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There used to be an unwritten rule in logistics: "If you want my good freight, you have to move my bad freight." The "good" freight (often called "optimal" freight) is a load that moves efficiently. The freight has a regular, predictable pattern, with backhauls. The "bad" or suboptimal freight fluctuates in volume, is unpredictable and has few backhauls. Put simply, freight is "good" when productivity is high and "bad" when truck productivity is low. In a perfect market, the two kinds of freight move at different prices. In the traditional truckload contract market, under the "unwritten rule," they moved at similar prices. Shippers liked that. It enabled them to lump a lot of freight into a few transactions, and it allowed the bad freight to move at predictable prices. The alternative, the spot market, has big swings in prices and capacity. The unwritten rule's certainty was important because the bad freight is good for the shipper. It is the high-priority freight that supplies critical promotions, serves lucrative, unbalanced consumer markets and solves emergencies.
Importantly, the unwritten rule produced a cross-subsidy: the shipper paid above-market rates for good freight, offset by below-market rates for bad freight. That imbalance inevitably initiated a market reaction that has had profound implications for supply chain costs.
Beginning in the late 1990s, a new class of carriers approached customers as specialists in good freight. They promised high service levels and attractive rates based on superior equipment utilization. Although these solutions have, by definition, limited scope, for the appropriate business, they produce unprecedented levels of performance. They are the trucking equivalent to Southwest Airlines' invasion of the hub-based airline market, where airlines blended the few-destinations, long-haul, "good" passengers with the many-destinations, short-haul, "bad" passengers. Southwest specializes in simple "out and back" good lanes that link large markets with popular vacation spots. Note, again, the limited scope of this solution. Southwest doesn't go everywhere, but where it goes, it excels.
On the trucking side, this trend accelerated rapidly when large customers discovered that their size was often sufficient to generate a chunk of good freight by themselves. The shipper's ownership of the good freight enabled them to capture the value of superior productivity through low prices. The boom in "dedicated" or "engineered" freight was born.
This segmentation of a previously generalized market has been accelerated by an accident of fleet management. The incumbent generalist carriers have been slow to react to the loss of their cross-subsidy. They have not raised rates on their bad freight even though their customers have withdrawn the high-margin, good freight. As a result, shippers get rate reductions on their good freight and pay the same historically low rates on their bad freight. Of course, they have converted to the new, segmented approach as rapidly as possible.
This market imperfection is the result of three factors. First, the generalized carriers were slow to recognize what was happening. Both costing systems and management habits obscured the change.
Second, 50 years of productivity-induced price reductions left the industry shy to ask for price increases, even for hard-to-move freight.
Third, the strong business cycles of the past eight years have clouded the data. The big cyclical swings in prices obscured the growing gap between the generalists and specialists.
In the end, however, markets work. The generalists are beginning to adapt by partially or fully exiting the bad-freight market. You can see it in the frequent reports of carriers reducing their capacity in "long-haul" segments. That is code for, "I want out of the low-margin, bad-freight segments." As yet, carriers have not widely adopted a second solution: raising rates on bad freight. This is in part because of their preoccupation with setting up new, segmented, good-freight operations and in part due to the freight recession's downward pressure on prices.
Note that this situation is largely limited to asset-based carriers. They provide the capacity certainty that formed the core of the traditional unwritten rule. Conversely, brokerage providers, who operate in the spot market, have no bias toward good freight and have stepped into the breach. This is not to say that the eventual solution is limited to brokerage.
Capacity certainty remains a shipper value, and assets are the ultimate guarantee of capacity certainty. Recognizing that, a few asset-based carriers have maintained their commitment to capacity certainty for bad freight, even as they expand options. These farsighted carriers will increasingly stand out when growth returns to the truckload market.
At that point, watch out! When capacity tightens, carriers focus on their highest margin freight. Since today that is good freight, the market will withdraw even more capacity from the bad freight. There will be a critical shortage in bad-freight capacity. Prices will rise rapidly. As margins improve, bad freight will be newly recognized as "good freight." It is possible, moreover, that the natural market overreaction will make it higher margin business than today's good freight. We may get the ironic condition where today's labels of good and bad are reversed.
What about shippers? We know one thing for certain. The economic value of North American trucking is so large that in the short term, customers will eat price increases without volume decreases. This is especially true in the bad-freight market. For retailers, seasonal surges, product introductions and promotions generate 30 percent higher margins than baseload sales. Orders to prevent stockouts may double that advantage. As a result, bad-freight supply chains now support well over half of all margins in most retail sectors. In the production sectors, orders to prevent a plant shutdown can generate daily savings in the millions of dollars. It is clear that bad-freight pricing is generally less elastic than good-freight pricing.
So, when the next upturn kicks off, bad-freight customers will pay. Because the crisis will probably produce actual shortages, retailers will compete aggressively for capacity in order to be the one chain with all the goods on the shelves. These powerful market forces will rapidly increase the price spread between good and bad freight, taking the premium for bad freight from the current range of 5 to 20 percent range to 20 to 40 percent.
Such spreads will change the market. First, shippers will turn their attention to the bad-freight carriers. Those shippers with the most critical service needs will favor the asset-based providers.
Second, shippers will revive unwritten rule contracts, bestowing an advantage on large, asset-based carriers with positions in both good and bad freight segments. It is certain, however, that pricing will be more careful than in the past. "If you really want standard pricing, I need to know that my total margin covers the full cost of the bad freight I am committing to."
Third, the pressure of the increased price will eventually work up the supply chain to retail marketing economics. When markets bear the full, true cost of bad-freight logistics, the propensity to emphasize seasonal and promotional tools will decrease. Those tools will still dominate, but the next upturn will be the tipping point between their growth and stability or modest decline. The market will now resist the prevailing culture of seasonal and promotional marketing. There will be a large emotional shock to marketers that will reverberate back through the supply chain. Shippers and their carrier partners who want to mitigate that shock would be wise to start their preparations today.
Here's what shippers can do:
1. Educate their organizations about the change. (Remember the shocked disbelief when capacity tightened in 2004.)
2. Identify their bad freight and its value, and understand what is at risk and how much they can spend to solve any problems.
3. Identify carriers with a lasting commitment to this segment and build relationships. Relationships will count in the frenzy caused by missed deliveries.
4. Adjust budget projections upward - you don't want to be impeded by outdated forecasts during a crisis.
5. Identify the key trigger points that announce that the crisis has arrived. Most shippers will be late reacting; the first to adapt will get their product delivered.
Of course the most aggressive shippers can lock up capacity now, if they are willing to invest a modest premium to avoid much greater costs two to three years out. It is worth noting, however, that the steps above do not require financial investment. They ask only that the shipper invest the management time in preparation.
Such modest investments promise great payback because few shippers will take the time during the current period of favorable rates and capacity surpluses. It takes significant forethought to invest today when the bad freight is moving at attractive rates. For those shippers with that forethought, the payback will be great as their product will be on the shelves, while their complacent competitors' products will not.
Noel Perry, formerly with Schneider National, Cummins Engine and CSX, is a principal with Transport Fundamentals.
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