Redefining the Contract in Contract Logistics

Blog post author: Professor Mike Wilson (PARC Director) & Katy Huckle (PARC Co-ordinator)

PARC Insight: The contract logistics industry asks you to predict the future and sign for it today. In this PARC Insight we question; should logistics providers be taking a more flexible approach? Is it time to take the “contract” out of contract logistics?

How accurate is your crystal ball?

If you look back five years in to the past, or even three years, did you expect be where you are now? If you had a plan, did things work out that way? And if you look forward three or five years, where will you be? What job will you fulfil, and where will you live? How will your relationships change and develop?

Whilst most of us dream of the future, some creating detailed plans of their goals and next steps, none of us know what will actually happen. We may have an idea that turns out quite similarly to real life, but in a fast-changing world where disruption is the norm, to predict anything with certainty is difficult at best and, more realistically, near impossible. But, if you run a business, this is what exactly what the contract logistics industry asks from you.

When it comes to contract logistics, predicting the future is expected. Customers are asked to forecast exactly how much space, labour and level of activity they will need, typically for the next three to five years, and commit to it in the ‘contract’ that makes up contract logistics. They are then penalized for straying from the contract; for example, if their business underperforms, then refunds on unused space are capped. If the customer business grows or diminishes outside of the original (contracted) forecast, then this comes at a price. This is a consequence of the evolution of the contract logistics industry…it isn‘t necessarily wrong, but is it the model for the fast-paced, shortening product life-cycle, supply chain that we see today?

Let‘s briefly look at how this has happened.

The surge in the contract logistics market started when the world went global. Manufacturing moved to low labour cost countries; the rise in consumerism created more product demand in more markets; international transportation grew at double digit annual growth rates; and technological advances meant that products could be managed across continents. These conditions also came at a time when manufacturers and retailers began embracing an outsourcing model, not just for non-core activities, but also to grow a global network without investing in fixed assets. They needed partner companies to turn fixed costs into variable costs. The logistics industry fulfilled this need and developed a global service network linking inventory storage with distribution channels.

In-Depth: How does contract logistics really work?

The contract logistics model relies either on building and owning warehouses (asset-heavy), or leasing existing warehousing space and ideally using the space to fulfill customer requirements with a ‘back to back’ contract – limiting exposure to the logistics provider (asset light). The logistics provider in this scenario is beholden to landlords who demand long-term contracts of several years or longer. The logistic provider then tries to match the leasing length with customer contract to limit exposure.

The logistics provider makes the space fit for use by installing racking and material handling equipment, and providing labour on a service contract. To fund these activities, the logistics provider either demands payment up-front, or amortises the set-up costs across the contract lifetime, normally with the clause that, if the customer terminates the contract prematurely, all costs are paid including the outstanding rental agreement.

The logistics provider also demands a minimum volume guarantee to cover labour and other costs, also for the lifetime of the contract. On top of this, any penalties for poor performance on the part of the logistics provider are typically capped at a specified rate, therefore further limiting liability and exposure. Whilst there are always variations on this theme, it basically outlines typical practices. In essence, there is little wonder that contract logistics has a reputation as a risk-averse industry; it offers a service with little or no risk to the service provider.

Over time, this set-up has become the accepted norm and even the industry standard and to repeat, there is nothing wrong with this model if it works, and it has worked for many years. If a customer wants to use a logistics provider, then they sign on the dotted line and commit for several years into the future, accepting all and any risk of fluctuation in business or demand. The market settled into this modus operandi and it quickly became the norm, hence the ‘contract’ in contract logistics.

But here is the rub…how long can this model exist without being disrupted? To the outsider looking in to the logistics industry it can seem a little one-sided. After all, many other industries have grown into more collaborative partnership arrangements and, as we see more of the sharing economy entering into our daily lives, the question is therefore: is this model outmoded?

Long-term contracts and the inherent inflexibility they come with are under threat. An excellent example is found in the mobile network operator industry, where heavyweight Verizon put an end to fixed term contracts in 2015, and T-Mobile in 2013. The shared economy entails that flexibility, freedom of choice and transparency become the norm, we have Product as a Service (PaaS) replacing product ownership and we see the asset sharing, hyper-connected Physical Internet as the model of the future… Watch this space for a later blog on the work of Georgia Tech and the Physical Internet.

When we put the logistics market into the context of consumers, e-commerce and the expectancy of immediacy that consumers demand, then this helps us formulate the new models that we see emerging in the logistics space. We are seeing (and will increasingly see more demand for) flexible facilities closer to the point of consumption. Facilities that can move product, not store product. There will always be the need for vast warehouses in the middle of the desert to store toilet paper, toothpaste and the student staple dried noodles with a seventy year shelf-life, so the contract logistics model isn‘t going to disappear.

However, as products are becoming more personalized and we don‘t want to days for them to arrive for the OEM, this poses a challenge. How to satisfy market demands when the standard model we described earlier is clearly not up to the job? That is why the answer lies in flexible, on-demand logistics services that have the inherent ability to flex with demand and not restricted to contractual obligations. On demand logistics as a service is the future! The tensions between service provider and customer becomes more relaxed and the service provider has to find new business models that accepts more risk, but satisfies market demand and hence greater reward… time to chuck away the crystal ball.