Getting the Best Rates: Operating Ratios Explained
Information, not a heavy hand, is the key to successful rate negotiations
Carriers are in business to make money, just like every other company. As counterintuitive as it sounds, understanding this and letting them is the key to your company getting the best shipping rates it can. This includes every mode of shipping — small parcel, LTL, and truckload.
Most shippers fall into the trap of thinking getting the best rates and service from carriers is only about beating them up on price and squeezing every penny out of a negotiation. Yes, obtaining the best rates for your company is the goal, but doing so at all costs is rarely the best approach. Relationships with carriers based solely on unsustainably low or below market rates do not last.
A Change in Mindset
Acknowledging that carriers have costs and need to make money too is understandably hard for many logistics professionals. After all, we take pride in our ability to negotiate and place cost and service efficiency above all else.
But over time, carriers have to be profitable and can only tolerate money-losing lanes (or entire customer relationships for that matter) for only so long. Short term, it can easily seem like a good decision for companies to pay submarket rates. This approach is not sustainable however, and here’s why.
The Costs of Carrier Turnover
From a rate standpoint, shipping with a rag-tag list of carriers willing to work at below-market rates makes sense. But shippers who take this approach underestimate the significant costs to carrier turnover.
Logistics operations are very process-oriented, relying on familiarity with procedure and constant communication. To start, many operations are dependent on proprietary manifest systems or 3rd party technology. Changes here can require additional investments in equipment as well as training.
There is also a lot that happens between your carrier’s dispatcher, drivers, and shipping docks most logistics managers never hear about. This can include behind the scenes details like a driver getting used to receiving requirements at consignees or how the shipping docks work. Carrier turnover changes the players and requires constant retraining or relearning. Worse yet, a lot of this happens at the expense of service to your customers.
Another common problem for shippers who base carrier relationships on price alone is a lack of capacity during peak periods. When truck capacity is tight, carriers will always service their high-margin customers. If your carrier program is based on always choosing the low-cost carrier, there will be many times you need capacity and it simply won’t be there.
Clearly, a short-term approach to rate negotiation and carrier management has cost implications that extend beyond rates.
Many shippers are learning that combining a cost-based approach with understanding the carrier’s operating ratios is the smartest way to negotiate. These companies have figured out that entering a carrier negotiation with this knowledge will get you the lowest rates possible with carriers who’ll provide stable, quality service. The cliché of creating a “win- win” solution actually applies here.
What Are Operating Ratios?
Simply put, operating ratios are a carrier’s costs.
The key to using operating ratios to get the best rates from carriers is understanding that carrier costs are very predictable. Although the carrier’s cost to service different shipments will vary greatly based on size/weight and distance (along with other details), each is still calculated by considering well-understood cost inputs like driver labor, mileage, maintenance, fuel (thanks to an adjustable surcharge), among other factors. Carriers can easily look at your shipment volume and know their cost to service your business. They can assign specific costs if, for example, you ship three loads per week at an average weight of 5,000 lbs. from point A to point B.
Why does this matter?
The opportunity for you as a shipper is to understand what those carrier costs are, and then negotiate with that knowledge. Having this information enables you to negotiate, on a lane-by-lane basis, rates that allow the carrier to make a small but sustainable margin on each shipment. This approach guarantees your rates are tightly in line with carrier costs and the real market rates for every shipment. It also builds a stable carrier portfolio that will attract higher quality partners and improve service to your customers.
Putting Knowledge of Operating Ratios into Practice
The problem is, of course, that carriers are not openly sharing their cost basis. If they did, this process would be easy. One approach can be to try and calculate the carrier’s operating ratios yourself. As we’ve suggested, carrier costs are very predictable, but knowing them with certainty without some amount of insider knowledge is tricky at best.
Be prepared to be “above market” in some areas of your contract to squeeze carrier operating ratios for the important areas (frequently utilized services, lanes, accessorials, etc.). This will breed a degree of “give and take” and allow the carrier to stay profitable, while you pinpoint the sweet spots that matter the most. In other words, choose your battles.
Other approaches to understanding the carrier’s operating ratios include leveraging 3rd party data or a partnership. There is no shame in leaning on a partner with insider knowledge of carrier pricing models to know the cost basis of your shipments. As we’ve outlined, being prepared with this information is the most valuable tool for negotiating the best freight rates you can.
The best rates and successful carrier relationships occur when the agreement works for both parties. The lowest rates and quality service do not have to be mutually exclusive, either. Using knowledge of carrier’s operating ratios during rate negotiations is the guaranteed way to get the best of both worlds.