A Closer Look at Fuel Surcharges in Transportation (Part 1)

In this mini-series of guest posts featuring Synaptic Decisions, we'll discuss a breakdown of fuel charges in transportation into four parts: Rate Basis, Price Basis, Price Peg, and Slope. We'll tackle them all in two days of guest posts.

Introduction

There are several key contract terms to be considered when negotiating deals with transportation carriers. Rate escalation, contract term and term options, shipment commitments and commitment options, service levels, carrier sub-contracting rights, fuel surcharge, performance incentives and payment terms are examples. In the case of fuel surcharges, many shippers grudgingly accept carriers' imposed fuel surcharge schedules. A carrier's recovery of actual added fuel costs makes sense since the risk of rising fuel prices is completely out of their control. But does your carrier's fuel surcharge schedule reflect a fair cost recovery mechanism or does it serve to make them added profit? This article will describe some things shippers should consider when negotiating fuel surcharge schedules with their carriers to help ensure a fairer fuel cost recovery mechanism and so doing -- reduce "all in" transportation costs.

Rate Basis

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Fuel surcharge schedules are either invoice based or mileage based. In an invoice-based schedule, the surcharge is a percentage of the line haul price and the percentage increases with increasing fuel price. This can result in over charges for shippers in two ways. First, if the percentage is applied to the total invoice amount, it may be applied to accessorial charges (which are not related to fuel). Secondly and more significant is the excess fuel charges shippers pay on short hauls. Here's the reason. Most carriers set a minimum line haul rate that's applicable regardless of shipment mileage (see illustration above). This is logical since carriers incur an actual loading cost at the origination (O) and actual unloading cost at the destination (D) (whether it's a 5 mile trip or a 1,500 mile trip).

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Here's the point. In an invoice-based schedule, if you plot your carrier's fuel surcharges for O-D pairs against the mileage for those O-D pairs, it will look something like the blue curve on the illustration shown above. Even after taking into account fuel consumed in idling, fuel costs are over recovered on short hauls. That's lost value for the shipper. Despite what carriers might say about the ease of administering invoice based schedules or that they under collect on longer mileage hauls and "it evens out for shippers," invoice based schedules should be avoided.

Price Index

Most carriers use the National On-Highway Diesel Index published by the Department of Energy. The DOE surveys 900 stations across the US and publishes the index weekly. The DOE also publishes indices for 5 regions (called PADDs): I. East Coast, II. Midwest, III. Gulf Coast, IV. Rocky Mountain and V. West Coast. The index in each region has a high correlation to other regional indices as well as the national average index, but it's not perfect. This risk is commonly referred to as basis risk.

For example, since 1994 the average difference (basis) between the National Average and the Gulf Coast (PADD III) has been about 5 cents per gallon. The basis can deviate from the average. In other words, the Carrier's actual fuel cost per gallon in a region may be quite different than the national average index.

To protect themselves from basis risk, carriers dial price contingencies into their base line haul rates. And on average and over time, they collect these contingencies. To avoid this, tie fuel surcharge schedules to appropriate regional price indices.

Stay tuned for the next post in this series where we'll tackle Price Peg and Slope, and also what we can conclude from all this analysis.

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