In Search of Alternatives to Truckload’s Fragile Freight Contracts
by Chris Caplice, David Correll, and Ken Cottrill
When a shipper and a trucking company contract to transport goods at a given time and rate, there is no guarantee they will meet the agreement’s terms. The loads may never materialize, or the carrier may not have the capacity in the right place when it is scheduled to haul the cargo.
To an outsider, it might seem odd that contractual agreements that are binding in price, but not in volume or capacity, are dominant in the truckload transportation industry. These contracts are used because it is the only way that shippers and carriers have been able to handle the volatility and variability of trucking demand and supply. But they do add costs and reduce the efficiency of freight networks.
Is there a better way? MIT CTL’s FreightLab believes so and is developing alternative contract formats that solidify full truckload agreements and give shippers and carriers more certainty about future freight movements.
These alternatives were discussed by over 200 executives from shippers, carriers, brokers, logistics service providers, and academic researchers over two virtual events this fall. The first event, a webinar titled State of the Art in Transportation Contracts, was held on Nov. 3, 2020, and presented a detailed history and overview of the current state of the art and practice in shipper-carrier relations. A week later, on Nov. 10, a smaller, select group of executives participated in the highly interactive Innovations in Transportation Roundtable: Transportation Portfolio Management, where they discussed their experiences in greater detail.
Stumbles at the second hurdle of the procurement process
Shippers typically bid out their freight business to carriers in an annual auction. They can tailor the auction event to their supply chain needs and preferences. For example, a shipper might incorporate incentives that favor the incumbent carriers it prefers. Another device is to build service constraints into the auction that effectively limits the cargo volumes awarded to individual carriers. This approach to securing truckload capacity is called optimized procurement and, after being pioneered at MIT CTL in the 1990s, has become common practice over the last 20+ years.
After the shipper broadcasts its freight transportation needs, carriers submit their offers for winning the business. The optimization tool selects the winning carriers on each lane or segment of business, and these are fed into its routing guide. The routing guide is a catalog that lists trucking companies the shipper will work with in order of preference from primary carriers to back-ups and specifies which carriers to choose in certain lanes and between origins and destinations. This assignment of carriers to lanes is the first moment of truth in transportation procurement.
Assuming the auction goes according to plan, the shipper allocates its freight business for the year to preferred carriers, and the trucking companies that win the bid secure business for their networks.
The transactions are completed when the freight is tendered and delivered by the designated carriers — but not always. All too often, the procurement process breaks down at this second moment of truth when an actual load is tendered to a designated carrier.
Reasons for reneging on contract agreements
When the tendering date arrives, sometimes carriers reject the loads. There are various reasons for pulling out of the agreement. Maybe the trucking company’s transportation network or fleet have changed in the interim, and the business it won is no longer profitable. Sometimes it is the shipper that abandons the deal. Again, there are various reasons for this behavior. Perhaps the shipper’s business has changed, and the loads it offered during the bid are no longer available. Loads that were bid out and awarded to a carrier but fail to materialize are known as ghost freight. Interestingly, ghost freight is rarely tracked, and its magnitude is only estimated anecdotally.
If the carrier is the culprit, the shipper must scramble to find alternative truck capacity; a tough ask if the truckload market is tight. Its first line of attack is to look in the route guide and go down the list of preferred carriers. If none are available, the shipper may have no choice but to resort to the spot market, where one-off deals for carrying freight are priced according to current supply and demand. In both cases — but especially the latter — the shipper will probably end up paying significantly more for truck transportation than it budgeted when its freight was put out to bid.
Research carried out by FreightLab in collaboration with logistics services company C.H. Robinson showed that the deeper a shipper goes into its routing guide, the higher the costs. For example, if a shipper goes down to the fifth choice of carrier in its routing guide, transportation costs could increase by some 15% over the primary contracted rate. If the company leaves the guide and uses the spot market, the increase could be more than 20–30%. These percentages can change significantly depending on the tightness of the truckload market.
Moreover, FreightLab’s research indicates that routing guides degrade as the number of loads rejected by primary carriers increases over time. The rate of degradation varies from shipper to shipper and from lane to lane.
When ghost freight is the problem, the price paid by carriers can be just as high as that paid by shippers for absentee trucks. First, the trucking company loses the business. Second, the efficiency of its network is compromised because the carrier has positioned vehicles to carry freight that is no longer available.
The portfolio route to freight contracting
A possible solution under development at FreightLab is the Transportation Portfolio Management approach to procuring truckload carrying capacity.
The central idea — which is not new — is that not every lane in a shipper’s network is equal, so why treat them as such when bidding them out? A more nuanced approach is to classify lanes according to where they are positioned between two extremes: those associated with consistent, balanced freight flows, and those where freight patterns are inconsistent and unbalanced. The type of lane is matched to the type of truck transportation best suited to carry the freight. Stable lanes are supported by dedicated fleets (trucks committed to respective lanes). Lanes in the middle of the spectrum are serviced by contract relationships (long-term contractual agreements with carriers). The spot market is reserved for unstable lanes.
A critical issue is how to structure the contracts within these different categories of lanes to make them enforceable. Current practice involves contracts that specify price and volume but ultimately are non-binding. There are alternatives, such as contracts that stipulate guaranteed volumes, or contracts based on tiered pricing schemes where the shipper pays different prices according to the volume of cargo carried in a lane by the day or week.
Another possibility is index-based pricing, where carriers’ rates are set in line with some mutually acceptable industry index. This concept is the foundation for adjustable-rate mortgages in the housing market. A corollary closer to the trucking world is the fuel surcharge, where shippers compensate carriers for fuel costs through a surcharge based on the prices listed in an industry index.
Leading the way with transportation contract research
FreightLab is helping the industry understand these alternatives and how to apply them with a comprehensive portfolio of research projects.
The lab’s research team and graduate students have completed dozens of research projects with various companies on numerous freight transportation topics over the last ten years. While all modes and geographies have been addressed in this research, the Lab tends to focus on improving the $670 billion US trucking market.
In 2021, we are continuing to focus on this exceptionally large and fertile market with three key initiatives:
- The Transportation Portfolio Management project discussed at the above virtual events is developing better ways for shippers, carriers, and 3PLs to work with each other. Specifically, how to employ a range of relationship forms from dedicated to contract to spot and the potential of index-based contracts in improving relationships.
- The Driver Initiative is looking at how to improve the efficiency of truck drivers as well as their general work environment.
- The Freight Resilience Project aims to provide a better understanding of how short- and long-term disruptions impact freight networks and how the industry can be better prepared for these occurrences.
In addition to these long-term research projects, in 2021, FreightLab will be holding quarterly virtual webinars and roundtables to discuss current topics of interest.
FreightLab is actively looking for shippers and carriers to participate in its transportation contract research. For further information, please contact the authors.
