The real impact of high transportation costs

By Dawn Russell, John J. Coyle, Kusumal Ruamsook and Evelyn A. Thomchick

High transportation costs are driving three main shifts in supply chain strategies. These changes
are having a beneficial impact not just on transportation budgets but also on broader supply chain
and financial performance.

During the 1990s and the first part of the 21st century, the high availability and low cost of
transportation services relative to the cost of holding inventory encouraged organizations to
emphasize fast, frequent delivery to customers through such means as just-in-time delivery. But
things have changed dramatically in the last decade, and companies increasingly are calling such
long-standing strategies into question. The "game changers" are volatile, escalating oil prices and
an imbalance of supply and demand for freight transport services. These realities have led to high
transportation costs—high enough to cause companies to make transport-driven shifts in their
supply chain strategies.

Three such shifts are having a notable impact today. The first is a shift from offshoring to
nearshoring sourcing strategies in an effort to reduce the number of miles shipments travel. The
second is a shift from designing products and packaging for marketability and more efficient
production toward designs that also incorporate "shipability" considerations. These include:
customizing packaging for individual products' sizes and dimensions for space efficiency and easy
handling; providing protection of goods in transit; and facilitating multiple processes of offloading,
repackaging, and reloading. The third is a shift from lean inventory strategies to hybrid lean
inventory/transportation strategies.

Why are prices high?

A conjunction of factors and economic developments lies behind rising transportation costs. At the
center of today's transport challenges are oil prices. Freight movement in most modes remains
largely dependent on ever-more expensive and finite fossil fuels, primarily diesel fuel. According to
the U.S. Energy Information Administration, the price of crude oil is the dominant factor
influencing changes in diesel prices.1 As depicted in Figure 1, crude prices have risen significantly
since the mid-2000s, but not in a predictable pattern.

An equally influential factor in transportation costs, the demand-supply imbalance of freight

transport services, is a repercussion of trade growth that has outpaced the availability of transport
services to such an extent that it has led to serious issues of congestion and capacity constraint in
the United States. The remarkable growth in U.S. international trade in the last 10 years has
resulted in rapid growth of traffic volumes throughout the nation's transport system. This is likely
to get worse in the coming decades. Despite a significant drop in total freight volume during the
depths of the 2008-2010 recession, economic conditions are improving, and it is projected that
freight volume will grow 68 percent by 2040, with particularly strong growth in international
freight.2
International trade growth places pressure not just on U.S. gateway ports but also on inland
transportation systems and service availability. Simply put, more goods entering through the ports
means more domestic moves to deliver these goods to their destinations. Moreover, as ships
increase in size, demand for inland transportation services also grows. This becomes clearly
evident when one considers that the average size of container ships calling at U.S. ports has grown
rapidly in the past few years. To put this trend in perspective, the average size of container ships in
1997 was 1,581 TEUs (20-foot equivalent units). By 2007, the average had grown to 2,417 TEUs,
and in early 2012, it reached 3,074 TEUs. More telling, perhaps, is that by that point,
containerships of more than 18,000 TEUs were already on order, and 22,000-TEU ships were being
discussed.3 Thus, whereas in the past a single ship might have discharged 2,000 or so containers
to be moved via truck and rail to inland destinations, today the number of inland moves generated
by a single ship can be more than five times as large. It is no surprise, therefore, that capacity
constraints are particularly severe at major truck and freight rail corridors linking major seaports
to inland destinations.4

This supply constraint is compounded by the fact that resources for investment in transportation
infrastructure are limited. The end-of-year balance of the Highway Trust Fund (HTF) is declining.
The HTF is a U.S. federal government program that is funded by a variety of transportation-related
taxes, such as those on fuel, tires, heavy vehicle use, truck and trailer sales, and so forth. The
money is distributed among the U.S. states to help pay for highway construction and maintenance.
It is estimated that the HTF will experience a deficit sometime in fiscal year 2015, and that it will
suffer an estimated cumulative shortfall of about US $92 billion by 2023.5 The dominant mode of
U.S. freight transportation—truck transportation—inevitably will be adversely affected by such
shortfalls.

In essence, persistent oil price volatility and capacity constraints mean that high-priced
transportation is here to stay. As a result, managing transportation costs is more important than
ever for preserving margins and profitability as well as improving supply chain performance.

The effect on strategy

A business environment that is being strangled by volatile oil prices and high-cost transportation
solutions has prompted organizations to rethink their supply chain strategies. Three transport-
driven shifts in supply chain strategy in particular have emerged and are gaining ground:

A shift from offshoring to nearshoring

A shift from product design for marketability and production to design for "shipability"

A shift from lean inventory policies to hybrid lean transport/inventory policies

The results we have observed at several companies that have adopted these shifts in strategy
indicate that their benefits go beyond ameliorating transportation challenges. These shifts also
help to improve both supply chain and financial performance due to lower costs and more
productive investments. The following is a brief description of each of these strategic shifts and its
impact on supply chain and financial performance.
Shift 1: From offshoring to nearshoring sourcing strategies to reduce the number of miles
traveled

Observation: This shift is driving a change in sourcing strategy. Instead of procuring supplies and
outsourcing manufacturing wherever it is cheapest to do so, more companies are now
concentrating on performing those activities as close to end markets as possible. The growing
attraction of sources in the United States, for example, can be gauged from the recent changes in
U.S. imports depicted in Figure 2. Year-to-year growth rates of imports from low-cost, long-
distance sources in Asia dropped sharply around the time of the oil-price peak in 2008. This is in
noticeable contrast to the sharp increase in imports from near-shore sources in North America,
Latin America, and the Caribbean during the same time period.

Supply chain impact: With supply sources moving closer to end consumers, the international
transportation component of a supply chain is shortened, and distance-driven costs are reduced.
Moreover, sourcing from near-shore sources—in the case of the United States, from North
America, Latin America, and the Caribbean—offers other advantages. For example, by bringing
imports from Latin America and the Caribbean through entry points on the U.S. East Coast,
shippers not only can avoid the congestion on the U.S. West Coast that periodically affects
inbound cargo from Asia, but they also can bypass the more expensive cross-country movements
from West Coast ports to population centers in the east. The shortened distance and reduced risk
of port congestion and associated delays also mean that companies can more quickly adjust
freight movements to changes in customer demand. Overall, then, this shift is both cost-
advantageous and beneficial to customer responsiveness.

Financial impact: Sourcing strategies that focus on nearshoring in an attempt to reduce the length
of the transportation pipeline are positively impacting freight costs, revenue, and current assets
pertinent to inventory. Freight costs are reduced because nearshoring means fewer miles traveled,
and thus lower distance-driven transportation costs and less fossil fuel burned. Revenue is
improved because nearshoring means being closer and more responsive to the market, allowing
businesses to make adjustments to order fulfillment with shorter lead times than if they were
sourcing from Asia. Current assets are reduced because nearshoring shortens lead times and the
uncertainty associated with the lengthy ocean line haul for Asia-sourced goods. As a result, less in-
transit inventory and safety stocks are required to buffer against that uncertainty.

Shift 2. From product and package designs for marketability and production toward designs that
also incorporate "shipability" considerations

Observations: Many companies are revising package and product designs to reduce weight and
increase shipment density. For instance, some have reformulated such products as laundry
detergent, dishwashing liquid, dairy powder, and fruit juice to make them concentrated and
physically more compact. Some manufacturers have redesigned rolled consumer products like
aluminum foil and toilet paper so that the cardboard tube in the center is smaller, or they have
even eliminated the tube altogether.
Like the products themselves, packaging is being redesigned to optimize package size and weight
for the contents through package reconfiguration, the use of lighter-weight materials, and the
elimination of unnecessary packaging layers, such as outer cartons and shrink-wrap film. More
products in lighter, smaller package sizes are appearing in retail stores. There are many examples
of this trend. The manufacturers of Windex and Method cleaning products, for instance, have
introduced refills in flexible pouches, as opposed to the traditional hard-plastic bottles. Ragú and
Bertolli now offer pasta sauces in flexible pouches as well as in the typical glass and plastic jars,
and many manufacturers package soup in aseptic cartons in addition to metal cans. They are far
from alone: According to a Grocery Manufacturers Association survey of its members, the number
of packaging improvements implemented by companies in the consumer products industry has
been increasing each year, resulting in more than 1.5 billion pounds of packaging avoided from
2005 to 2010.5

Supply chain impact: This "don't ship air, don't ship water" approach to package and product
design helps to reduce shipping weight, size, and materials while maintaining the products' appeal
and convenience for consumers. These changes translate into savings in freight costs, packaging
costs, and space utilization.

Financial impact: Freight costs are reduced because the reduction in package size and weight, as
well as the use of fewer packing materials, allow more goods to be shipped in one truck,
container, or other conveyance. Moreover, a larger number of smaller-size containers, such as
those described above, can fit within a manufacturer's allotted retail shelf space. Thus, revenue is
enhanced through better utilization of valuable shelf space.

Shift 3: From lean inventory strategies to lean inventory-transport hybrid strategies

Observation: Lean theory and practice, which seek to reduce inventory costs, evolved back when
oil, which accounts for 98 percent of energy consumption in transportation, was around US $25
per barrel. Common transportation strategies of companies that implement lean principles include
just-in-time delivery; small, fast, and frequent shipments; and using a dedicated fleet—all of which
depend on cheap transportation. However, as oil prices escalate, the importance of transportation
economies of scale (achieved by making larger and less-frequent shipments) increases, and trade-
offs between inventory and transportation costs become more important.6 As a result, companies
have shifted to inventory/transport hybrid strategies that not only focus on safety-stock and cycle-
stock policies but also consider the benefits of lower transportation costs.

A number of popular techniques corresponding to this shift have emerged. First, shippers are
paying closer attention than ever to shipment consolidation. They are examining their own
shipping patterns to find opportunities to consolidate their shipments, and are considering
potential leverage to be gained from using a third-party logistics provider (3PL) as a matchmaker
for shipments along shared routes. Second, they also are focusing on building consolidated,
multiproduct containers, pallets, or cartons to optimize capacity utilization. And finally, shippers
are becoming more astute in evaluating alternative modes of transportation to cope with high
transportation costs. This means looking increasingly to intermodal rail services, instead of
trucking services, for long-haul freight.7
Supply chain impact: These shifts toward shipment consolidation reflect lean
inventory/transportation hybrid strategies in which lower transportation costs offset increased
inventory carrying costs. Shipping larger loads translates into higher levels of inventory on hand,
and the longer transit times associated with intermodal rail versus truck mean higher costs for in-
transit inventory and safety stock. But these inventory-cost increases are offset by freight-cost
reductions achieved through improved shipment economies, fewer empty runs, and better vehicle
utilization.

Financial impact: Freight-cost reduction is made possible by trading off marginal transportation
costs for inventory holding costs. At the same time, revenue is enhanced because more inventory
is readily available to fill orders with shorter lead times. The substitution of inventory for
transportation costs by no means suggests that inventory will become a less significant factor
influencing total logistics costs. On the contrary, these hybrid strategies emphasize balancing the
cost of transportation and the cost of carrying inventory, which includes interest, taxes,
obsolescence, depreciation, and insurance. The fact that interest rates have followed a downward
trend since the middle of 2000 and have remained essentially unchanged since 2008 contributes
favorably to this shift in supply chain strategies.8

Key takeaways

In this article, we observe and highlight three shifts in supply chain strategy in response to higher
costs of transportation. Based on this exercise, we underscore that those strategic shifts represent
the manifestation of a renewed focus on the long-established principles of transportation
management that distance, density, and shipment size are key drivers of transportation costs.

In considering distance, logistics and supply chain managers are exhibiting renewed interest in the
extent to which components and finished goods travel along the supply chain. Sourcing strategies
that focus on pursuing low costs for labor and raw materials from overseas sources have given
way to strategies that consider sources in closer geographic proximity in order to reduce distance-
driven transportation costs.

In terms of shipment density, previously overlooked density-dampening factors, such as unfilled

space within packages (air) and volume-adding ingredients (water), have lately drawn shippers'
attention relative to the impact they have on transportation costs. Managers now strive to avoid
paying to ship air and water by focusing more on the designs of products and packaging for
shipability, as opposed to designs for marketability and production alone.

Shippers are also controlling shipment size to reduce per-unit transportation costs. The widely
practiced lean inventory approach favors minimizing inventory costs at the expense of
transportation costs, due to the requirement for small and frequent shipments. In an environment
where transportation costs are high, however, managers have become more astute in regard to
shipment size, migrating from lean inventory to a hybrid transport/inventory strategy. They
engage in freight consolidation (either among their own business units or by leveraging third
parties), and select transportation modes that facilitate less-frequent, larger shipments of freight
when it is appropriate.
While the direct benefits of the strategic shifts outlined in this article target reduced
transportation costs, we articulate through the lenses of the Strategic Profit Model9 in Figure 3
that they also favorably contribute to other factors impacting supply chain and corporate financial
performance (see Figure 4). Considering the long-established principles in transportation
management through this new light, we recommend three simple rules for managers who are
navigating the continuing challenges of high oil prices and transport service constraints: count the
miles; don't ship air and water; and consolidate, consolidate, consolidate.