We need more control of inventory, says Cliff Lynch. Speaking as part of a panel following the release of the Annual State of Logistics Report, Lynch noted U.S. companies need more inventory to cope with extended supply chains, but they're managing it better because of lessons learned and better technology tools.

Rosalyn Wilson, author

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of the State of Logistics Report, highlights some of those rapidly increasing inventory carrying costs. Interest rates are one component of the cost increase, but despite the Federal Reserve actions of the last year or more, Wilson agrees, inventories have been on the rise. The good news is that we are keeping them flowing. The inventory/sales ratio, which measures the rate of sales against the amount of inventory, has been declining for 15 years, she notes. Even a recent minor spike has moderated, keeping the ratio around 1.30. It started the 15-year period near 1.60—meaning it would take 1.6 months to consume current stocks at the current monthly sales rate. Wilson reports that the inventory sales ratio dropped from 1.56 in January 1992 to 1.28 by the end of 2006. (The 18th Annual State of Logistics Report measures performance for 2006. It does not reflect a reported inventory draw down in the first part of 2007.)

For real drama, look no further than interest rates. The current interest-rate level at the time the State of Logistics Report was released was about 5.25%, just below the level of 2000, but far ahead of the 1% rate during 2003 and 2004.

Interest rates tell part of the story when it comes to examining the rapid increase in carrying costs. Though transportation accounts for much of the increase in total logistics costs in 2006, inventory carrying costs rose faster than transportation costs for the third year in a row.

Overall, business inventories were up $109 billion in 2006, the year covered by the report, reaching nearly $1.9 trillion. Retail inventories appear to be down in 2006, while wholesale inventories increased. Companies are holding buffer stocks to hedge against disruptions, but those stocks appear to be located with their suppliers.

As a consequence of or a driver of increasing whole sale inventories, warehouses are being used for more value-add services and as processing centers. It's clear that warehouses are holding strategic reserves of goods (safety stock) to meet surges in demand or to respond to disruptions in the supply chain, but retailers are also shifting retail deliveries from large shipments to smaller, more frequent deliveries.

Large, regional distribution centers are less able to pro vide the flexibility and time-sensitive deliveries that come with this shift from daily or every-other-day deliveries to multiple daily deliveries. This has meant a move to more local warehouses serving fewer locations, but with more technology in use to manage inventory.

In fact, says Lynch, there are approximately 12 billion square feet of existing warehouse space in the U.S. and another 140 million square feet being built to help manage business inventories. Yet, the vacancy rate for warehouses is a respectable 8%. Keeping in mind this is an average, it suggests there are markets with plenty of space available and others where capacity is extremely tight.

Interest costs are the big news in inventory. At $93 billion in 2006, interest charges equaled the 2000 level, the highest year for interest costs since the State of Logistics Report began publishing. The lowest recorded interest costs were in 2003, when the total dipped below $20 billion. But, in 2004, interest costs started to rise, increasing two and a half times between 2004 and 2005 and just over one and a half times between 2005 and 2006.

With some fluctuation over the years, taxes, obsolescence, depreciation and insurance on ever-increasing inventories managed to grow to 1.65 times their 1993 level in 2006. Warehousing costs, which exhibited a much more even pace over the years, have accelerated in recent years, rising 10% from 2004 to 2005 and another 12% from 2005 to 2006. This also brings warehousing costs to a level of 1.65 times their 1993 level, and 2006 was the first year above $100 billion.

Transportation gets the majority of the headlines, and rightly so at 61% of total logistics costs (Trucking is 48% of the $1,305 billion total.). International transportation (including forwarders) nearly doubled from 2001 to 2006; domestic transportation costs rose just over 28% in the same period.

For a look at what shippers expect to see in the coming months, Morgan Stanley recently released its 12th Freight Pulse Survey. The semi-annual survey compiled responses from readers of Logistics Today and members of the National Industrial Transportation League (NITL).

One of the first findings on the motor carrier section of the survey was that shippers are seeing abundant capacity in all modes. Ranking capacity on a scale where 10 is very tight and 1 is abundant, shippers said truckload was at 3.5, intermodal at 4.4, regional less than truckload (LTL) was 3.2, and national LTL was also at 3.2. These results, says Morgan Stanley, reflect more abundant capacity than at any other time in the history of the survey.

Coupled with greater availability of capacity, shippers suggest LTL volume growth will decelerate. Measured in terms of "changes in LTL volumes," shippers reported expectations of a 1.8% increase in national LTL volumes and 3.0% for regional LTL. "Given the highly leveraged nature of the LTL market," said the Morgan Stanley report, "carriers will likely continue to use price discounting to attract and/ or defend volume." Competition would only continue to intensify in the event of a continued economic slowdown. Putting further pressure on LTL carriers, the soft truckload market has led some truckload carriers to compete in the regional LTL market.

When shippers speak of specific carriers, it appears they are more inclined to increase volumes with premium operators, suggesting service is a differentiating factor, says Morgan Stanley. Unionized carriers are the most vulnerable in these market conditions based on their higher cost structure. (The National Master Freight Agreement covering LTL carriers is due to expire at the end of March 2008,and none of the carriers have begun talks with the International Brotherhood of Teamsters.)

Shippers translated their volume expectations and capacity experiences into anticipated pricing. Exclusive of fuel surcharges, shippers reported they expected national LTL rates would rise 1.2% and regional rates just 1.5%. This compares with 1.6% and 1.5%, respectively in the prior study (September 2006). Looking back a year, the increases are about half the Spring 2006 expectations, which were reported at 2.8% for national LTL and 2.7% for regional LTL.

In the current environment, with soft volume increases and plenty of capacity, Morgan Stanley reports that many shippers are taking this opportunity to lock in multi-year contracts with minimal price increases. In the shorter term, shippers responded that carriers are offering steep, even unsustainable, discounts to win or protect market share.

Shippers report they expect truck load volumes to increase 3.3%, roughly the level of 2002 through 2003 and 1% to 2% below the growth rates they anticipated in 2004-2006. Morgan Stanley's proprietary Truck load Index confirms demand is in line with 2003 levels.

The impact on pricing of this slow volume growth and plentiful capacity has many shippers moving freight back from intermodal to truckload. Though shippers anticipate ˚at truckload rates through the fourth quarter of 2007, actual reported rate increases tend to exceed anticipated increases. With the exception of the September 2006 Freight Pulse Report, shippers have underestimated truckload rate increases in every period since May 2002. Last September, shippers expected an increase of 2.5%, but they are reporting rates only increased by 0.7%. The current forecast is for a 0.4% rise.

Intermodal volumes are expected to grow 2.4%, the low est growth rate since September 2004. Drivers of this trend include excess capacity in truck load and lower rate increases. Motor carriers will first win back freight where rail service is weakest. The dual pressures of a slowing economy and truckload competition will have a moderating effect on inter modal rate increases. Shippers say they expect rates to go up 1.7%, nearly a full percentage point behind the 2.6% forward view from September 2006 and almost 2% below the year-ago forecast increase.

Shifting to rail, shippers have different expectations for rate increases on each Class 1 rail road. Western railroads appear to have the strongest pricing position, with the Union Pacific (UP) expected to achieve a 4.7% rate hike, while the Burlington Northern Santa Fe (BNSF) falls in right behind at 4.1%. CSX, Canadian Pacific (CP), and Norfolk Southern (NS) are in the 3% range, with shippers expecting CSX to come in at 3.2%, CP at 3.1% and NS 3.0%. Canadian National (CN) and Kansas City Southern (KCS) were reported at 2.5% and 2.4%, respectively.

The expectations may underestimate the ability of at least some rail roads to push rates higher. Western railroads have "a longer tail on legacy contracts" says Morgan Stanley. Coal shippers and international intermodal shippers have the greatest number of legacy contracts, points out Morgan Stanley, and the UP has been one of the prime beneficiaries of the new, stronger pricing environment when contracts have come due. One contributing factor is the aggressive discounting it had done in earlier contracts.

Looking out to 2008, shippers expect a further 5.4% increase in rail rates.

Though service will win some intermodal loads for truckers, rail roads have picked up the pace on improvements. On average, 22% of shippers report "delivery when expected" improved. The service measure stayed the same for 64% of shippers. "We believe that service improvements will be required in the long run for the rails to continue to capture rate increases in excess of inflation," said the Morgan Stanley report.

Always a touchy issue, fuel surcharges elicit strong opinions from shippers. Most rail shippers report that they compensate railroads for increases in fuel prices on the basis of a percentage of revenue. In other words, fuel surcharges are based on freight charges. Over 70% fall in this category, with only 8% using mileage/weight as the basis for fuel surcharges and only 7% saying they don't pay fuel surcharges.

Though shippers don't feel the mileage-based fuel surcharge will result in lower fuel surcharges, most prefer it. Only 30% of shippers said the mileage-based charge would lower fuel surcharges, but 62% prefer it and 64% feel their current systems can handle the mileage-based mechanism.

Nearly two thirds of shippers believe the railroads will attempt to convert more of the fuel surcharge rate into their base rate.

"Railroads will continue to charge what the market will bear," said one shipper. Another added that "railroads are acting like ocean carriers and will be treated the same way when the economy softens. The trucks will get their choice of freight, and the railroads will have to buy back business."

The same shipper continued, saying that, beyond pricing, rule changes were an even greater problem, especially with respect to storage, chassis, service lanes and service levels.

Shippers appear to be largely dubious of pricing and fuel surcharges on railroads, saying the railroads will use a combination of base rate and surcharge to protect their healthy margins.