The Bargain: Low Hanging Fruit in Trucking ContractsPosted November 22, 2016
Today’s article looks at two failures in transport contracting, and a common solution. It may be challenging to read. It might trigger a natural defensiveness from those responsible for negotiating trucking contracts. Or pique at national pride, because in part this article is about what can be learned from other trucking markets. And the article looks at complexities of pricing and contracting in general, something that is abstract and requires deep attention to detail.
For the readers who stick with it, we think it offers a significant opportunity for improving their business. Before we look at the problems, let’s quickly recap what makes for good contracting.
What is Good Transport Contracting?
Supply chain management says that transport contracts should be evaluated on three goals.
Incentive alignment. The best contracts will make it worthwhile for the haulier and cargo owner to behave as if they were the same company. A more intuitive way to describe this is that the best contracts mean the haulier makes its money with the cargo owner, not against the cargo owner, and vice versa. The gold standard for such a measure is transparency: would the contract remain the same if both sides knew what the other side knows.
Risk transfer pricing. A good contract distributes down or upside potential across the parties proportional to their contribution to the outcome. Or, when the two sides do not see risks or upside in the same way, by transferring them to the other side in exchange for a financial incentive. For example, a haulier may be more interested in cash flow certainty and therefore moves that risk to the cargo owner via take-or-pay provisions, in exchange for a lower rate.
Reduced transaction costs. Bargaining for a contract takes time and resources. Good contracts balance the cost of creating them with the stability they provide. Therefore, a contract should have a corollary reduction in transaction costs, all else being equal. If not, it’s better to simply negotiate every transaction as it arises.
Notice that the three goals described above are agnostic to the contracting side (haulier vs. cargo owner). These are qualities both sides should strive for because they make for more valuable and stable arrangements.
Problem #1: Static Pricing
Let’s start by way of metaphor. Imagine you have a clock and it’s broken. One day while eating lunch you decide to set the face of the clock to match your watch: 12:42. For a minute, the clock tells the correct time. Twice a day afterwards, it tells the correct time. And, ironically, if you decide to check it regularly while eating lunch, it will be pretty close to the right time. But we know that is an accident. Nothing mechanical aligns the time the clock tells us with the real passing of time.
Now think about transport sourcing. Nearly every New Zealand transport contract gets negotiated annually, with prices locked for a given service for 12 to 24 months. What’s the problem with this? Annual RFQs, even when successful, give a market picture that degrades in accuracy quickly. We know it must be wrong but can’t tell how much until the next annual RFQ. How often are one or both sides of an RFQ surprised by the results? This happens. But not all the time: which actually uncovers the more pernicious issue with an annual RFQ cycle. They tend to be executed by a cargo owner at the same time each year. This is a failure to test the market properly. In the clock example, if you check it at the same time every day it would appear accurate. A thermometer left outside, which swings between freezing cold and blistering hot through the change of seasons, will show a much smaller temperature range if only checked one day each year. So it is with RFQs done every 12 months.
This is crucial because the New Zealand transport sector has intense seasonality. The primary industries create mini-peaks in regions depending on what products are harvested that week. The larger trend is agricultural work peaking in time with consumer demand in the warmer summer months. Thus, trucking capacity is undersupplied in peak and oversupplied much of the rest of the year. That sort of supply-demand imbalance, when combined with a static price, means the average New Zealand truck is mispriced relative to the market most days of the year.
Would it make sense just to add seasonal discounts or surcharges, but still negotiate every 12 months during an RFQ? Probably not. What makes the market rate move is the true demand placed on New Zealand trucking, which is itself variable with the weather. Kiwi fruit, Avocado, Apples, Dairy, Fish, and many other agricultural products have unpredictable harvest dates. Fixing the price for a truck based on the expected peak harvest weeks per product is suboptimal. It must be done in real time.
Problem #2: No Obligations
New Zealand cargo owners and hauliers tend to make annual contracts that have two unusual qualities:
They have no binding minimum spend commitment, meaning the cargo owner does not have to offer loads at all.
They have no binding minimum acceptance commitment, meaning the haulier can turn away loads offered to them if they don’t want them.
Which begs the question: what’s the point? Yes, price is agreed in advance by these negotiations and that somehow simplifies the day-to-day relationship. But if neither side is obliged to do business later, it doesn’t reduce risks or align incentives. A cargo owner who needs to know her product will move doesn’t have that level of assurance. A haulier who wants to rest assured his truck loans are covered is likewise out of luck. By making no commitment, both sides have lost the ability to meet their own needs and coordinate their efforts towards a shared goal.
These contracts are really options, i.e. the right but not the obligation to do something at a pre-agreed price. The cargo owner has an option to offer loads. The haulier has the option to accept them. That’s something not seen in transport in China, the EU, and the USA. So it’s unique to New Zealand. But is it a bad way to do business? Yes. Using options instead of obligated contracts has three key drawbacks.
First, they are risky. The key risks cargo owners want to control are (1) the risk of cargo not moving and (2) the risk of going over their budget. Since the haulier can decline any loads they are offered, neither risk is reduced. The haulier is also facing the risk that their revenue does not cover operating costs for a period. Assuming the long-term profitability of the haulier is not a problem, it is still a cash flow risk because the haulier must keep a cushion of cash to pay wages, rent, fuel, and so forth. This inflates the balance sheet, reduces return on assets, and adds risks of late payments. Options tend to accentuate risks because they fail precisely when the market rate for a service gets further from the contracted rate. So options become unused at the edge cases in which risk-mitigation from long-term contracts would have been the most attractive. For example, imagine a particularly strong kiwifruit season which creates high offers for trucks for several weeks. The further away from the long term rate the offers are, the more likely the haulier will be to decline the long term work in favour of the kiwifruit loads. Long term contracts are supposed to provide stability over variations and the optionality does exactly the opposite by making them more likely to fail when price variability is most in play.
Second, they create conflicts of interest. Without obligations, the cargo owner will always be better off exaggerating or taking the high-end of their expected volumes. Likewise, the haulier is incentivised to overpromise their capacity. They commit to many cargo owners and then accept or decline the offered loads based on their relative attractiveness at the moment. Ironically, both sides intuitively know that the other side overpromises. So they try to factor in the overpromising in to their own behaviour which leads, as you’d expect, to an even greater overpromising. Even if both sides get this right, it’s simply extra work with no real benefit in terms of alignment. Options do not align the two sides.
Third, they are mispriced. Option pricing is hard to get right. But one aspect that should be obvious is that an option has an inherent value. Imagine that Acme haulier signs a fuel agreement to buy diesel all year at $0.97 per litre. Also imagine that their competitor has the same contract but instead of it being an obligation it becomes an option. Acme haulier must always pay $0.97 per litre, but their competitor chooses between $0.97 or another provider if their price is lower. Clearly the competitor has a better deal. If prices decline even for one day, the competitor’s average price will be lower than Acme haulier. Even if the prices stay high they are equal. In short, the option is more valuable than an obligation. Options have their own value. That value should be visible in the pricing of options, such as in an up-front charge regardless of if the option is used. Cancellable airline tickets are such an example: the option to cancel is valuable and therefore has a related up-front charge. Yet, most New Zealand trucking contracts treat an obligation and an option as identical and therefore misprice one or both.
Two Problems Together: A Story of Rejection
Now consider how these two problems interact. From problem #1 we have a static price that is valid 365 days of the year regardless of what is the actual demand and therefore offered rate for competitive work. From problem #2, we know that the static price in no way obligates the two sides to offer or accept loads. To visualise the situation, imagine that the demand for a haulier’s truck looks like this:
Underlying demand for trucking
And that a haulier and a cargo owner have agreed on a flat $30 per tonne price, valid 365 days of the year, but without obligation to offer or to accept the loads. So pricing looks like this:
365 day static pricing
What happens? Rejection rate varies instead of price. Rejection means that a load is offered to the haulier but the haulier declines it. Given the two graphs above, we should expect to see rejection rates like this:
Dynamic Rejection Rates
This could be summarised as: variable demand + fixed price = variable rejection rate. Which, really, is not how most cargo owners want to run their business. Any rejection means extra work. At the very least it means one more load offer must be prepared and sent to another haulier. It also correlates chance of rejection with the peak business period, heightening stress and the risk of failure to get cargo moved as needed.
A Common Solution: Long-Term + Spot
One way to resolve both static pricing and options is to move to a combination of long-term contracts (with obligations) supplemented with spot contracts. This is the norm in other developed countries, where spot contracts represent 10% to 30% of trucking spend. Spot contracts are one-time agreements to move a load at an agreed price. Although only one job, it is an obligation on both sides. Cargo owners must pay for the service even if it is cancelled, and hauliers must complete it once accepted. The other 70% to 90% of trucking spend is done through long-term contracts with true obligations to offer and to accept loads.
Why is this better than the typical New Zealand approach? By running ~20% of trucking through a spot market the two sides conduct continuous price discovery. This helps maximise the return on assets for the truck and reduces the size, frequency, and intensity of the RFQ process for the cargo owner. Understanding the market rate for a service also helps improve a host of other decisions, such as where to site DCs and what assets to add to a fleet. The compliment to having 20% spot spend is the true long-term contract with the obligation to offer loads and to provision trucks to move them. This ~80% of spend is contracted in a way that aligns incentives, reduces risks, and creates a stable environment for investing in common processes, systems, training, and so forth. It has the peaks and valleys of demand levelled off by the spot market. Using both spot and long-term contracts achieves a separation of concerns: spot is dynamic and responsive, long-term contracts are about efficiency and commitment.
Hauliers who receive true long-term contracts know that they can plan asset portfolios, staff, and complimentary sales around them. Cargo owners know that their cargo will be moved when requested at a budgeted price. Long-term contracts, when they include obligations, align the incentives of the two parties. The haulier is incentivised to promise only what they can execute. The cargo owner is incentivised to be accurate when forecasting.
If we go back to the same kinds of charts used above, the difference in strategy should be clear. Notice that now price has three components: the long-term contracted rate, the spot rate, and therefore the weighted average price. Weighted average price has variance because spot rates are dynamic, but the variance is muted by most of the transport being in long-term contracts. The budgetability remains high for both sides. By being willing to pay higher prices during true high demand periods, the rejection rate also flattens. It’s a better way of contracting.
Long Term Contracts + Spot
Hopefully, this article sheds light on two common contracting weaknesses and gives an indication of how to improve on them. Is it an innovative solution? Perhaps not. The structure described here is status quo for over a trillion dollars of trucking services per year. But in New Zealand, it’s a fresh perspective and a way to add value to both sides. TNX plays its part here, making the spot component easier to execute and more effective at price discovery. Contact us if you’d like to discuss them in more detail.