Fuel Cost Impact on Supply Chain

GUEST COLUMNIST:

Chelsea (Chip) C. White. Ph.D.

H. Milton and Carolyn J. Stewart Chair

Schneider National Chair in Transportation and Logistics

Chaired Professor in Transportation and Logistics in the School of ISyE,Georgia Tech      

Let me get started by making a few general comments and stating a few simple principles that might be useful in this morning’s discussion.

• As we all know, total product cost includes both production cost and logistics cost, where logistics cost is primarily due to inventory and transportation costs.  We also know that it often makes good sense to spend more on logistics in order to save an even greater amount on manufacturing by manufacturing off shore and then shipping to the customer market.  This is an argument for globalization.
  


• But what generates logistics costs?
  • Of course we know that transportation costs go up with the cost of fuel and labor.
  • But there are two other principles that we need to keep in mind.  Assume for a moment that as transportation costs rise, that we want to keep the same level of customer service (as measured by, for example, the likelihood of a stock-out).  Then two principles come into play:
    • First, the longer the lead time, the higher the logistics costs, where lead-time is the length of time it takes to move freight from origin to destination, for example, from a manufacturing site in China to a retail store in Baltimore.
    • Second, the greater the variability in lead time, the greater the need for larger inventory buffer stock, which generates higher inventory holding costs.

Thus, both lead time and lead time variability are critical issues in determining total logistics cost.

• These comments lead to three related remarks:
  • The first is that international border crossings generate increased lead-time variability – no surprise here.
  • Second, congestion (created in large part by an infrastructure in the U.S.that is insufficient to meet demand) generates not only longer lead-times but also greater lead-time variability.  Thus, congestion is really doubly insidious.  I don’t think we fully appreciate the negative impact on productivity due to congestion at ports, at rail heads, on highways, etc., and this should be more of a concern than it is.
  • Third, awareness is relatively new and just emerging regarding the extent of lead-time variability in long, global supply chains.  Basically, lead time variability for supply chains that cross international borders and oceans can be surprisingly large.

What do these comments mean in light of some of the topics for today’s conference call?

First, let’s consider supply chain design.  As fuel prices go up, we would expect to see supplier footprints moving closer to the U.S. domestic market.  What we’ve been seeing are increases in NAFTA trade, Maersk reducing its workforce, and anecdotal evidence that supports this expectation.  It appears that supply chains are being re-designed to accommodate not only higher fuel costs but also the growing awareness that global supply chains create more lead-time variability than initially realized. 

With respect to mode selection and more generally mode selection mix.  Due to rising fuel costs, we would expect shippers to increase their use of lower cost modes (e.g., use barge services instead of rail, intermodal instead of truckload, truckload instead of less-than-truckload) in order to reduce exposure to rising energy prices, even at the expense of lower service quality (i.e., longer lead-times and greater lead-time variability) and we’re certainly seeing this.    Although it is not clear which mode is benefiting the most from these mode shifts, it appears that rail is at least one beneficiary.

With respect to mode mix.  A clear beneficiary is All-Water-Service to East and Gulf coast ports from Asia Pacific, primarily through the Panama Canal.  There are several reasons for growth in AWS; I’ll mention three:

• The first – an obvious one - is the increased cost of moving goods across the land bridge (due to increased fuel costs and other costs associated with a congested infrastructure).
• The second is labor issues.
• Importantly, the third is the significantly improved service quality of AWS over the last several years. 

A result would be a shift from long haul trucking and rail to mid and short haul trucking for the last mile as goods enter the U.S. at ports that are closer to the U.S. customer base east of the Mississippi.

Let’s note, too, that although the completion of the 3^rd set of locks for the Panama Canal is years away, it will help to further increase the desirability of AWS.

Regarding inventory strategy.   Much of what we have said thus far would indicate a need for additional buffer inventory and hence a growth in inventory holding costs.  However, this assumes inventory levels are currently right sized (following, for example, lean inventory principles).  In reality, distribution centers typically hold more inventory than they need in order to protect against stock-outs.  This leads to the first of two (of perhaps many) ways that I see to reduce the impact of rising energy costs:

• The first is to work harder on right-sizing inventory levels as we re-design and transition to our new supply chain structures and eliminate truly unnecessary buffer stock.
• The second way of mitigating increased fuel cost is to get better at using information technology and the resulting real-time data to help turn the phrase ‘trading information for inventory’ into a reality.  We’re just now learning how to extract maximum value out of real-time supply chain data, which we’re inundated with, and we need to learn this faster.

One parting remark.  As expected, we are seeing a reduction in capacity occurring (witness the Jevic suspension of operations and the rise in bankruptcies), and capacity reduction is helping to sustain and in some cases improve yields for survivors, which also is expected.