improvements to the system."
Improved intermodal service may be the railroads' best hope for growth. The potential is definitely there: White notes that intermodal transportation set a record last year with nearly 9.4 million originating trailer and container units, up from 8.9 million in 2001. That's a 4.6-percent increase, and first-quarter numbers suggest that volumes will rise again this year.
Divisive Issue
Although that upswing in intermodal shipments is welcome news, the rail industry has its share of controversies, too. First and foremost is the dwindling number of major railroads, which has raised questions about whether the federal government needs to foster more competition. Another is the issue of open access, which allows customers moving freight along one rail line to choose an alternate provider or route. That's a controversial solution that's driving a wedge between shippers and rail carriers, Morgan says. "The problem is that if you introduce competition throughout the network, rates would come down, which will create a long-term reduction of revenues."
That presents a Hobson's choice: The railroad network can't sustain itself if rates are too low, but if rates get too high business will shift to trucks, leaving rail with only captive traffic in bulk commodities such as coal and chemicals. "The railroads have to combine the rate structure of their captive traffic with competitive traffic to come up with a revenue flow that covers all their costs," says Morgan. "And that includes infrastructure costs, which are significant."
In the meantime, open access has become a hot-button issue that will likely get hotter over the coming year. Morgan wants the industry to take its time to come to a logical decision. "I don't know what the answer is, but I do believe that we need to discuss it with our eyes open," she says. "If you're concerned about the rail network long-term, you have to be concerned about a plan that could reduce revenues to an unnaturally low level. Everybody needs to understand that it sounds good in the short term, but in the long term we may be burying ourselves."
OCEAN SHIPPING
Smooth-and secure-sailing
The past year for ocean carriers can be summed up in one word: security. With the implementation of the Bureau of Customs and Border Protection's 24-hour advance notice rule, all hands were on deck to ensure that freight continued to flow smoothly through America's ports.
"Security was Number One, Number Two, and Number Three this year," says Christopher Koch, president and CEO of the World Shipping Council, a carrier industry group.
When customs authorities announced that they would require ocean carriers to submit detailed cargo manifests 24 hours prior to sailing, the industry initially was in a panic, with many fearing widespread service disruptions. Carriers wondered how much time it would take to replace general classifications like "freight all kinds" with detailed cargo descriptions. They were concerned, moreover, that the newly created Department of Homeland Security would clamp down on security at the expense of trade flows. But when it came down to crunch time, the new procedures slipped into the dock with nary a bump.
"It hasn't been easy, but it's been relatively smooth," Koch says. "Customs has been very sensitive to trying to implement the new program without adversely affecting trade, and overall I'd have to say it hasn't."
In fact, Customs reported in April that out of about 2 million bills of lading examined since February, it had only issued about 260 no-load directives for failure to adequately describe cargo. And although a tightening of the rules that began last month may result in a greater number of "no loads," it's still not likely to put a chokehold on operations.
So far, compliance with new security rules hasn't deeply affected carriers' balance sheets. Although they have had to make investments to bring their procedures up to snuff, that outlay has been fairly minor—which isn't to say that compliance costs won't trickle down to customers. "Carriers have incurred costs, from computer programs to operational changes to hiring new people," Koch says, "and they'll certainly look for cost recovery to the extent that they can get it."
Showdown in the West
After security, the biggest impact on ocean shipping in the past year came as a result of the shutdown of West Coast ports. For 10 days in September, an estimated 300,000 containers were held up as the International Longshore and Warehousing Union (ILWU) and the Pacific Maritime Association locked horns over an unfair labor-practice complaint. The shutdown caused headaches for everyone involved, but shippers had enough time to make contingency plans.
"A lot of people saw it coming," says Bruce McMillan, director of intermodal for CSAV, an ocean carrier in Iselin, N.J. "The astute importers made diversionary plans. When they saw it, and even after it had started, companies began diverting cargo to the East Coast.
The shutdown was a logistical horror show for shippers and carriers alike. It had an impact in financial terms, too, for both parties. Some carriers declared force majeure, an insurance term absolving ocean carriers from liability if they are unable to perform due to circumstances beyond their control. Some were able to partly recoup extra costs by assessing diversion fees. But the shipping lines' total bill for those 10 non-productive days has yet to be tallied, McMillan cautions. There are still unresolved claims, and some carriers are still trying to collect fees from importers, he says.
AIR FREIGHT
Going to ground?
Like a thick fog hanging low over an airport, the economic pall over the airline industry just won't lift. The anemic economy—compounded by the American public's reluctance to fly after Sept. 11—has caused passenger airlines to scale back their scheduled flights and substitute narrow-bodied aircraft for cargo-friendly wide bodies.
That's reduced capacity and caused many shippers to switch from airfreight to trucks. In many cases, industry observers say, shippers that have made that change are choosing to stay on the ground.
Dave Wirsing, executive director of the Washington, D.C.-based Airforwarders Association, points toward Sept. 11 and the subsequent 72-hour embargo on loading cargo onto passenger planes as the turning point in the shift toward ground transport. "Product couldn't just stop moving, so people found other ways to move it," he notes. "A lot of that traffic hasn't returned to air, and that's driven in part by the reduction in capacity by the airlines."
Capacity Shortage
Wirsing hopes that an economic recovery will pop all of that business back into place—wide bodies included. "Once the economy starts turning, the airlines will grow their capacity consistent with more passenger travel," he predicts. "Hopefully, cargo shipping demand will mean an upscale of equipment. Instead of running small aircraft point-to-point, [airlines] may run bigger aircraft with more capacity."
Consultant Greg Hendricks, a partner at the UniSys R2A Transportation Management Group, isn't counting on that happening. "I suspect that when the economy situation gets back in order you'll see the capacity return, but I think a lot of the wide body capacity will be gone," he says. Instead, he expects, many of the wide-body aircraft that are becoming available may be picked up by integrators such as FedEx, United Parcel Service, and DHL, which operate both ground and air transportation.
Even if capacity does return, Greg Schultheis, vice president of airfreight, North America for DHL Danzas Air & Ocean, doubts that all of the business will come back. He points to a recent shipper survey conducted by investment bankers Morgan Stanley, in which more than half of the respondents who had converted from air express to surface transport or deferred air services said they would not switch back to air express even when the economy improves.
"In the domestic environment, it won't come back," Schultheis says. And it's not just Sept. 11 that's to blame. Wirsing points out that it's possible to move goods from the East Coast to the West Coast in three days with tandem driver teams. Expedited trucking services, moreover, are now priced competitively with air service.
An increase in the number of regional distribution centers also has encouraged shippers to turn from airfreight to trucks, Schultheis believes. Through the creation of regional networks, manufacturers can reach their customers with time-definite truck deliveries in just one or two days, he says.
"Most domestic air freight now goes within 600 miles. As a result of that, it's easier to truck it than to fly it. It's less expensive and the transit times are just as good," Schultheis observes. "And as long as the pricing is competitive, manufacturers will be looking to reduce their bottom line."
SOFTWARE
Waving the red flag
No one has yet invented a crystal ball, but software vendors believe that supply chain event- management software is the next best thing. That software automatically sends out alerts when a scheduled occurrence goes awry—a truck missing a delivery, a stock-out of a popular product in a warehouse, a ship sailing delayed due to weather. Those alerts are then tied into key business measures—inventory on hand, for example. Thus, the alerts notify logistics managers to take action before a crisis occurs.
No wonder, then, that in the past year, many software vendors have focused on incorporating event-management capabilities into their products. In particular, makers of warehouse management and transportation management software have begun adding those functions to their offerings. "Supply chain event management is becoming an important piece of any supply chain capability," says John Fontanella, vice president, research, with AMR Research in Boston.
A few years ago, a flock of niche vendors offering applications that furnished visibility into the distribution pipeline appeared on the scene. Today, most of them have fallen by the wayside. "Twenty-five vendors of event-management startups have gone defunct or been bought and merged," says Steve Banker, an analyst with ARC Research in Dedham, Mass. "Only four or five startups are left."
Challenges for Vendors
Supply chain event management links planning with execution applications. "With the introduction of supply chain event management, a company can monitor the flow of material from raw material to finished goods, and update its planning systems when an exception such as late shipment is discovered," Fontanella says." With the connection to planning, it also allows for identifying the implications of a performance breakdown in the supply chain."
Event management also depends on cooperation with carriers and trading partners to provide the initial alerts—a practice that's easier said than done. "Vendors have underestimated the efforts [required] to get this running," says Dwight Klappich, a program director with consultants Meta Group in Stamford, Conn. "There are lots of data sourcing and integration issues with end-to-end supply chain visibility."
Although it's fairly easy to write code to earmark an event, says consultant Phil Obal, it's tougher to write an application for a non-programmer to determine the business rules that apply when alerts are triggered and plans recalculated. "Most software is not proficient enough to allow a non-programmer to create the rules and give the choices without programming the supply chain event," says Obal, president of Industrial Data and Information Inc. in Tulsa, Okla.
Even in its nascent form, supply chain event-management software could prove to be a godsend for international shippers. With the government imposing new security rules that threaten to hamstring tightly run supply chains, shippers may need software alerts to notify them that a shipment is hung up in Customs for inspection.
So far, though, the ability to provide real-time information is missing in event-management software. Consultant Jim Uchneat of Benchmarking Partners in Cambridge, Mass., for one, believes the deployment of radio-frequency technology to tag shipments will solve that problem. "Today event management is driven off batch data," he notes. "When you move to real time, you can generate alerts earlier."
That day will not be too far away. "You'll see progress on this in the next year," he says. "Homeland security will be the driving force that creates change."
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