The recent historic rise in fuel cost and the corollary impact on transportation rates have been well publicized during the past year. These monumental changes have not only ushered in new highs in the cost of transportation, but now shippers need to be prepared to ride out a new wave of price volatility.

This new environment is creating serious consequences for companies that import, export, ship, or manufacture goods. Even companies that simply consume indirect or MRO materials are affected, as are retailers and other direct-to-consumer entities. In many respects, fuel cost is now the “universal influencer” of business strategy and activity.

However, most supply chains were designed in an era of significantly lower fuel prices. Global sourcing and manufacturing decisions traded off longer transport distances for cheaper labor. Inventories were kept low, with materials shipped in smaller batches via faster but more fossil-fuel-intensive modes. Distribution models emphasized consolidation, with fewer facilities and longer transport distances. Each of these supply chain strategies depended on—and assumed—reasonably priced transportation.

The volatility of global transportation costs has generated a long list of significant questions that need to be addressed by today’s supply chain and corporate leadership. First and foremost: How has their current or planned low-cost-country-sourcing (LCCS) strategies been affected by this new unpredictable environment? But even more importantly: Is LCCS still a viable strategy?

The impact on transportation costs in lanes supporting LCCS strategies has been dramatic. A recent CIBC World Markets study reports that the Pacific-purchased metric ton bunker fuel price almost doubled ($296.16 vs. $582.82) between January 1, 2007, to March 18, 2008.

Additionally, an average forty-foot equivalent unit (FEU) shipment from Shanghai to the U.S. East Coast has risen from $3,000 in 2000 to a current average of $8,000. The 96-percent fuel-cost increase and the 266-percent cumulative effect of general rate increases, capacity recalibration, and ocean carrier pricing strategies are undoubtedly making a significant impact on the overall LCCS equation.

For most companies, a net landed cost analysis will confirm that high fuel costs have affected their purchase of nearly everything. The core issue, not surprisingly, is the relationship between savings associated with “low-cost-country” sources and the rising expense of moving purchased goods from those sources. There is no way to know where the top of the price-rise spectrum is or, for that matter, whether prices will continue to fall in the near or not-so-near future.

Predictions—like those affecting global companies—are all over the map. But even if they can’t know the future, companies can’t afford to do nothing. The consequences are too extreme and too far reaching. And the likelihood is too high that competitors will respond creatively, and thus gain an insurmountable edge over those that are slow to react.

In recent years the utilization of LCCS strategies provided such significant cost benefits that execution did not have to be superior in order for an organization to realize the benefits. It was common to find projected benefits of 15 percent to 25 percent or more on a total delivered cost basis, so there was a large risk buffer in implementing this strategy.

However this benefit “cushion” has been reduced or totally removed in some cases due to rising transportation costs, and efficient execution is now necessary to generate planned benefits. In fact, based on a study by Accenture and Logistics Management conducted earlier this year, some buyers of third part logistics (3PL) services indicate that they, in fact, have already started shifting their off-shore sourcing strategy.

Recent increases in overall freight costs have exacerbated this situation. Companies are experiencing reductions in overall savings from LCCS programs servicing the U.S., Canada, Europe, and parts of Asia. The level of reduced benefits can vary depending on product type and value. Many smaller volume SKUs that provided relatively small savings (<10%) from China are no longer being considered for LCCS as Risk vs. Reward has diminished. Sourcing activities surrounding “non-market basket” items have been postponed in many cases.

However dire these conditions may seem, this is not to declare an end to LCCS. While price increases have lowered overall savings for some products, the decision to source from China is still beneficial for many other products. We recommend taking the following into consideration:

• Due to the initial “cushion” in benefits, companies are continuing to buy from low cost countries as the comparative price disparity between the low cost country and domestic or near-shore sourcing can still be in double digits.
• Increasing fuel costs are not as much of a concern when compared to issues such as the power shortages/production shutdowns stemming from the Olympics, the continued diminishing value of the U.S. Dollar, and growing resource scarcity.
• For many items sourced in China, fuel is only a small percentage of the overall cost.

Fully understanding net-landed cost will be required to determine if existing sourcing contracts are still justifiable since baseline costs have changed. Thus, more contractual flexibility—ensuring the ability to adapt to changing market conditions—is essential. This lends credibility to the development of a dual-sourcing strategy, where multiple regional suppliers are used to hedge against the dynamics of changing transportation cost structures. Companies that excel at calculating net-landed cost could derive significant savings from this approach.

The near-future outlook is both uncertain and challenging. It’s expected that volatility will continue as every global action (terrorism, currency change, environmental, etc.) generates a price reaction. Where transportation cost was once assumed to be fully recoverable and an accepted advantage, the new reality suggests that fuel pricing will remain unstable.

Carriers will continue transferring fuel cost volatility to customers, align capacity to segmented demand, and lengthen transit times. Supply chains reliant on Asian low-labor cost differentials could rapidly find transportation burdens eroding previously secure, predictable margins. So what is the right strategy? We recommend that global shippers using or planning to use LCCS as part of their supply chain strategy should consider the following comments and suggestions:

• Excel at net-landed cost calculations to make the right sourcing decisions. Volatile transportation costs fundamentally change most companies’ net-landed cost calculations, therefore changes in sourcing and procurement won’t be effective without landed-cost expertise.
• Ongoing network design and analysis must be utilized in order to support development of transportation network efficiencies. This may include potential changes in supplier locations, order quantities, frequency of shipments, packaging, and delivery mode segmentation based on delivery speed.
• As transportation costs increase, manufacturing and sourcing activities closer to market demand—“hemispheric supply markets”—become more attractive. Adding more fuel to the fire is the fact that labor costs—long the staple of LCCS—are rising in many areas. This is causing companies to rely less on volatile labor arbitrage and to place a greater premium on shorter transport distances.
• Global shippers should put greater emphasis on utilization of logistics partners with flexible capabilities to help align required cost parameters and service-level requirements. Development of viable, cost-effective options that can be fully utilized in the landed-cost model will be valued. Asset-based and indirect carriers have important, long-term interests in the outcome.
• Increased demand for supply chain visibility and measurement tools including the deployment of specialized software that can provide real-time global information to allow better monitoring of changing conditions. Logistics and supply chain managers should also demand tools that improve shipment optimization and management of delivery cycles.
• Put more emphasis on advancing procurement capabilities through transition to international procurement offices and/or joining of purchasing cooperatives.

In summary, fuel-related transportation cost increases will continue to exert significant pressure on low-cost-country sourcing. The game has changed for companies that expect to reap the benefits without developing the strategies and capabilities to effectively manage logistics costs.

Future success will require superior net-landed cost analysis and execution and an ongoing process to adapt strategies as conditions change. This will result in companies seeking to find added value from their carriers and logistics companies that will be asked to provide greater flexibility in the services they provide.

It’s key to remember that those companies that can demonstrate high performance in this environment will realize significant rewards. Skill of execution and adeptness in these volatile markets will provide a competitive advantage that can drive sales and profitability. Logistics leaders will thrive with the new opportunities to manage Risk vs. Reward and find creative ways to manage the continued complexity in a global logistics environment.