The important pricing increment that keeps you profitable
In this, the fourth part of this 12-part series on freight/logistic pricing, we diverge slightly from examining an actual specific pricing strategy in order to put ‘contract escalations’ under the magnifying glass. Escalations are usually in place across the vast majority of contracts, but what are good and bad contract escalations? This article will attempt to address this dilemma.
ESCALATORS ARE VERY COMMON IF NOT ESSENTIAL
Throughout the life of most freight or logistics contracts there will be regular periods when cost increases are sought.
This could be quarterly, bi-annually or annually. It is unusual that a fixed price contract is put in place for a three- or five-year period without escalators as it adds very considerable risk to the provider, who would usually seek a hefty premium to cover that risk and still not be certain of full cost cover if a very hefty fuel increase happened, for example. So certainly at least annual escalators are warranted.
Some 20 years ago, it was not uncommon that some quite simplistic escalation clauses were used for contract negotiations, and some of these are still being used, for example the consumer price index (CPI) and the transport consumer price index (TCPI).
Surprisingly, these escalators were used although their relationship, to say road freight transport, bore little refection to the costs incurred by operators. The CPI has virtually no useful componentry for truck operations and transport CPI comprises an average of public transport fares and the family passenger car, although the fuel index can be useful.
Some 25 years ago, a few private, and detailed, indices appeared on the Australian road freight scene, and in March 1997 the Australian Bureau of Statistics released a road freight Producer Price Index (PPI), which reflected an index of prices paid, but not costs incurred. It is also a mixture of different road freight services, and this index, if used as an escalator, might not truly reflect the costs that a specific B-double operator incurs as opposed to a courier operator.
So, what should an operator do other than the ‘open book’ alternative, which has also been around for 20-plus years?
Open book relationships can be expensive with regard to auditing, and still leave room for less than honest behaviours by unscrupulous operators. Some contracts, however, do work exceptionally well and are to be applauded.
CONSTRUCTING A FORMULA
Hopefully operators know their costs. Let us assume this is a given, which may not always be the case. However, from the costs, at a point in time, the operations cost profile can be constructed. This will be different for each vehicle configuration and operation.
Table 1 is such an example, which were the surveyed cost profiles for two common types of performance based standard (PBS) vehicles: a linehaul A-double and a peri-urban rigid truck and four-axle dog trailer. Although these are actual cost profiles they are not directly comparable, as the profiles were constructed on a cent/kilometre basis. However, the A-double performs some 240,000km/annum, whereas there are only about 110,000km/annum performed for the PBS truck and four-axle dog combination.
Here are some rules to help you construct your own escalation formula:
Rule 1: The cost profile segments should reflect the actual makeup of the operation. This author did experience an escalation formula between two large corporates for road/air operations where some 16 inputs were used, however, only half that number could actually be measured. One input involved industry efficiency gains, which was almost impossible to measure. (CPI-X percentage productivity measures were fashionable, but in these days of low inflation and where the customer is going to get the efficiency benefits anyway, the scheme is not nearly as common as some 15 to 20 years ago.)
Rule 2: If a cost profile is agreed at the beginning of a contract then the easiest way to escalate each input in the cost profile is by an agreed external measure, or public source. This saves very significant haggling if the labour, fuel and tyre costs escalators have been agreed at the time of the contract kick-off.
Rule 3: Allow for unexpected large rises and falls. For almost three years, we saw diesel prices fall, but this trend has been reversed over the last 12 months. Instead of waiting for a quarter or a year to have these costs recouped, often an ‘exception clause’ might be inserted so that an interim increase can be triggered if a particular input was to rise by more than say 10 per cent. Usually this would only apply to fuel, as other inputs are usually better behaved, although some very significant jumps in registration charges have been seen over the last decade for some configurations.
Rule 4: Productivity arising from the use of new vehicle configurations will, and must, be shared with the customer. Often if this is not done and some customers have not been aware that on some corridors, B-doubles, for example, had been replaced by more efficient configurations, and then that customer becomes aware, and the incumbent operator can usually wave the contract goodbye.
Rule 5: Have operations be part of the calculation process for changes in the cost profile escalations. The corporate accountants from either purchasing, accounts, or the respective product areas sometimes need close supervision, despite their good intensions.
ARE THERE GOOD AND BAD ESCALATORS?
Figure 1 compares three common public and one private escalation formulae over the last four years.
The escalators are: the ABS’ PPI, national CPI, national transport CPI, and a private long distance road cost index. Since June 2014, a CPI-adjusted formula has risen by 6 per cent and the road freight PPI has risen by about 2.4 per cent. However, customers have been aware that fuel prices in particular were falling and capital costs had been somewhat stagnant, while wage growth continued to see enterprise bargaining agreements around the 2 per cent mark of recent times, despite the Fair Work Commission’s attempts to up the basic wages with increments near the 3.5 per cent mark. Because of fuel decreases, most customers would have demanded a discount to either CPI or the ABS’ PPI.
In fact, over this period, transport CPI was actually close to a private long-distance articulated cost index. However, over much longer periods, transport CPI generally understates truck costs as the basket transport CPI is drawn from, as stated above, comes from public transport (trams, trains, buses, etc.) fares and the urban passenger car.
So what are the learnings when constructing a contract escalation formula?
Know your cost profile, pick a set of external public measures to escalate each input by (this will say time and arguments), and make allowances in the rules for unforeseen surcharges, and lastly share productivity.
Happy negotiations!
12 FREIGHT PRICING STRATEGIES SERIES
Part 1: Network link (density) pricing