By Cass Logistics--Bob Delaney

(SELECTED EXCERPTS FOR LTM 310)

For More information go to www.cassinfo

Introduction

The State of the U. S. Business Logistics System is extraordinary. Last year, our business logistics costs declined by $33 billion compared to 2000. This was the first decline since 1991. Logistics costs were equal to 9.5 percent of nominal gross domestic product during 2001. That is a record low in the history of the data.

The slowdown that began in our economy as the third quarter arrived in 2000 continued for the entire year of 2001. The National Bureau of Economic Research officially announced that our economy went into recession in March, 2001. Second quarter GDP growth was scarcely measurable. A negative growth rate occurred during the third quarter. Although slight, fourth quarter real GDP growth of 1.4 percent was surprising, especially since it followed the September 11 terrorist attacks. The real story achieved by our logistics profession during 2001 was the significant reductions of inventory. Note the bottom line in Figure #1. Inventory investment was reduced during all four quarters of 2001. Even more remarkable, note that the changes in inventory were also negative during the third and fourth quarters of 2000. So, we have experienced six consecutive quarters of declining inventory investment! We have worked hard in order to understand what is going on regarding inventory investment and what it means to the profitability of U. S. businesses. We will present what we have learned thus far. We confess that we have much more to learn. We have a lot of work to do. As most of you know, we have previously reported that we do not expect future reductions in transportation costs. We will explain why compliance with the Environmental Protection Agency’s new standards for diesel engine emissions will make it unlikely that we will be able to maintain our current level of transportation productivity. Future reductions in business logistics costs will have to come from managing inventory investment more efficiently. We intend to "stay curious" about inventory for the balance of this year and probably for some time in the future.

Co-Sponsors

This report is co-sponsored by Cass Information Systems, Inc. and ProLogis.

The Business Logistics System – 2001

During 2001, the cost of our business logistics system declined to $970 billion, or the equivalent of 9.5 percent of nominal Gross Domestic Product (GDP). The average investment in all business inventory including agriculture, mining, construction, utilities, services, manufacturing, wholesale, and retail trade declined to $1.44 trillion. Inventory investment during 2001 was $38 billion lower than it was in 2000. The cost of carrying inventory during 2001 includes interest at the annualized commercial paper rate of 3.8 percent. The cost of taxes, obsolescence, depreciation, and insurance follow the Alford-Bangs Production Handbook formula that has been used in this methodology since its publication in 1973. The cost of warehousing was flat and is an estimate based on the expenditures for public warehousing reported by the Commerce Department’s Census Bureau.

Transportation costs are the preliminary estimates published by the Eno Transportation Foundation. Trucking costs increased by $10 billion, or only 2.7 percent. That was lower than the 3.4 percent growth in nominal GDP. Motor carriers reported that trucking tonnage was down between 5 to 10 percent depending on the market segment. The profitability of trucking companies declined because of under utilization, higher insurance, and fuel costs. BBT Capital Markets reports that 60,000 owner/operator businesses went bankrupt during the past two years. The current market for truck service reminds us of the poem which the late Malcom McLean wrote 50 years ago. "May the day never come when the rising sun sees rates below cost and freight hauled for fun." The extended trucking industry now faces compliance with a new EPA standard for heavy duty diesel emissions by October 1. The implications are huge. EPA originally estimated that compliance costs with the new standard would be $320 million. They now acknowledge that compliance costs will approach $2 billion, an increase by a factor of six! The increase in engine costs will be at least $1,500. One manufacturer will accept a penalty cost of $5,000 per engine to market its existing engine. An increase in fuel costs per mile of two cents is likely. The real "wild card" is engine performance and reliability. There is a report that Werner Transportation inspected the new EPA standard engine after 200,000 miles of operation. It resembled a five year old engine after one million miles of operation. The EPA has understated "the costs." That calls into question "have they overstated the benefits?" The Department of Justice is researching the economic impacts of the standard. We suggest that the public policy question is "how robust are the health benefits of the standard?" The Americans for Safe and Efficient Transportation will hold a meeting here in Washington on June 19 to develop support for longer tractor trailer combinations and heavier six axle vehicles. Without a legislative consensus on vehicle length and weight, we will not see any improvement in the productivity of our trucking industry. Trucking has an 82 percent share of our nation’s freight bill. Consider that trucking accounts for 50 percent of U. S. total logistics costs and you will understand the challenge to our productivity.

Rail costs increased by $2 billion or 5.6 percent during 2001. Improvements in intermodal services reliability has enabled railroads to capture some long haul traffic from truckload carriers. The railroads also managed to increase rates selectively on non-competitive traffic. That is becoming a subject of proposed legislation. Railroads are capital and labor intensive. Our view is that railroads are entitled to earn returns that are comparable to their customer base. The cost of domestic and international transportation by water increased $2 billion. We round these numbers to the nearest billion dollars. Water transportation costs benefited from the effect of rounding more than an actual increase. Oil pipeline transportation revenue was flat. Domestic and international airfreight transportation costs declined by $3 billion. The economic deregulation of trucking within 41 states that became law in 1995 has really paid off as Federal Express, United Parcel, Airborne, and BAX have increased their ground transportation operations in second day delivery. Domestic freight forwarder revenues, after payments to linehaul carriers, increased by $1 billion. Shipper related costs combine the loading and unloading of transportation equipment and the operation of traffic departments. Logistics administration is imputed at 4 percent of total logistics costs following the methodology that we have consistently employed since its original publication in 1973.

Figure #11 in your press kits shows the detailed cost of the business logistics system during the past 21 years. It is too crowded to display on the screen but it is the most important exhibit in this presentation, so please take time and study it carefully.

Here is how the trends appear graphically with 1981 serving as the base. Transportation costs have declined by 24 percent during these 21 years. All of that decline occurred during the 1980s, following the end of economic regulation. Transportation has been on a plateau of about 6 percent of nominal GDP since 1991. Inventory carrying costs have declined by more than 60 percent during these 21 years as faster and more reliable transportation allowed U. S. businesses to invest in less inventory and consolidate it into fewer locations. We believe that we have benefited from better forecasting, systems, and communications in managing inventory. With the record low achieved during 2001, total logistics costs have declined by more than 40 percent during these 21 years. It is clear that inventory efficiency is now the driver. The focus of everyone managing in logistics has to be on inventory investment.

Third Party Logistics

The segment within the $970 billion of logistics expenditures made by manufacturing and distribution businesses that continues to receive the most attention is the third party logistics services segment. This research is updated annually by our colleague Richard Armstrong. He is the internationally recognized expert on the third party logistics industry. The 10^th annual edition of "Who’s Who in Logistics? Armstrong’s Guide to Global Supply Chain Management" is now available. 3PL services grew by 24 percent in 2000. In 2001, the total contract logistics market grew by 7.4 percent. Lower growth is a direct reflection of our economic slowdown, which lead us into recession. When you consider the fact that expenditures for truck transportation grew by only 2.7 percent during 2001, the 7.4 percent growth reported by third party logistics services providers is attractive. The 13.3 percent growth rate reported by 3PLs in the Value-Added Warehouse/Distribution segment really looks good. The April issue of Distribution Center Management reports on how warehouse management systems and supply chain event management systems are being integrated to improve the visibility of inventory. Improving the visibility of inventory for their customers can be a value added benefit for 3PLs in the warehouse/distribution segment.

Inventory Investment

We have often said that logistics is the management of inventory in motion or at rest. Inventory is in motion during transportation. Inventory is at rest awaiting production into finished goods or in distribution at the final point of sale. We have said that the logistics manager has the primary responsibility for the investment, condition, and location of inventory. That is still true regarding raw material and work in process inventory. But, we are learning that the management of finished goods inventory is also a marketing activity with strategic implications. That is a significant change in our previous analysis that was presented in our first twelve "State of Logistics Reports." It is very important to reserve the right to know more tomorrow than you do today. We shall try our best to clearly explain what we have recently learned.

We begin with the macroeconomic indicators. Here is the ratio of business inventory investment to nominal gross domestic product. It has declined from 24 percent in 1981 to 13 percent in 2001. This solid trend reflects continuous effort and progress in lowering inventory investment. Here is the monthly inventory/sales ratio that we displayed last year. It includes only manufacturing, wholesale, and retail trade. The data reflects the old Standard Industrial Classification System methodology, which dates back to the 1930s. You will observe the reduction in months of supply between 1991 and 1999. The economic slowdown began 2000. The ratio increased from a record low of 1.31 months of supply in March, 2000 and gradually increased to 1.36 months of supply as the year 2000 came to a close.

T

Strategic and Marketing Implications

In order to better understand what is going on regarding inventory investment, we invited Roger Urban to join us at a meeting with Ohio State University’s Supply Chain Management Research Group in Columbus, Ohio. We have worked with Roger Urban since 1975. His firm, Urban Wallace Associates, was established in 1980. He concentrates on business strategy and operational marketing issues. His client list includes manufacturers, distributors, financial services, software, transportation carriers, and logistics service providers.

Urban observes that despite the ten year plateau we have witnessed regarding transportation costs, many shippers continue to seek transportation savings. They are "buying down" in order to cut costs. This means choosing slower, less expensive transportation services. They are investing in transportation management software in response to the cost reduction claims made by software vendors.

The TMS cost reduction strategies are rather elementary. They include the switch to slower less reliable modes, consolidation of orders into larger shipments and shipping less often. There is nothing new here. It is rather unremarkable.

While reducing transportation costs, Urban observes that each of these strategies increases the amount of inventory held in the supply chain. The cost of holding additional inventory more than offsets any transportation savings. He concluded that in this economy cutting transportation costs is a suboptimization that produces false savings.

We have focused on The Ohio State University’s research capabilities but we should also acknowledge the "school up north" that is the birthplace of our logistics profession. That school is Michigan State University. To be sure, Michigan State is where Bud LaLonde earned his Ph.D. Mr. Urban agrees with Michigan State University’s Global Logistics Team that logistics is now the management of continuous change. Agility, accommodation, and flexibility are the keys to survival for supply chain managers. The emphasis is on constant adjustment today, not optimizing on yesterday’s data. To illustrate his point about flexibility, he related a hypothetical conversation between Siemans Corporation and a supply chain manager at Texas Instruments. "You know that inventory that you are holding for me in Germany? Yes. Well, I want it in Singapore now. But you told me to hold it in Germany. Well, that was then. This is now." Roger Urban emphasizes that supply chains must be actively managed. As an operational marketer, Urban is no fan of optimization using yesterday’s data. Continuous adjustment is the business goal. Accurate inventory information is needed in order to continuously adjust supply chains.

Urban went on to answer why manufacturers have an increase in finished goods. He acknowledged the growing power of retailers and the power of manufacturers over their suppliers. He believes that vendor managed inventory is really "vendor owned inventory." The buyer has the power. The vendor must locate the inventory where the buyer wants it. To some extent, this reclassification of inventory may explain why macroeconomic measures are no longer helpful. You have to look at microeconomic measures of individual companies in order to understand what innovations are taking place. That is the real breakthrough achieved by The Ohio State University’s Supply Chain Management Research Group, as Roger Urban sees it. The Group is offering a benchmark analysis of company specific inventory performance compared to their industry peer group and the implications on corporate profitability on a service basis. Trust us. The cost of this service is a bargain at ten times the price.

To illustrate manufacturer power, Urban references examples where the vendor owns the supplies in the manufacturer’s warehouse and is not paid until the manufacturer takes them into work in process. The seller absorbs all of the inventory risk. For example, Chrysler used to buy paint from DuPont. Chrysler had paint in their raw material inventory. The paint was reclassified into work in process inventory as Chrysler painted the car. Now Chrysler pays DuPont for each car painted! Chrysler has no paint in raw material or work in process inventory. In effect, DuPont has reclassified the sale of paint into a service. This is much more than a reclassificiation of inventory. This is a fundamental change in the business relationship between Chrysler and DuPont.

To illustrate growing retailer power, Urban refers to Wal-Mart, where point-of-sale data has historically been used to reorder and replenish inventory. Wal-Mart is now testing the use of point-of-sale data to trigger vendor payment. The cost of shortage or damage now falls to the seller. Accounts payable and accounts receivable are now eliminated.

Urban’s final observation deals with the correlation between high finished goods inventory and high gross margins. His experience has been that companies with higher gross margins can afford larger amounts of finished goods inventory. They use their availability of finished goods as a marketing weapon and service advantage. They provide a high level of customer service and they get paid for it. Urban believes that managing finished goods inventory is a marketing activity and one that is becoming more important in our service intensive economy. He believes that the trends among companies in raw material, work in process and finished goods inventory are not merely reclassification. Rather they reflect innovation and change in the way that companies are doing business.