Management Accounting

Sucking It Up

With prices gushing past $100 per barrel, companies are trying to consume less oil.
Vincent RyanApril 1, 2008

Here’s a consequence of escalating oil prices that many businesses have yet to contemplate, or don’t want to: The supply-chain management strategies spawned during the last 20 years — quick transport, lean inventories, and a growing reliance on low-cost, offshore labor — may not make good business sense anymore.

Why? The era of cheap oil, which those strategies depended on to be economically viable, is over. Crude-oil prices in the United States have reached the stratosphere, setting an inflation-adjusted record of nearly $110 a barrel in early March. They could rise by 50 percent in as little as two years, if recent predictions are anywhere near accurate.

The long-term supply outlook is not promising: petroleum production levels are showing signs of peaking, as the world’s huge fields are depleted. In the United Kingdom’s well-harvested North Sea, producing a barrel of oil now requires a capital outlay four times greater than in 2003. On the demand side, the U.S. Energy Administration projects that worldwide oil needs will reach 98 million barrels per day by 2015, up from 2007’s 85 million barrels — an output level experts see as a long-term peak.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Much of this fossil fuel is being burned in corporate supply chains. The movement of goods by truck and rail consumes 20 percent of all energy used in transportation, which itself consumes one-third of all energy. In commodities businesses, total logistics costs can account for as much as 15 percent of a product’s total cost, says Steven Serneels, a partner at S&V Management Consultants in Belgium.

Reducing the supply-chain consumption of expensive oil has therefore become a priority for many companies. No, they aren’t giving up just-in-time inventory strategies — not yet anyway. But they are adopting practices that use fewer trucks and save thousands of gallons of fuel — also cutting costs, as it happens — while still being efficient. Given that the United States uses 25 percent of the world’s oil and demand from emerging economies is escalating, “there will have to be big changes” in supply chains, says Chuck Taylor, president of Awake Consulting. “Conservation is the biggest and quickest way to extend the supply of oil.” Adrian Gonzalez, a consultant at research firm ARC Advisory Group, agrees: “It’s something that hits the bottom line; it’s very evident. You have more control over it, and it can make a bigger impact” than other green strategies.

Inventory policies, sourcing, and distribution-network decisions have a direct impact on oil consumption. As a first step, some companies are looking to what happens on the highways — although it can be tough to eke out savings.

Streamline the Fleet

Companies are upgrading their fleets of trucks with auxiliary power units, automatic tire-inflation systems, and enhanced trailer aerodynamics (such as spoilers), as well as switching from large tractor-trailers to smaller trucks when delivering finished product into congested cities. Wal-Mart, which operates its own vast fleet, is saving 60 million gallons of fuel annually by using some of these strategies. The retailing behemoth intends to double the fuel efficiency of its fleet by 2015.

More than 600 carriers and shippers have signed up for the Environmental Protection Agency’s SmartWay program, a voluntary freight-industry partnership aimed at fuel-efficiency improvements and reduced CO2 emissions. SmartWay offers a small-business loan to help trucking companies purchase upgrade kits (average price: $16,500) that include idle-reduction devices, low-rolling-resistance tires, aluminum wheels, and aerodynamic equipment. But the payback from these upgrades is not always immediate, Gonzalez says.

Count the Miles

An easier way to cut oil consumption may be simply to ship products fewer miles. “Once you get to $100-per-barrel oil, the incremental cost of adding smaller warehousing facilities closer to the customer to drive down transport cost makes sense,” says Curtis Greve, executive vice president at Pittsburgh-based Genco, one of the largest third-party logistics providers in the United States.

The high cost of oil was a principal driver of Kimberly-Clark’s “network of the future.” Begun three years ago, the project involves moving the company’s distribution centers closer to end-users in major markets, says Mark Jamison, vice president of Dallas-based Kimberly-Clark’s customer supply chain. Kimberly-Clark also decided to lease distribution centers and have them run by third parties, so the network can flex as market conditions change, Jamison says.

So far, relocating distribution centers has reduced customer miles (the miles driven from a center to a customer) by 2.8 million and cut fuel use by 500,000 gallons. The new network has also enabled Kimberly-Clark to use more intermodal transport — in particular, “trailer on a flat car,” in which the long-haul portion of a product’s journey is by rail. Rail use saved the company almost 2 million gallons of fuel in 2007 alone, Jamison says.

The network has yielded customer benefits, too. By locating its distribution centers closer to major markets, Kimberly-Clark has cut the time needed to replenish customers’ shelves. “Now, within 85 percent of North America we’re within one day’s transit time,” says Jamison. “With the previous network, it was 65 percent.”

For fast-growing businesses such as United Natural Foods, rising fuel costs make a more compelling business case for distribution facilities that reduce the miles that products travel. The new distribution centers that the company opened last year have helped its fuel consumption grow more slowly (10 percent) than its business volume (mid-teens), says CFO Shamber.

Higher oil prices are also exacting a toll on offshore outsourcing, where manufacturers may be located 10,000 miles from consumers. Rhode Island–based toymaker Hasbro, for example, expects a 15 percent increase in the costs of made-in-China products in 2008. CFO David Hargreaves says some of Hasbro’s Chinese vendors are relocating portions of their supply chains from coastal to inland areas to cut labor costs, thus adding even more shipping miles between factories and consumers.

Still, “the price of oil would have to increase fairly dramatically to wipe out completely the benefit of manufacturing in China,” says Lorcan Sheehan, senior vice president at ModusLink, a Massachusetts-based supply-systems vendor.

Pack Smarter

In the drive to cut fossil-fuel consumption, truck loading has become a science. Fitting more product on a pallet can mean less-frequent trips and fewer trucks. By eliminating an outer carton from its Knorr vegetable-soup mix and creating a new shipping and display box, for example, Unilever halved the packaging. That resulted in 280 fewer pallets and six fewer trucks a year to transport the same quantities.

Similarly, Wisconsin-based consumer-goods company S.C. Johnson saved $1.6 million, cut fuel use by 168,000 gallons, and used 2,098 fewer trucks in 2007 through a “truckload utilization project.” The project changed the company’s habit of packing Windex glass cleaner and Ziploc bag products in separate loads, because it found it could utilize the vehicle’s maximum load weight by mixing them. The company also used more “day cabs” (trucks with no sleeping compartments) because they are 3,000 pounds lighter and can hold more product.

Many companies have been asking, “Why do we have an extra two inches of air space in our container design?” Genco’s Greve says. “The impact of design on the cost of transportation is on the radar screen of marketing departments and designers.”

For 2008, Kimberly-Clark is also working on packaging. To outfit items such as Depend undergarments with end-of-aisle displays, the company used to ship the finished product to a co-packer that assembled the displays and returned them to Kimberly-Clark docks. Now the company is putting the co-packers into its own distribution centers to assemble the displays, so that the products make only one outbound trip. “This one is a slam dunk,” Jamison says. “We’ll start saving money the minute we start.”

Rethink JIT

Other supply-chain management strategies that developed in the era of cheap oil will almost certainly have to be rethought. Example: just-in-time delivery to keep inventory costs down.

In Europe, with gasoline and diesel representing 20 to 30 percent of total transport costs, companies shipping or receiving low-value-density products like food or commodities are seeking a new balance between working capital and the cost-to-transport, says S&V’s Serneels. In doing so, they are making JIT less of a priority. Some customers are becoming content with fewer shipments to avoid less-than-full truckloads, he says, accepting slight increases in working capital to reduce transportation costs.

A European organization called ELUPEG (European Logistics Users, Providers and Enablers Group) is even helping competitors team up for fuel reduction. For example, a distribution center in Holland serves two independent manufacturers (Lever Faberge and Kimberly-Clark) with consolidated deliveries to retailer sites. Benefits include increased delivery frequency, lower inventory, fewer out-of-stock situations, and improved on-time performance, according to Alan Waller, vice president of supply-chain innovation at Solving International, a UK consultancy.

Aligning the interests of supply-chain partners and competitors in the United States may be more difficult. Over time, service-level agreements with suppliers will develop to include clauses requiring the partner to disclose its oil footprint, “but it will be a relatively slow adoption and evolution,” predicts John Fontanella, vice president of research at AMR Research.

Looking Down the Road

Expensive as oil is at present, it could get worse in a hurry. A disruption of the thousands of barrels flowing into U.S. ports per day is certainly a possibility, given that the politically volatile countries of Venezuela, Nigeria, Angola, and Iraq were among the top 10 oil suppliers to the United States last year. But Taylor of Awake Consulting contends that, in general, companies are not concerned yet about making a supply chain more resilient in the face of possible oil shortages.

Such passivity may be the result of two things. First, over the past 30 years, the cost of oil has caused no degradation to service levels, whether it be air, ocean, or surface transport. Second, companies continue to believe that higher oil prices can be passed downstream. “If diesel were to go to $4 to $5 a gallon, in all likelihood [we would absorb some of it], but a portion is going to get passed on to our customers,” says Shamber of United Natural Foods. How economically viable that will be remains to be seen.

What about alternative energy sources? Ethanol has long been heralded as a substitute for gasoline, but it takes more energy to produce a gallon of ethanol than the fuel delivers, points out Taylor. In 2007, according to the American Trucking Association, the U.S. biodiesel industry produced about 400 million gallons of biofuel, an amount the ATA calls de minimis.

Organic grocer Whole Foods Market Inc. started converting its trucks to run on a biodiesel blend (B20), made from vegetable oils or animal fats, in late 2006. Four of its nine regional distribution centers have trucks that run on biodiesel. But B20 is still 80 percent petroleum, and the trucks have to be filled from tanks on the distribution center’s premises.

United Natural Foods, based in Dayville, Connecticut, has also tested biodiesel, but CFO Mike Shamber doesn’t see it as commercially viable yet. “Manufacturers haven’t modified engines enough so they can run on those fuels for a longer period,” he says.

In the long run, companies have to learn how to become energy-efficient customers, not just energy-efficient suppliers, says Larry Lapide, director of demand management at MIT’s Center for Transportation & Logistics. He says Wal-Mart’s recent efforts to green its supply chain probably won’t change its own stringent demands for supply-chain partners to meet JIT delivery windows, for example. “They’ll still want JIT replenishment, forcing smaller, more-frequent deliveries that require the use of less-oil-efficient transport modes,” Lapide says.

But companies are at least beginning to consider that a different sort of supply-chain calculus is required in an era of expensive oil. Says ARC’s Gonzalez: “If you believe the environmental problem is big and you have a finite window to solve or control it, we have to start doing things that are not just good for business.”

Vincent Ryan is a senior editor at CFO.

Oil Change

Before oil prices skyrocket further, companies should redesign their supply-chain networks for maximum fuel efficiency. Here’s what CFOs can do:

Review Frequently. Companies usually wait until they enter new markets or acquire other businesses to analyze the oil consumption of their distribution networks. That’s a mistake, says Mark Swenson, a vice president at Miami-based Ryder System Inc. Optimizing the supply-chain network should be a continuous effort, he says. Growth-phase outfits should be adjusting distribution-center locations according to developing demand, for example, while mature companies need to find facilities that can be shut down.

Know Total Costs. To sustain oil-reduction projects, CFOs have to help supply-chain executives obtain data on product-specific and network-wide costs. And they have to be aware of the effect of oil-reduction strategies systemwide. Even as warehouses lower transportation costs, for example, inventory carrying costs rise due to the safety stock each facility must have on hand.

Apply What-Ifs. Is your supply-chain network designed for what’s coming in five years, or even three? “I’d advise any CFO to become aware of not just their company’s petroleum spend but how their distribution system works and what the impact would be of oil shortages or $10-a-gallon fuel,” says Chuck Taylor of Awake Consulting.

Consider Outsourcing. It may help smooth the effects of violent spikes in fuel expenditures. IBM, for example, has outsourced all distribution since 2001. Increases in fuel costs are managed through agreements with logistics providers, says vice president of global logistics Gary Smith. If the price of jet fuel fluctuates outside a set band of 10 percent from an index price, only then does IBM pay a surcharge or receive a discount. After that, the index price resets. Since 1996, IBM’s hardware revenue has fallen 28 percent, but its logistics costs are down 47 percent. — V.R.

West Texas intermediate spot price for crude oil
Projected global oil production vs. demand