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Basic forms of transport procurement

The characteristics of private fleets, spot contracts, and long-term contracts. What are risks and rewards of different strategies?

Transport services are typically procured in one of three forms: as private fleets, spot contracts, or as long-term contracts.

Private Fleet

In a private fleet setup, the shipper controls the means of transport. There are a few ways to achieve this, for example by the shipper owning the trucks and employing the drivers, leasing trucks, or exclusively contracting with owner drivers.

The common outcome is that a shipper exercises full control of a fleet of vehicles and treats most of the associated costs as sunk costs.

Private fleets can serve multiple purposes, a theme we’ll return to in detail later. In most cases though, they can be used for either ensuring high service quality above other means of procurement, or for reducing transport costs.

Long-Term Contracts

Long-term contracts are the result of regular – mostly annual– procurement cycles that result in an agreement between the shipper and a group of carriers on specific services and prices.

One of the basic premises of long-term contracts is that they allow shippers to concentrate buying power with few carriers, in turn optimizing pricing. Empirically though, the pricing from contracts tends to be higher than the pricing from spot contracts.

While the premise might be correct, it gets mingled together with the myriads of assumptions that go into a long-term contract: if a carrier is required to provide pricing a year out, he may as well include some cushion in his pricing to compensate for the fact that his costs a year out are uncertain.

One solution to this predicament is to allow for price adjustments based on external factors. A popular one is a cost adjustment based on some agreed index of fuel prices. Thus, while prices may be variable to a certain extent, the formula to calculate them is fixed.

With only long-term contracts, daily dispatching becomes an exercise in allocating work to a small group of carriers based on a pre-agreed rate book. Pricing discussions are excluded from daily discussions, reducing operational strain, and allowing for easier budgeting of transport spend.

Spot Contracts

While there are various definitions available for spot contracts, they all share the following similar characteristics:

In most markets, spot transactions make up 15-20% of transport spend. Over recent decades, prices for spot transactions average 10% lower than similar services when procured under a long-term contract.

Spot markets are attractive because the carrier getting a job has the strongest economic alignment to it. Thus, the lower pricing does not come as a surprise.

However, spot transactions carry some downside for carriers and shippers: they are hard to budget for, introduce counterparty execution risk, and require dedicated infrastructure to operationalize.

Volatility is the major reason for budget uncertainty. With prices being set every day, shippers and carriers are directly exposed to changes in market price.

Competitive spot procurement increases execution risk. Finding the carrier that has the strongest economic alignment usually means opening up the pool of possible carriers to a – at least slightly – larger group. This increases the time required for vetting carriers and increases the risk of service interruptions caused by a non-performing carrier.

Further, executing spot transactions requires more effort than long-term contracts, as prices need to be negotiated for every job. With hundreds or thousands of jobs per day, this results in substantial effort levied on a dispatching organization.

Hybrid Strategies

Next time, we will be looking at hybrid strategies combining private fleet, spot contracts, and long-term contracts. What are the benefits and the challenges such an approach? Why should you look into it for your transport procurement?