The cost of fuel is a major driver of supply chain efficiency, and the increasing volatility of fuel prices can undermine performance if not managed properly. Research at the MIT Center for Transportation & Logistics' (MIT CTL) FreightLab has identified four broad strategies that companies can deploy to smooth out these effects.

In 2007, logistics costs in the United States amounted to a little over one trillion dollars; approximately 10% of GDP. Of that spend, some $840 billion was devoted to transportation, and $670 billion of that budget went to trucking. Transportation is a huge component of logistics costs.

Supply chain managers are used to making trade-offs to counter the effects of fuel cost fluctuations, for example, by moving stocking points closer to end markets when prices soar. However, keeping pace with the ever-changing cost of fuel has become a major task.

A measure of this instability is the coefficient of variation, a standard metric calculated by dividing the standard deviation of the price of a gallon of fuel by the average price. From 1994 to 2004, the coefficient of variation was 0.14; from 2004 onwards it almost doubled to 0.27. Further, the average weekly change in the first period was about a penny per gallon of diesel, but for the more recent period it is almost five cents.

Another complication is that the industry projections of fuel price movements are often wrong by a wide margin. Managers tend to base their forecasts on past experience, which is not a reliable guide to future trends.

There are many ways to dampen the effects of seesawing fuel prices. MIT CTL's FreightLab has grouped these strategies under four broad headings.

1. Improved Risk-Sharing Contracts: The fuel surcharge is the most common risk-sharing mechanism used by freight carriers and shippers to mitigate the effects of fluctuating prices at the pump. The problem is that surcharges are being applied imprecisely, leading to confusion and the uneven distribution of risk.

Carriers and shippers should avoid incorporating fuel surcharges into other charges such as line haul rates. Merging the fuel factor with other transportation charges makes it extremely difficult to reflect the upward and downward movement of fuel prices in overall costs. Fuel prices should be isolated, measured, and managed separately from the pure cost of transportation.

2. Leverage Sustainability: A more fuel-efficient supply chain also meets sustainability goals. Supply chain managers should leverage this relationship to implement fuel-saving programs that were dead on arrival only a few years ago.

A classic example is the reformulation of washing detergents. Some years ago, manufacturers had the bright idea of producing detergent in concentrate form, thereby slashing shipment volumes, but the idea flopped. Fast-forward to today and the concept has taken off because such "green" ideas are in vogue. In fact, last year Wal-Mart mandated that it would only sell concentrated laundry detergent.

3. Establish a Portfolio of Supply Chain Options: Companies use many types of supply chains to deliver product to customers. Direct store delivery and regional/warehousing configurations are two examples. Supply chain managers that have these various options in place can switch between them when fuel prices change, to give them maximum operational flexibility.

4. Use Scenario Planning: Traditional forecasting methods, such as point forecasts are handicapped because they take past experience and project it forward. These conventional forecasts should be complemented by scenario planning, which instead of projecting old misrepresentations forward, establishes possible scenarios and projects these backwards to the present. An example could be a scenario where a gallon of diesel reaches or exceeds $4.00. The idea is to simulate outcomes in terms of your current operations: what would happen if this world became a reality?

By having these various methods primed and ready to be brought into action, supply chain managers can shield the organization from the excesses of the energy markets.

This article is an extract from "Four Strategies for Taming Fuel Price Volatility" published in the March 2009 issue of MIT CTL Supply Chain Strategy. For more information on FreightLab's research contact Dr. Chris Caplice who is Executive Director of the MIT Center for Transportation & Logistics and head of MIT CTL's FreightLab.
MIT Center for Transportation & Logistics