For many companies, 2015 is looking rosy. The overall economy is finally accelerating out of the worst recession since the 1930s, helped in no small part by construction as the Construction Backlog Indicator (published by Associated Builders and Contractors) reached an all-time high in June.

J. Michael Kilgore

J. Michael Kilgore

But the recent rise in consumer spending has fueled inflation speculation, foreshadowing an inventory carrying cost upswing in the form of rising short-term borrowing rates. Couple that with a truck driver shortage and the resulting upward pressure on freight rates, 2015 may challenge CFOs of product-based companies to guide financial policy through turbulent waters.

Balancing Trade-offs

To effectively manage supply chains, one must tame the three-headed trade-off monster. Or, simply put, balance service levels, capital and operating expenses. One of the classic supply chain choices is to lower inventory and the resulting carrying costs, which generates higher freight costs and thus an increase in operating budget to sustain the same level of customer service. While this is a dramatic oversimplification that omits the more strategic supply chain infrastructure decisions, it captures the essence of the many tactical and operational decisions that supply chain leaders are faced with every day.

Each day, decisions are made that trade-off the balance between transportation (operating expense) and inventory (working capital). These costs are heavily influenced by market and regulatory forces that dictate the cost of holding inventory in the form of short-term interest rates and the cost of freight transportation driven by capacity. When these rates are stable, supply chain costs exist at an equilibrium that lies at the intersection of transportation costs and the cost of holding inventory.

But when these rates are volatile, more dynamic decision-making must occur. Being too focused on the cost of capital can lead to higher freight costs that outweigh working capital reductions. Dictating working capital constraints too far in advance, especially in a volatile year with limited freight capacity, can lead to debilitating service failures or unforeseen spikes in operating expenses.

Next year (2015) may prove to be just the year when this volatility and upward pressure collide. The classic response of trading inventory for transportation, and vice versa, proves more challenging when both increase simultaneously — as is projected.

Market Pressure

The Fed has hinted that interest rates are soon to rise. More than 60% of economists expect the Fed to begin increasing their fund rate in the first half of 2015, according to the Wall Street Journal, and market rates should move in advance of this. Many forecasts indicate the prime rate to rise from its current state of 3.25% to 4.5% by the end of 2015. Whether you pay a spread above Prime, LIBOR or other indices, it’s not unrealistic to expect 20% to 40% increases in the cost of short term borrowing by the end of 2015 and likely continuing at a healthy pace into 2016. These signals will increase the cost of carrying inventory in the near future — an issue that many companies solve with freight tradeoffs.

The only problem? Transportation cost projections might even be worse.

If the polar vortex of 2014 is any indication, a transportation capacity shortage can drastically increase costs. In February, icy roads and sluggish systems shut down interstate highways in 12 states, temporarily driving truckload rates up by 15% to 20%. As companies struggled to get capacity, many saw load acceptance ratios fall below 70%. (The “load acceptance ratio” is the percentage of load tender offers accepted by carriers. For example, if I’m Pepsi and I have a load that needs to move tomorrow, I send a load tender to the primary carrier on the routing guide. They can reject the load if they do not have the capacity to handle it.) Similar disruptive events in 2015 are likely to exaggerate these statistics as we move from a balanced market to a market where demand exceeds supply.

To say freight capacity projections are tight is an understatement. Currently, the United States is short 30,000 drivers. Tighter regulation, driver turnover and more appealing semi-skilled construction jobs have contributed to this shortfall.

Opinion_Bug7Changes to hours of service and a regulatory crackdown are forcing companies to add more drivers and trucks to haul the same freight. Quality of life continues to increase the driver turnover rate to more than 90% for the ninth straight quarter — likely to soon be in excess of 100%, compared with an average of 39% just 4 years ago. A steady rise in construction jobs will continue to put upward pressure on driver wages and carrier pricing. Simply put, freight costs are in the running as one of the most volatile lines on this year’s P&L.

The only way to address this shortage in capacity is through wage increases which will be pushed through in the form of higher rates. Couple higher rates with greater pricing power from the transport providers, many companies are budgeting for double-digit increases in 2015. Given the magnitude of freight spend on many income statements, this is cause for concern.

Weathering the Storm

To prepare for market dynamics that can sabotage financial plans, CFOs should take two key actions that will enable their businesses to dynamically balance operating costs and working capital.

1. Aggressively segment customer service levels.Service levels, for product availability and order-cycle time, are typically mandated to supply chain management by marketing and sales. As a consequence, service targets are often set at too high a level of aggregation. Such ill-conceived service targets inherently lead to over-serving segments of the market, with more inventory and higher freight costs.

Aggressive segmentation stratifies customers, channels and products to optimize service strategy around the full cost-to-serve and resulting customer profitability. Many companies do not even realize (1) what the total cost truly is for their service levels and thus set an arbitrarily high number for all customers, and as importantly, (2) their customers may not value the level of service they are receiving if they have to pay the real cost. The lesson learned is: know your true costs for various service-level performance and segment and communicate with your customer what increased service levels will cost.

2. Increase attention to tactical planning. In a volatile market, companies need to use a single sales & operations (S&OP) plan, one that seeks to optimize operating costs along with capital requirements. Many enterprises have improved the capability and sophistication of their S&OP process to  not only work from a single plan, but to deploy advanced analytics to model specific tradeoff decisions  that predict clear business outcomes. For example, faster, more reliable transportation services can be employed to reduce inventory but they come at a price. Simultaneously modeling these operating cost variables can show subsequent impacts on inventory carrying costs and allow selection of the most cost-effective way to meet service goals.

As enterprises march into a 2015 marketplace slated for considerable transportation and inventory cost increases, cooperation between the supply chain and finance teams will be critical to balance overall costs. Scenario modeling and data analytics can help decipher increasing layers of complexity, but tools themselves are not enough to weather this storm.

These problems must be solved by business people with the wisdom, insight and rigor to make sense out of the data they examine at every level. Effective financial policy set by the CFO enables supply chain executives to make the best decisions to sustain a healthy bottom line.

J. Michael Kilgore is CEO of Chainalytics, a  leader in supply chain consulting, analytics and market intelligence serving 18 of the top 25 Gartner Supply Chains. Regular insights from Chainalytics appear via the Supply Chain Intelligence Network on LinkedIn and the Chainalytics blog.

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