Coming to terms with fuel surcharges

Why are fuel surcharges so high? How can I keep costs under control? Here’s everything you need to know about fuel surcharges but didn’t know who to ask.

By John D. Schulz, Contributing Editor -- Logistics Management, 11/1/2006

Fuel surcharges first appeared on the transportation scene after the first Arab oil embargo, circa 1973. They disappeared for a couple of decades before returning as a permanent addendum to motor carriers’ tariffs in the mid-1990s, when diesel fuel spiked to the then-unheard-of price of $1.15 a gallon.

Now, trucking company executives say, fuel surcharges are as essential to the survival of the nation’s 700,000-odd trucking companies and 2 million owner-operators as air brakes, tires, and semi-trailers.

“There wouldn’t be one trucking company alive today without fuel surcharges,” asserts Jon Shevell, vice chairman of the Shevell Group, which operates New England Motor Freight, a Northeast regional LTL. “They are not an option any more.”

Strong words indeed—but Shevell is not alone in that opinion. Asked where the trucking industry would be without fuel surcharges, trucking analyst Donald Broughton of A.G. Edwards & Sons, St. Louis, replied: “In a word, bankrupt.”

Fuel-surcharge revenues do add up. Take the example of Phoenix-based Swift Transportation, the nation’s largest publicly-held truckload conglomerate. Last year, according to Swift’s annual report, revenue from fuel surcharges totaled $391.9 million, on top of its $2.72 billion regular revenue from trucking services. That was a 107 percent increase over surcharge revenues in 2004, which in turn was 113 percent higher than 2003’s fuel-surcharge revenue. In other words, from 2003 through 2005, Swift’s income from fuel surcharges grew by more than 400 percent—from $88.8 million to $391.9 million.

As diesel-fuel prices have continued their sometimes meteoric rise, truckers have come to rely on surcharges to keep them in the black. “These additional revenues contribute substantially to operating profits after fuel expense,” says Satish Jindel, principal with Pittsburgh-based SJ Consulting, which tracks fuel surcharges for all transportation modes.

Fuel surcharges are calculated as a percentage of the base rate and are added to a shipper’s freight bill to cover the carrier’s added cost of operations. The surcharge is linked to a government-reported average fuel price and is “indexed” for the carrier based on an individual company or industrywide ratio of fuel cost to revenue.

The fuel surcharge for most LTL operations rises by 0.5 percent for every five-cent increase in average on-highway diesel prices, as reported every Monday by the U.S. Department of Energy (DOE).

In general, truckload surcharges are about twice that of less-than-truckload (LTL). For truckload carriers, which perform longer lengths of haul and thus consume more fuel, the surcharge rises 1 percent for every nickel increase in fuel prices.

Originally, fuel surcharges were quite manageable for shippers; when fuel rose from $1.15 per gallon to $1.20, the surcharge rose from 1.5 percent to 2 percent. That’s a real bargain compared to the kinds of percentages shippers are seeing today.

For instance, Old Dominion Freight Line (ODFL), a North Carolina-based regional and interregional LTL carrier, reported that it was assessing a 21 percent fuel surcharge during the week of Aug. 9, 2006, when diesel-fuel prices peaked at more than $3 per gallon. Last January, when diesel was around $2.35 per gallon, ODFL’s surcharges were down around 14.5 percent of a shipper’s freight bill. Meanwhile, many truckload carriers were reporting surcharges of about 40 percent last summer and about 30 percent last January.

In an online survey of more than 600 buyers of truckload and LTL services, conducted in late August 2006, Logistics Management asked how much respondents were paying for fuel surcharges at that time. Interestingly, not all of their responses appeared to reflect the widespread reports of very high surcharge percentages that were circulating in late summer.

Nine percent of LTL shippers said they were paying 5 percent or less. Some 17 percent reported surcharges between 6 and 10 percent; 18 percent were paying 11 to 15 percent; 27 percent were paying between 16 and 20 percent, and 7 percent reported surcharges higher than 21 percent.

On the truckload side, 6 percent of survey respondents reported that they were paying between 0 and 5 percent; 12 percent were shelling out between 6 and 10 percent; 15 percent were paying from 11 to 15 percent; 23 percent were hit up for 16 to 20 percent; and 24 percent were paying surcharge rates exceeding 21 percent. About one-fifth of respondents in both categories weren’t sure exactly how much they were paying.

The sliding surcharge mechanism has been well accepted by shippers, for three reasons. First, shippers can clearly see that it’s necessary. Diesel prices have been trending upward at a rate of 20 percent annually since 2001, and the trucking industry will collectively spend in excess of $100 billion this year on fuel, up from $87 billion in 2005. That has resulted in an increase in surcharges for shippers of between 3 and 5 percent annually for LTL and 5 to 10 percent annually for truckload.

Analyst Broughton says the reason carriers have been so successful in getting what they’re asking for is that they have been unified in seeking the charges. “I remember carriers asking for fuel surcharges in the early 1990s, but shippers could route around those guys and find one who didn’t have surcharges. But all those carriers who didn’t ask for fuel surcharges in the early 1990s are gone,” he observes.

Although shippers may not like paying the extra money, the surcharges are actually helping to maintain competition in the trucking industry. Broughton believes that fuel surcharges have reduced the number of trucking failures and bankruptcies, which no longer spike whenever there is a sudden increase in fuel cost. “That would indicate the surcharges are working in most quarters,” Broughton said. “The results speak for themselves.”

Second, shippers can sometimes pass rising surcharges on to their customers. “These costs have largely been absorbed by the retailers; however, as they realize that the fuel prices are not likely to drop, there will be pressure to adjust prices to compensate,” observes Dustin Smith, North America transportation manager for International Paint LLC in Houston. This is more likely to occur when a high percentage of a product’s unit cost is composed of transportation expenses, he adds.

And third, it is possible in many cases to negotiate the surcharge level. As a permanent part of most carriers’ tariffs, surcharges rise and fall weekly to help truckers cope with volatile fuel prices. But if shippers would prefer to pay higher overall freight rates, many motor carriers are willing to cap—or even nearly eliminate—fuel surcharges for that shipper’s specific account.

But capping fuel surcharges is not always a winning strategy, according to Jindel. “In my judgment, shippers are hurting themselves when they do that,” he says. “As a carrier, if I take a cap, I try to make it up elsewhere. If fuel goes down, they (carriers) can still get the money from the base rates. If shippers can get the fuel surcharge capped after they negotiate their rates, they’re better off. If they do it in conjunction, they end up losing.”

What are the most effective ways to deal with rising fuel surcharges? Shippers are taking several approaches these days.

Gary Girotti, vice president of the transportation practice at Chainalytics, an Atlanta-based supply chain management consulting firm, says that he sees about a 50–50 split among his shipper clients. Some prefer keeping their base rates as low as possible, while others feel they gain additional leverage when surcharges are negotiated into the overall rate, he says.

The carriers really don’t care which tactic their customers adopt, as long as they are being adequately compensated for additional operating costs that are beyond their control. “I have shippers who prefer a separate surcharge and some who prefer rolling it into base rates,” comments Douglas G. Duncan, president and CEO of FedEx Freight. “I gave up dictating to customers long ago. It’s their preference.”

Shippers say dealing with fuel surcharges is not unlike a cat-and-mouse game. “Carriers will do all they can to pass any excess cost back to the shipper,” International Paint’s Smith says. “Smaller carriers are definitely feeling the pain associated with the fuel increase and are demanding more for their services. When it comes time to negotiate rates, carriers will be talking a lot about the cost of fuel and using it as a leverage point for general rate and line-haul increases. Shippers must be acutely aware of what percentage of their invoice cost is actual fuel surcharge,” says Smith.

“I want my carriers to give me fuel surcharges based on cents-per-mile, not based on a percentage of freight bills,” says Bill Brinkley, vice president of transportation for Interstate Foods in Boise, Ida. Whether it is better to separate out fuel surcharges or wrap them into overall rates depends on where you are shipping from and the price of fuel at the time of negotiation, he suggests. “If fuel is low, then you want to make your rates 'all in.’ If the fuel is high, then you want to have it separate.”

Other shippers agree. “I feel that you lose your leverage in a package deal,” says Brian Messinger, logistics manager for Sure Fit Inc. in Allentown, Pa. “I feel it is much more prudent to know exactly what you are expected to pay for all services leading to a final price.”

Girotti of Chainalytics says he advises his clients not to roll the surcharge into base rates. “Break it out. Make it visible and transparent,” he says. “If it’s part of a base rate, it gives the carriers the ability to manipulate it.” He also suggests that shippers try to keep their base rates low to expose all of the surcharges and force carriers to explain any increases.

One of the more novel approaches to coping with fuel surcharges was developed by former Owens Corning executive John Gentle (see article about John Gentle in this issue - A Gentleman of Principles). He and his colleagues chose to protect their company from potential financial losses caused by volatility in fuel prices by better forecasting the future price of diesel. In essence, instead of basing its cost projections on the Department of Energy’s weekly average diesel price, Owens Corning bases its forecast on the trading price for No. 2 heating oil on the New York Mercantile Exchange (NYMEX) over the most recent month, plus the cost of transportation, refining, and taxes. The idea was that it would more accurately forecast Owens Corning’s future fuel costs while enabling its carriers to recoup legitimate fuel expenses. (See “A hedge against uncertainty,” March 2006.)

That tactic has worked well for Owens Corning, but Girotti generally advises shippers against hedging. He notes that some shippers are locking in fuel-surcharge terms at a high introductory rate in order to avoid future increases. But according to Girotti, research has shown that doing so will increase shippers’ costs by a few cents per mile as carriers roll more expenses into the number on which the surcharge is based.

Regardless of which approach shippers take, Girotti says, transportation and logistics folks ought to make sure their companies’ CFO understands that fuel costs are not going away and that they need to be accepted as a general cost of doing business.

Some shippers may be wondering if the days of volatile fuel surcharges are almost over. Gas and diesel prices began to decline after Labor Day as crude-oil prices collapsed from their all-time high of $78 a barrel over the summer, and shippers and truckers alike are hoping that prices will continue to slide this winter.

But that scenario is far from assured, most observers believe. “This isn’t going to go away–fuel is going to keep getting more expensive,” Girotti says. “The old rules don’t apply any more.”

That’s for sure. Old Dominion’s current tariff includes a table listing fuel surcharges for when diesel reaches $5.10 per gallon. If the price should ever reach that height, the fuel surcharge for LTL would be 41 percent, and the truckload surcharge would be a whopping 83 percent.

Now, doesn’t that make you feel better?