Academic journal article The McKinsey Quarterly

Freight Expectations: Freight Transportation Companies Have Moved Slowly to Keep Up with Modern Business Practices. Risk and Revenue Management Could Provide the Boost the Industry Needs

Academic journal article The McKinsey Quarterly

Freight Expectations: Freight Transportation Companies Have Moved Slowly to Keep Up with Modern Business Practices. Risk and Revenue Management Could Provide the Boost the Industry Needs

Article excerpt

Like it or not, globalization is shaping the modern world. Yet international freight transportation, one of the industries that support the process, remains paradoxically old-fashioned. It is highly fragmented, with the top five container-shipping lines, for example, carrying only a quarter of the world's ocean freight among them; prices on some routes bear little relation to supply and demand; and contracts are so casual that they might be sealed by a one-page fax or a handshake. Despite growth, since the mid-1990s, of more than 5 percent a year in the revenues of the air- and sea-freight sectors--to more than $130 billion annually by the end of the decade--both consistently underperformed the S&P 500 during the same period (Exhibit 1, on the next spread).

The proprietors of the many freight companies (including freight forwarders) that are state owned, in private hands, or owned by conglomerates have mostly been content to let them bump along the bottom. Are they doomed to stay there, or can the freight industry bring its practices and profitability more into line with its role in the modern world?

We believe that it can. Much of the trouble in the freight industry stems from the unusual amount of risk affecting its revenues. But the industry also satisfies the conditions required by the risk- and revenue-management concepts that, over the past 20 years, have markedly improved the performance of the fairly similar energy and airline industries. The big question facing freight businesses is how soon they too can apply such measures. As leading companies begin to take them up, others will have little choice but to follow, for those that apply them will also serve customers better.

More value at risk

Risk in freight transportation stems largely from three sources: changes in demand caused by the economic cycle, anomalies in the way contracts are drawn up, and uncertainty over prices.

Demand changes

Demand for freight transport generally tracks global economic cycles, so the freight industry could keep its margins steady by matching supply to demand. But individual companies can increase supply only in "lumpy" increments of productive factors with long lead times: ships and planes. Companies tend to order these simultaneously, when they think the world economy is set to grow. If, as can easily happen, they make a collective mistake about the cycle's timing, they might all take delivery of new capacity just as demand drops.

The fortunes of air cargo in particular are tied to those of the world economy, partly because sea freight offers customers a cheaper substitute. One international freight forwarder, expecting prices to reach at least $3 a kilogram on the trans-Pacific air route at the end of 2000, chartered several large freight planes for six months under a fixed contract. But from mid-2000 to mid-2001, air cargo rates--reflecting the global economic slowdown and an increase in air cargo capacity--dropped by more than 30 percent, leaving the forwarder substantially exposed.

Contract anomalies

Contract practices in freight make future revenues extraordinarily unpredictable. Customers can reserve space on terms that in effect give them a free call option, for example. If the spot price for space falls below the forward price agreed upon between carrier and customer, the customer can simply rebook space on the spot market, without paying any penalty to the original provider. Even if the contract has a minimum-volume clause, such provisions are rarely enforced.

Equally curious, the industry gives volume-based discounts on all routes, regardless of capacity constraints. A customer seeking a lot of space on ships sailing from Hong Kong to Antwerp--a route in high demand--always pays less per 20-foot equivalent unit (the size of a typical freight container) than customers booking smaller volumes. …

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