Is it possible to create a fuel surcharge program that is consistently fair to shippers and carriers?
As we have seen over recent months, the cost of motor vehicle fuel is a national preoccupation. Perhaps this is one reason why rising prices at the pump, and mechanisms such as fuel surcharges that are designed to spread the pain between shippers and service providers equably, attract so much attention.
Another possible reason is that freight practitioners come under pressure to control fuel costs when prices are climbing. Corporate procurement departments are not always familiar with the intricacies of freight transportation. When fuel prices are rising, procurement has been known to increase scrutiny of transportation managers’ decision making and pricing practices.
Even though these competing interests are unlikely to disappear, creating an unbiased surcharge formula that works for all parties in the transaction does seem like a good idea. Such a solution would remove – or at least mitigate – a potential source of conflict between shippers and transportation providers.
One reason why this subject sparks lively debate is that some believe surcharges are not always used to fairly distribute the costs between shippers and providers. The challenges of such programs are highlighted in research carried out recently at the Massachusetts Institute of Technology (MIT)[i] . The graduate students in the MIT Supply Chain Management (SCM) program at the MIT Center for Transportation & Logistics, point out that when a shipper modifies a fuel surcharge, “the carrier will counter with an adjustment to the line-haul bid. This means that ultimately line haul rates and FSC (fuel surcharge) schedules are compensating.” This “revenue neutrality” means that “it does not seem possible for a shipper or carrier to establish a new FSC or modify their existing FSC in order to significantly reduce costs (shipper) or increase revenue (carrier),” according to the researchers.
But even if a fair-minded fuel surcharge is desirable, is it possible? The answer is affirmative, providing more thought is given to how the formula is structured.
The number of miles that a truck covers does not necessarily correspond with the point-to-point distances between origins and destinations, for instance. Calculating mileage when driving a car is relatively straightforward: you simply record the odometer readings at the beginning and the end of a trip. In trucking industry parlance this is called hub miles (hub refers to a wheel hub or the actual miles traveled). However, carriers don’t get paid on the actual distance traveled but according to a set of theoretical miles derived from a mileage program.
Another complication is deadhead miles, which can significantly increase the distance covered to deliver a load and hence total fuel consumption. Short haul carriers tend to have higher deadhead mileage and probably worse fuel economy in terms of the number of loaded miles they travel.
The three scenarios below illustrate how these factors affect the miles per gallon (MPG) figure that is the basis of fuel surcharge programs. The calculations show what the real MPG should be in order to fully compensate the carrier for the distance it covers. The hub miles refer to the actual distances traveled by the carrier, and the paid miles are point-to-point map distances as measured by guides such as PC Miler or Rand McNally.
We compiled the figures for illustrative purposes only. Scenario 1 might be a long haul carrier being paid on short miles. The statistics in Scenario 2 fit the profile of a regional short haul carrier with higher dead head. Scenario 3 depicts a long haul carrier being paid on practical miles. The difference in effective MPG between the highest and lowest scenarios is 17%; a significant number.
The MIT researchers maintain that the escalator, the factor that represents the fuel efficiency of the carrier’s fleet in the fuel surcharge equation, is the “most contentious issue of the FSC discussion.” The above three scenarios illustrate why. The escalator defines whether a fuel surcharge is perceived as “at-market” or “below-market” or “generous” by carriers. Even a generous surcharge is not necessarily well received by carriers because “it forces them to drop their line-haul rates, in effect, placing the cost of transportation into the FSC.”
So what is an equitable solution? I’m not sure there is a single answer. However, one way to minimize the variance in these scenarios is to set a fuel surcharge program base or trigger point as close as possible to your average fuel cost. This minimizes the amount of variance between your fuel escalator and the carrier’s actual needs. The approach is not without risk since a decline in fuel costs will require you to reduce the carrier’s rate, and as a manager you will have to explain why these costs have moved from the fuel surcharge expense bucket to the line haul bucket.
Do you agree, and what is your experience? We welcome your input.
[i] “Risk Sharing in Contracts: The Use of Fuel Surcharge Programs,” Madhavi Kanteti and Jordan Levine, MIT Supply Chain Management thesis, Class of 2011. To view the abstract and Executive Summary, visit http://ctl.mit.edu/library/risk_sharing_contracts_use_fuel_surcharge_programs. To request a copy of the full thesis, please contact Dr. Bruce Arntzen, Executive Director, MIT Supply Chain Management Program at: email@example.com.