You're (too) Busy Managing an Index Contract You Didn't Realize You Were In

I have been a proponent of index-linked contracts in ocean freight for well over a decade. It started in my days with Electrolux when, together with a large carrier, I developed a model for an index contract so robust that this carrier still signs customers up on it. But they are a hard sell.

Yet, there are BCOs who do work with index-linked contracts. Probably more than you think, and definitely more than I know of. And right now - if they’ve done it right - both parties to those contracts are happy.

The carriers are happy because, even though rates are probably only adjusted quarterly, they will get their increase in due course, even probably for a good while after the market starts falling again, as it inevitably will. And they are happy because that’s one shipper less that they have to face, spending sales- and back office resources on. Resources that can be much more gainfully and productively employed on something else.

The BCOs’ logistics staff are happy because they don’t have to face irate internal stakeholders pushing for explanations as to what they are doing about this situation (and that pressure is there whether the rates go up or down, ask any BCO logistician). Instead, they can simply explain that the matter will resolve itself automatically, give the stakeholders the exact date and time for when this will happen, and even quantify the risk and the upside quite precisely!

Then they can focus their time and energy and resources on more productive activities.

To an awful lot of procurement departments, index-linked contracts are old hat - except in our commodity. They have been around for decades and decades, used to buy anything from base metals to fuel and other oil derivatives, agricultural products - and shipping, but not container shipping!

To procurement professionals who have tried working with other commodities, it makes little sense that this hasn’t happened. So why hasn’t it ?

I’m glad you asked :-)

In all the companies I have worked for or advised, ocean freight has this peculiar standing in the minds of P&L owners, as some kind of “game changer”. And for some, it really is, for example if you are operating on margins so razor-thin that your entire business model stands or falls with the cost of shipping. That’s a model so obviously risky, and a business case so obviously flawed (unless you are extremely geographically diversified) that it falls outside the scope of any solution.

But many, probably most, manufacturers (which is my area of modest expertise) simply don’t have gross margins that thin. Not by a long shot. Reality is that ocean shipping costs probably constitute on average 1% of the landed cost of the product.

On its face, worrying about a $200 higher ocean freight cost, or for that matter celebrating a $200 reduction, simply shouldn’t matter that much, even at scale. And if we start seeing much higher changes, then the increase gets passed on to the customer to the largest possible extent.

To wit: How many medium-to-large manufacturers went bankrupt during the pandemic, solely because of ocean shipping costs ? How many will in this crisis ? I’m not saying they don’t exist, but I am saying I don’t know of any.

But because ocean freight cost has this undeserved reputation as a massive differentiator, a strange kind of logic creeps in:

A forwarder friend said at a TPM many moons ago, “as a shipper, 8 times out of 10 you short this market, you win!”.

And since a good index contract has both a floor and a ceiling attached to it, you might “lose out” if the market drops lower than the floor. For some (but by no means all) carriers, the reverse is equally true.

The other excuse for not going into an index-linked contract that I’ve heard frequently over the years is that “the company is not ready for that”, or “the company can’t manage that”.

If you have worked in ocean freight through the entire period from 2019 until today, and you can STILL say that with a straight face, then the Academy of Motion Pictures Arts and Sciences would like to hear from you, and maybe invite you to their event in Los Angeles next spring.

By now, those two should be up there with, “letting our employees work from home would never work”…

That period has, for nearly every BCO and carrier out there, been one long index contract! But painful, frustrating, infuriating, et cetera, for BCOs and carriers alike.

But your company has managed it. And because it has managed it, your company is obviously now ready for it.

So here’s a crazy idea: maybe think about a better, smoother, anxiety-reducing, resource-freeing, de-risking way of doing what you’re already doing anyway ?