For some, the weakening global economy has pushed the high cost of fuel from top priority and relegated it to the back burner. Doing so, however, can be a big mistake.

It is true that in October, crude oil retreated 40% from its July 11 high of $147.27 per barrel, which seems to indicate the threat of the $200 a barrel has disappeared. Whether fuel will return to its triple digit figures or remain at sub-$100 per barrel levels is a matter of speculation. But one thing is certain: your preparedness in dealing with the impact on supply chain of increasing or fluctuating fuel costs and increasing macroeconomic volatility can make or break your organization.

Fuel costs can no longer be considered static or less significant than other supply chain costs such as inventory, labor or raw materials. Knowing the full impact of current fuel costs on your supply chain and having a perspective on how those costs affect your suppliers─as well as your customers─will allow enable you to respond with all the levers at your disposal. Among these levers are changes in sourcing location, transportation mode, distribution/manufacturing network design, inventory levels, order frequency and even pricing. 

Supply chain practitioners will have to re-evaluate these levers frequently to deal with global macroeconomic volatility. Only through insightful analysis will they be fully aware of the optimum decisions for their supply chain in multiple macroeconomic scenarios. Only then can they create the flexibility in their supply chain to quickly align with this optimum design. 

This article identifies and defines those levers and offers questions that practitioners should be asking in relation to their own set of circumstances.

Exchange rates and geography

The first important lever for the supply chain decision maker that is profoundly linked with fuel costs is choice of sourcing location and exchange rates. 

Low cost country sourcing (LCCS) has become increasingly prevalent. But if fuel costs climb above $150, sourcing from within the U.S. or from Mexico will become attractive in categories where savings from LCCS were in the low-to-medium range.

When fuel was $30 a barrel, most companies obtained an 18% to 25% cost savings from China sourcing. They enjoyed those savings in return for increased complexity, longer lead times, and poor on-time delivery (e.g., 3 x lead times and 9% On-Time-Delivery on electronic components from China compared to 81% OTD from near-shore sourcing). 

Freight costs from China were on average 20% of landed costs of goods, and fuel was on average 20% of freight costs.  Consequently, a rise in fuel costs by 400%, from $30 to $150 a barrel, would translate to a 16% increase in the landed cost of goods (assuming the shipper passes on the entire cost increase). This rise will wipe out almost all the savings from LCCS in some categories. The recent lifting of some fuel subsidies by countries like China, India and Indonesia will make raw material and production costs in these countries go up, putting further pressure on the savings from sourcing.

Furthermore, hedging against exchange rate risks has to be integrated into the sourcing strategy. The burden of importing with rising fuel prices has been exacerbated by a decrease in the value of the U.S. dollar. Historically, an increase in oil prices is accompanied by an increase in the value of the USD. That makes imports cheaper—creating a natural hedge against rising transportation costs. Instead, oil prices increased almost six fold since 2002, while the dollar has slid against most major currencies in the same time period.

To deal with this double whammy of rising fuel costs and a falling dollar, the sourcing executive must effectively answer the following questions:

•    Do I understand my total cost of ownership (TCO), including my detailed landed costs?

•    What is the inflection point in the price of crude and the USD exchange rate at which one sourcing location will become unviable compared to another?

•    For which categories of sourced goods is transportation a large component?

•    Can the cost increases in these categories be passed on to customers?

•    Can a premium be obtained for shorter lead times or on goods made in the US?

•    Are the savings on these categories sufficient to justify continued LCCS, or should they be near-shored?

•    Should the prices with suppliers be contracted in USD or in local currency?

•    Should length of contracts be re-evaluated to protect from further increases in fuel costs and currency depreciation?

•    Which suppliers are more fuel efficient or improving fuel efficiency levels?

•    Is one country a better long-term choice because of proximity to oil, government subsidies on fuel, availability of alternative energy sources, etc.?

Transportation mode

Another lever that the supply chain practitioner can use to control supply chain costs is choice and mix of transport mode. With rising fuel costs, fuel efficient modes of transport will replace quicker and more fuel intensive forms.

The rise in fuel prices has widened the cost gap between air freight and ocean freight, as the corresponding fuel surcharges have been much higher in air freight. Today, sending a container from Shanghai to the U.S. West Coast by air costs about 10 times more than by ocean.

In addition to this widening cost gap between the two transport modes, experts say that as much as 80% of intercontinental air cargo moves by air for time-definite reasons, and not for the lower transit time offered. To meet this time-definite need, ocean carriers are providing services that compete in time-definiteness with the low end of air freight services. For example, Con-way Freight and APL Logistics both recently introduced accelerated ocean-truck service. This new ocean LCL/domestic LTL service from China offers faster transit times and day-definite delivery at a lower cost than air freight, while potentially taking 10 to 20 days of variability out of the supply chain.  This capability should have a large effect on inventory levels and product availability.  These time-definite ocean services are meaningful to air freight users that import high value, short shelf-life products such as toys, electronics and fashion merchandise.

The widening gap between the two modes of transport, accompanied by the new time-definite services offered by ocean carriers, has allowed ocean container freight to capture market share from air freight. Ocean freight has grown by 9.5%—more than double the growth in air cargo between 2000 and 2005. An extreme example of this mode shift from air to ocean is the exports of LCD displays and monitors moving out of Korea, which in the past were moved exclusively by air. Virtually all of these products are now shipped by ocean vessel.

Domestically, ground transport is now competitive with air freight for up to 1,000 to 1,500 miles. LTL truckers are now offering two- to three-day time-definite service, which is adequate for many domestic shippers. 

While making a choice on transport, the sourcing strategist should consider the following questions:

•    What categories of goods are air-freighted most frequently?

•    What percentage of air freight is for time-definite reasons and what percentage is for transit time reduction?

•    Can the goods shipped by air freight for time-definite reasons be shipped by the newly offered time-definite ocean freight or ground services?

•    Can a portion of demand of goods that are regularly air freighted be near-shored and ground shipped?

Distribution and manufacturing networks

To deal with rising fuel costs, supply chain practitioners have still another lever they can push─distribution and manufacturing. As fuel costs rise, distribution and manufacturing will become more decentralized. Supply chain executives will see the necessity in having more distribution centers in the network to get closer to customers and reduce outbound shipping costs.

Analyses by Dr. Simchi Levi, a well-known MIT professor, bear out this thinking. Dr. Levi studied the impact of rising fuel costs on a company’s supply chain network design. The study reveals that rising transportation costs would prompt a design change in the core supply chain design for that company only when oil rises beyond the inflection point of $150. Dr. Levi’s analysis to determine the optimal manufacturing mix for the company reveals that with oil at $75, the optimal mix is to produce 22% of goods in its Philadelphia location and 78% in Juarez, Mexico. But as oil rises to $200/barrel, the higher transport costs from Mexico make it less viable. Mexico’s recommended manufacturing share then drops to 54%. A new location within the States takes most of the change, even though it has higher labor costs.

The same analysis reveals that even with oil at $125, the optimal distribution network design stays the same, with five distribution centers within the States. But once oil climbs beyond $150, the optimal network changes to include seven distribution centers.

When configuring the right network design, the sourcing executive must consider the following questions:

•    What costs/barrel were assumed when manufacturing and distribution networks were designed?

•    What will be the optimum networks at different oil prices, and what is the inflection point at which a change in design is needed?

•    Can a design deliver flexibility to achieve near optimum cost and service at varying oil prices without sacrificing large investments?

•    Are there specific customers that have become too expensive to serve, and can this increase in supply chain costs be passed on to them?

Inventory management

Still another critical component in supply chain design is inventory management. With fuel costs rising, inventory policies such as just-in-time (JIT), which were designed when fuel was cheap, have to be revisited. 

Most retailers and manufacturers that sit at the end of the value chain have pushed the burden of maintaining inventory down to their suppliers. These suppliers, in turn, are holding higher buffer inventories to hedge against uncertain delivery times or supply disruptions, and to still be able to deliver in a JIT fashion.

Though the costs of maintaining a JIT inventory system are being eaten by suppliers, rising fuel costs will not allow this for long. If the economics of the entire value chain are taken into account, there will be an inflection point in the cost of fuel where maintaining buffer inventory will become the right answer compared to frequent milk-runs by suppliers and maintaining a JIT system. While the costs of fuel could continue to rise, the cost of carrying a buffer inventory for retailers and manufacturers will not increase appreciably as long as long term interest rates (which determine 70% to 90% of inventory costs) grow only incrementally. Such a change in inventory management policy has to be accompanied by an agreement on sharing across the supply chain the savings from lower transport costs.

When analyzing the right inventory management policy, the supply chain executive must consider:

•    What costs/barrel were assumed when the current inventory policies were designed?

•    Have the costs of running a JIT system been considered for the entire value chain?

•    What is the optimum inventory management policy when oil is at different price levels?

•    What are the savings that suppliers experience in transportation and other costs when a lean inventory system is replaced with a system that maintains buffer inventory?

What's a supply chain executive to do?

Probably the best place to start is to create a customized and flexible distribution and manufacturing network design that fosters fast response to changing macroeconomics, minimizes costs, and delivers against required service levels. Next, analyze costs of holding increased inventory and the corresponding savings from reduced transportation needs. Conduct this analysis under likely interest rate and fuel price scenarios versus maintaining current replenishment cycles and minimum-order quantities.  In addition, design a category-wise sourcing strategy with the right mix of LCCS and near-shore sourcing. Build a decision framework for choosing between time-definite and normal transport services as well as between the modes of air, ocean and ground.

Taking these steps will prepare the organization for whatever shifts the price of fuel makes. wt



Michael Deering is Managing Partner and CEO for Alaris Consulting with over 20 years of experience in global supply chain management and operations improvement. Bob Forbes is a Partner for Alaris Consulting with over 20 years of consulting and industry experience in manufacturing, consumer products, and retail industries. For more information on our supply chain advisory services, please visit our Web site at www.alarisconsulting.com.