As the logistics industry embraces technology, it has begun a shift from static contract arrangements to dynamic pricing structures.
We’ve already seen this shift in the FTL spot market. Shippers, brokers, and carriers once relied on mileage bands or rates on file (rates which often did not reflect true market conditions and resulted in unsolvable bid-ask spreads), but now shippers and carriers both large and small can access instant pricing from a wide range of providers.
Instant dynamic prices on the spot market have created much more flexibility, adaptability, and transparency in the freight market: shippers can match loads to vetted carriers at competitive prices, carriers are incentivized to position themselves in the right place at the right time, and all parties can quickly benchmark rates through price comparisons. Dynamic pricing has been essential as supply chains become more efficient and variable.
Despite the dramatic change in spot market pricing, however, contract pricing has remained largely static, even as Covid-era disruption has revealed the limitations of the traditional contract pricing structure.
Why Static Contracts Fail
Consider the typical RFP process, which the logistics industry has relied upon for decades now to contract out their established lanes: the shipper sends out dozens, hundreds, or thousands of lanes to as many reliable brokers and carriers as they have in their network, a long pricing and feedback process takes place, and then lanes are finally awarded. While service and reliability are taken into account, most shippers still prioritize price, so brokers and carriers are pressed to offer their best static rates.
In doing so, brokers and carriers take on almost 100% of the pricing risk, particularly in a volatile market. As we’ve seen throughout 2020 and into 2021, agreed-upon contract rates have consistently been too low and, having taken all the pricing risk and lacking other recourse, brokers and carriers reject their awarded volume, causing operational inefficiencies and higher-than-expected prices for shippers. Additional work is created on all sides of the marketplace as shippers, brokers, and carriers scramble to realign their networks and re-price lanes.
Contracts are ultimately about risk allocation. Standard RFPs with static pricing fail shippers, brokers, and carriers because they don’t allocate risks optimally: brokers and carriers currently take on pricing risk, and shippers take on service risk. This crude, binary division of risk often results in a lose-lose outcome for both sides.
To help manage pricing risk, shippers have more recently turned to “mini-bids,” RFPs with shorter commitments. While the general risk allocation and available recourse remain the same, mini-bids can help in a volatile market by requiring brokers and carriers to take on pricing risk for only a short period of time, which both moderates their risk exposure and makes price forecasting easier.
But, mini-bids are not a perfect solution. To implement them, shippers, brokers, and carriers must now repeat what was traditionally an annual process several times throughout the year, multiplying workload to move the same number of shipments. This obviously increases operational work and therefore costs for both sides of the market and is strictly worse for all parties’ unit economics.
A better solution to the pricing risk allocation problem is a well-designed dynamic contract pricing structure. If contracted rates could be more dynamic, brokers and carriers would not take on almost all the pricing risk and then fall back on rejecting awarded volumes to stay afloat when market prices increase. However, dynamic contract pricing must be thoughtfully structured to retain sufficient price stability for shippers and good incentives on both sides.
There are a few keys to successful dynamic pricing that optimizes the inherent tradeoffs between tender acceptance, attractive prices, and financial forecasting.
First, shippers must accept some variability in price, so that pricing risk can be split between shippers and brokers or carriers. This may seem unappealing, but in practice, shippers already experience price variability in static contract pricing structures: it manifests when brokers or carriers reject primary tenders and shippers must buy on the spot market, in the form of rate relief requests when market prices rise, or in ever more frequently held mini-bids. Agreeing on a target price but accepting some variability both above and below that target price, depending on the state of the market, makes it more realistic for well-intentioned brokers and carriers to provide 100% primary tender acceptance.
To support shippers’ financial forecasting needs, shippers and carriers can decide on a rate ceiling for each lane to keep prices within certain bounds. Shippers may be tempted to demand that prices stay within a very narrow range (i.e., that the rate ceiling be only a little higher than the target rate), but should be aware that the degree of price variability permitted will almost always be correlated with primary tender acceptance rates. In other words: let prices vary more and expect closer to 100% primary tender acceptance with strong service; push carriers to adopt very low ceiling rates and prepare for rejections to rise or service to be poor.
Another key feature for dynamic contract pricing structures is a sliding fee scale. Simple “cost plus” structures, where brokers or carriers charge their own cost to source a truck, with a fixed percentage markup on top, don’t work well because there are limited incentives for brokers and carriers to keep their own sourcing costs down. A sliding fee structure, where brokers and carriers can charge a higher take rate as their purchasing performance improves, provides the right incentives, and should reassure shippers that they are being offered good rates.
Finally, mutual trust is important in any contractual relationship, and brokers and carriers can establish greater trust from shippers by opening their books and showing how much it costs them to source each shipment. Shippers will have a much greater ability to see whether carriers are actually buying well and charging a fair price.
These key features — accepting some price variability within certain bounds around a target price, sliding fee structure, rate ceilings, and fee transparency — allow the parties to allocate the risks associated with contracted pricing with greater nuance and precision, giving all parties a degree of risk that they can practically manage. Static contracts can only really work in a market with highly stable prices, and as we saw in 2018 and more recently since COVID-19, those types of markets are rare and shouldn’t be counted on.
For shippers that care most about 100% primary tender acceptance, sophisticated brokers are now offering a structure where they agree on a target rate and ceiling rate, charge a modest markup when they buy below the target rate, a much smaller markup when they buy above the target rate but below the ceiling rate, and provide pass-through pricing with no markup when they exceed the ceiling rate, all while guaranteeing 100% tender acceptance. This incentivizes brokers to buy well while making it possible to take 100% of their allocated freight even in volatile markets. Shippers sacrifice some financial forecasting accuracy but are rewarded with strong and reliable service.
For shippers that particularly value financial forecasting accuracy, brokers may offer a similar structure where they agree on a target rate and ceiling rate with a sliding fee structure but cap the shipper’s costs at the ceiling rate. In other words, brokers will cover any excess costs above the ceiling rate. But, to make this work on a business level, brokers also agree with shippers that when rates persist above a certain level, which is meaningfully higher than the rate ceiling, for an extended period of time, this will be considered a “black swan event” and the parties will reconvene to agree on a price adjustment. This approach slices the pricing risk much more finely and offers shippers greater ability to forecast prices (since prices will be capped at the rate ceiling in standard markets), but also sets forth a plan of action in the event that something truly unforeseen happens in the market and gives parties a chance to work together to prepare and adjust.
Ultimately, soft contracts with static rates where both shippers and contracts frequently fail to honor their commitments are highly damaging to shipper-carrier trust and relationships and prevent them from working together effectively to build a more efficient, healthy logistics industry. We’ve already seen dynamic rates increase opportunity and efficiency in the spot market, and it’s time for freight contracts to take that next step too.
Felipe Capella is co-founder, president and chief operating officer, and Amy Li is strategic projects lead, at Loadsmart.
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