A Market-Based Pricing Model for Transportation Contracts

Editor’s Note: Every year, 40 or so students in the MIT Center for Transportation & Logistics' (MIT CTL) Master of Supply Chain Management (SCM) program complete one-year thesis research projects. The students are early-career business professionals from multiple countries, with two to 10 years of experience in the industry. Most of the research projects are chosen, sponsored by, and carried out in collaboration with multinational corporations. Joint teams that include MIT SCM students and MIT CTL faculty work on the real-world problems. In this series, we summarize a selection of the latest SCM research.

In a tight truck transportation market, a shipper can be forced to tender shipments to the spot market when contracted carriers are unable to fulfill its demands. As a result, the shipper is likely to incur higher costs and lower levels of service.

One approach to addressing these issues is to make the tenders more attractive for the contracted carriers. To achieve this, MIT CTL researchers worked with a leading shipper to develop a monthly index that adjusts current contract rates based on the prevailing market conditions.

More responsive long-term transportation contracts

The sponsor company was experiencing a high level of rejected loads by primary carriers. These shipments ended up being fulfilled by carriers in the spot market.

The problem of load rejection was especially prominent in low-volume lanes with sporadic shipments, which make up around 30% of the shipment lanes used by the company. Certain lanes in this category exhibit carrier rejections as high as 80%, resulting in higher costs, increased administrative overheads, and poor service levels. In response, the company wanted to ensure that its contract linehaul rates are attractive for its carriers.

To achieve this goal, the researchers needed to address several key issues.

• How can contract rates be adjusted dynamically?
• What is a good proxy to represent market dynamics?
• How often should the contract rates be updated?
• What are the financial implications of updating contract rates dynamically?

Developing a market-relevant monthly index

The researchers formulated a model that linked the carrier rejection ratio with the prevailing spot premium (percentage increase in rates for shipments fulfilled by spot market as compared to those fulfilled by contract carriers). After evaluating various market indices in the US trucking industry, the research team decided to peg the monthly linehail rates to the DAT line haul index.

An optimization model was developed for each warehouse to minimize the rejections by carriers with the lowest financial impact. This model was validated over a one-year time horizon to analyze the impact on monthly line haul costs incurred by the shipper.
A monthly aggregation was chosen because the sponsor company had access to monthly DAT rates. Additionally, the results of a weekly aggregation were too volatile, while a quarterly aggregation required too much smoothing of price trends.

Pros outweigh the cons

Out of the 12 warehouses analyzed, four exhibited a strong correlation between the monthly spot premium and the corresponding auction ratio. Hence, the index-based pricing approach achieved a net reduction in linehaul costs for shipments from warehouses in Wisconsin and Missouri. For shipments dispatched from other warehouses, there was a net increase in line haul spend. However, this increase can be partially offset by reductions in the penalties associated with shipments fulfilled through the spot market that fail to comply with performance standards.

An index-based pricing model can be leveraged to align contract rates with prevailing market conditions.

As a result, shippers can enter into longer-term contracts with carriers. Also, the model can be used to gain valuable freight market insights, to drive improved service levels, and to reduce costs even in tight market conditions.

Although such a model requires an upfront investment as well as technology and contract changes, the benefits make it a prudent investment.

The SCM research project titled Alternative Pricing Model for Transportation Contracts was authored by Atmaja Sinha and Rakesh Thykandi and supervised by Dr. Chris Caplice, Executive Director, MIT CTL. For more information on the research, please contact Chris Caplice at [email protected].

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