Growing pains for logistics outsourcers

Growing pains for logistics outsourcers

The customers’ demands are outpacing the logistics providers’ ability to meet them.

Bernard L. Bot and Carl-Stefan Neumann

May 2003---from the McKinsey Quarterly

From beginnings in the 1980s as humble additions to road, sea, and air carrier services, third-party logistics providers (3PLs) have built a $100 billion industry that plays an increasingly important role in the world economy. Determined to save money and to focus on core businesses, companies in the automotive, electronics, chemical, and fast-moving consumer goods sectors, among others, are outsourcing more and more of their warehousing, distribution, and other supply chain activities to these 3PLs. In Western Europe, they already handle more than a quarter of the total volume of shipments, while in the United States the figure isn't far behind. In the world as a whole, the market the 3PLs serve has grown at a compounded annual rate of more than 10 percent since the mid-1990s—a level of expansion that will probably be sustained (Exhibit 1).

Yet customers want more. They are starting, for example, to ask 3PLs to redesign their supply chains and to make those chains as efficient and inexpensive as possible. And as customers move from local to regional and then global scale, they want logistics specialists to serve them with consistent skills wherever they do business. Although the industry is at pains to respond, many logistics providers are hard-pressed to meet such demands.

Even as customers ask more of their 3PLs, they are beating down prices through canny contract negotiations that shrink profit margins and make returns on invested capital inadequate. The result is a business model increasingly under pressure precisely as related transportation businesses—freight forwarders, express integrators, contract manufacturers, and wholesale distributors—are encroaching on the 3PLs' territory.¹

Raising profitability in such an environment poses its own logistics challenge for the industry, since the customers' expectations have clearly outpaced the 3PLs' ability to respond. For the winners, catching up is likely to mean adopting a business model built on greater structural and technological savvy and, in many cases, greater consolidation. More specifically, the 3PLs must build regional and global scope by establishing themselves in geographies ahead of their customers. They will also have to achieve economies of scale by orchestrating ways for their customers to share warehouse and distribution facilities instead of bowing to demands for customized service. Doubling the number of spare parts delivered through a single distribution network, for example, could cut a 3PL's costs by up to 15 percent (Exhibit 2).

For this kind of multiuser approach to work without provoking nightmarish operational lapses, 3PLs will have to invest heavily in standardizing their IT systems interfaces. They will also have to hone their skills to design efficient supply chains and to pursue best practices in far-flung offices. And if their main customers—global industries—are going to be served efficiently, they will have to bulk up, fueling the continued consolidation of an industry that continues to be fragmented.

The world of the 3PLs

Logistics specialists have made their bread and butter by offering customers 15 to 20 percent savings on warehousing and transportation costs. In particular, 3PLs help clients reduce their capital spending (by eliminating assets such as trucks and warehouses), their working capital (by cutting inventories), and, especially, their personnel costs (through the 3PLs' more advantageous labor contracts).

More recently, the logistics companies, focusing on improving their customers' supply chains, have promised a 10 to 25 percent reduction in their customers' delivery cycle times by eliminating certain goods-storage steps and improving their information-management skills. Such efficiencies can boost sales because they help producers to respond more quickly to market trends and to reduce stock-out costs. In a recent worldwide survey of 50 large customers, we found that those using 3PLs to manage their warehouses moved goods in and out more than twice as quickly as those relying on in-house logistics departments. Logistics specialists also increasingly finance their customers' activities by taking ownership of inventories.

Another new wrinkle in the logistics game is the fact that many 3PL customers are changing the scale of their outsourcing. In the electronics and automotive industries, customers are moving from contracts for single localized services—a solitary warehouse in one country, say—to contracts for integrated services in several countries. Top logistics providers are following suit: Exel, for example, has a contract with Motorola to manage large parts of its supply chain to and from warehouses in Amsterdam, Chicago, Hong Kong, and Singapore. Given the importance of cross-border flows in these sectors, such contracts are likely to proliferate; in electronics, cross-border flows already represent 35 percent of total industry value.

Besides managing physical assets, leading logistics companies are using sophisticated IT to optimize the flow of information through the supply chain. In many industries, information-related logistics costs—lost sales, rebates, and inventory financing—surpass asset-related direct costs such as freight and warehousing. The impact of markdowns and lost sales in the apparel industry, for instance, means that information-related costs make up nearly 70 percent of total logistics costs (Exhibit 3); in toys and games, the figure is 60 percent. Moreover, the potential savings are frequently larger for information-related logistics costs than for asset-related ones, which in many cases have already been squeezed dry.

A tougher world for logistics providers

Still, logistics specialists are falling short in profitability. The average return on invested capital (including goodwill) for pure 3PL players—7 to 8 percent—has been below their weighted average cost of capital for years, so they have destroyed shareholder value. These disappointing returns can be explained only in part by overpayment for acquisitions and delays in capturing integration benefits. Margins, measured as earnings before interest, taxes, and amortization, have also declined, from about 5.3 percent in 1997 to 3.4 percent in 2002 (Exhibit 4).

Many of these economic woes can be traced to flawed contractual relationships. Customers specify requirements in detail, often parceling out pieces of the supply chain to different 3PLs and limiting their opportunities to differentiate themselves, since the division of responsibility prevents them from optimizing their operations. Essentially, customers buy commodity services largely on the basis of price and continue to design their supply chains in-house. In addition, the 3PLs' cost structures are transparent. About half of the industry's contracts are "open book"—so customers know what costs the 3PLs bear—and include contract-margin and cost-reduction commitments. With "closed-book" contracts, by contrast, customers get fixed, indexed prices for given volumes but don't see the 3PLs' actual costs. Customers can, however, usually make good estimates based on experience and benchmarks from in-house operations. Tire manufacturers, for instance, employ specialists capable of walking through a tire warehouse and estimating the cost of warehousing to within 1 or 2 percent of the best-practice level.

Another problem is the fact that logistics operators find it hard to cash in on good performance: customers demand more stringent performance levels at the end of contracts, which typically run from three to five years. In addition, low renewal rates of around 40 percent—prompted in part by disappointment over the quality of service—mean that 3PLs can get stuck with expensive warehouse capacity and freight purchase obligations. And because contracts abound with individual requirements, 3PLs have difficulty exploiting economies of scale. Instead of installing an industry best-practice IT system developed and improved over the course of many client contracts, for example, 3PLs must often build expensive customized systems or links into legacy logistics systems providing for limited or no economies of scale.

The contract-by-contract approach also harms operations. In the rush to move from one customer to the next, 3PLs often fail to benchmark and establish best practices, instead constantly reinventing the operational wheel. Within any given company, it isn't uncommon to find productivity differences of 50 to 75 percent among similar operations in the same industrial sector and even the same country. Furthermore, the industry's single-contract norm means that a logistics provider's business-development employees spend their time fixing problems rather than studying clients in depth and building mutual trust.

Building a leading logistics player

Our research suggests that logistics providers eager to establish more equitable customer relationships and to shore up their long-term business models might consider a strategy built on three related approaches: offering more value, creating structural scale advantages, and pursuing consolidation.

New sources of value for the customer

The micromanagement of contracts will go on until customers stop seeing 3PLs only as lower-cost alternatives to in-house logistics operations. To strike out in a new direction, 3PLs should first improve their supply-chain-design skills, focusing on industries with reducible asset- and information-related costs. The potential varies: bulk commodities, for example, largely involve transportation, whereas the more complicated and time-sensitive flow and storage of electronics and automotive parts offer greater scope for reducing customer costs. Companies in some industries regard the optimization of logistics as a core success factor and see little point in outsourcing the design of their supply chains. These kinds of companies are best ignored.

To get the most from logistics once an opportunity has been identified, 3PLs must master the specifics of the industry supply chain by analyzing supply-and-demand flows and matching them with the cost and performance (speed, reliability, flexibility) of various warehouse and distribution options. Savings can be had by managing a complex, labor-intensive, and fragmented supply base and by getting a grip on the suppliers' lead times. To do so, logistics managers need IT systems that make it easy to follow the flow of goods in the supply chain. Certain 3PLs have already developed relevant skills and systems. TNT Logistics, for instance, uses a software tool that makes it easier to see the inbound flow of parts in an automotive operation, thereby helping vehicle manufacturers to fine-tune production schedules up to the last moment.

Economies of scope offer 3PLs a chance to expand the range of their services to a degree that customers could never accomplish in-house. Integrated logistics and freight forwarding, for example, might be attractive to companies that prefer to deal with fewer transport and logistics providers. Exel has successfully introduced such a combination; 40 percent of its new business is generated by cross-selling freight-forwarding services. Integrating a freight forwarder with a logistics provider also offers advantages such as improved customs handling and a greater international presence.

But combining these two kinds of businesses isn't right for all companies in the industry. Freight-forwarding capabilities, for instance, have greater importance in some sectors than in others—a 3PL that focused on electronics would need these services more than one specializing in chemicals. Besides, many 3PLs are too small to acquire a freight forwarder, and integration can raise operational difficulties: a freight forwarder's business, based on trading, is light on assets and longer-term contractual risks; the operations of 3PLs, by contrast, require longer-term commitments as well as investments in assets.

Enhanced regional and global scope becomes more important to logistics providers as their customers expand around the world, because it helps providers offer consistent service and supply chain transparency. Unilever, for example, is looking to Exel to provide warehouse services in Brazil, Mexico, the United Kingdom, and the United States—all countries where it has built a presence. But at times, a 3PL will have no assets on the ground. It will then have to decide whether to find a local partner, to buy one, or to build from a standing start.

Structural scale advantages

New services are important, but they aren't enough to revitalize a 3PL's business model; some could be matched by competitors and, in certain cases, by customers. The 3PLs, to buttress their position, must build scale advantages that will be harder for competitors to duplicate. To that end, they can learn from leading network companies such as United Parcel Service. UPS has come to dominate the US parcels and express market by realizing scale benefits other operators can't copy. Logistics providers should seek scale advantages by striving to use the same warehouses and transportation assets to serve many customers, which will share in the savings. Logistics providers can offer these savings to encourage a move away from shorter-term, commodity-like contracts that are unlikely to be renewed. With every new customer, the system gains scale and appeal. The individual components of logistics contracts—warehousing, freight transport, local distribution, IT, the back office—provide many opportunities to leverage scale. Larger volumes enable 3PLs to consolidate and renegotiate freight purchases at better rates and to spread back-office and IT costs over a larger customer base.

Density too is a vital factor in the cost of local delivery: since route costs are fixed, doubling volumes can reduce the expense of delivering individual items by about 20 percent. Several logistics operators² have joined forces with CAT, formerly Renault's automotive-logistics branch, to operate a network serving a range of automotive customers for new vehicles and spare parts; at 48 logistics centers, they are stocked side by side and delivery is shared. Shared networks exist in other industries too. Exel's Tradeteam has consolidated deliveries to the UK drinks industry, for example, and TNT Newsfast has done the same for the UK publishing market.

The benefits of networks can be significant, but putting them in place will be hard. First, the 3PL will have the complicated task of linking several participants in one network. This challenge will involve standardizing and integrating various IT systems—for example, by installing middleware that links the IT systems of a 3PL with those of its customers and by aligning communications and product standards and operating procedures. Only then can the 3PL decide on the rules of the game in the joint network. Priorities must be set; which customer, say, takes precedence in the case of rush orders, and how are costs to be allocated? Finally, the 3PL will have to negotiate the way benefits will be shared and which company must shoulder the fixed network costs if, for instance, the system's volumes fall.

How more consolidation may help

Globally, the third-party logistics market is fragmented: Exel, the largest operator, has only about a 4 percent share. Although Exel is particularly strong in electronics, TNT Logistics in automotive products, and Hays Logistics in fast-moving consumer goods, no company has yet gained a leading European or North American, let alone global, position in these sectors. Mergers and acquisitions could help logistics providers improve their economics by combining volumes in some sectors and shedding activities in others. Such deals would also help providers meet the demands of their customers by filling geographic or capability gaps; some European logistics specialists, for example, have used acquisitions to enter the US market,³others to build freight-forwarding capabilities.

Mergers, however, offer limited economies of scale in the immediate term, for there are no established networks to be integrated; most of the business is configured client by client. Nonetheless, longer-term benefits of integration, such as the streamlining of back-office and IT activities, might be available. The potential for building multiclient user networks would improve if the merged companies had customers in the same sector; moreover, a 3PL's reputation might be enhanced if, after a merger, it could claim to serve all of a country's leading OEMs in a sector. Finally, the more concentration of this kind takes place, the more power 3PLs will have to resist onerous contracts.

Industry consolidation is already under way, and two clear groups have emerged. Companies in the first, which includes Exel, TNT Logistics, and the DHL Worldwide Express/Danzas logistics unit of DPWN,⁴ are developing strong regional (and often global) positions in a number of sectors. These positions make it possible to accumulate scope and skill advantages and to build denser networks. Companies in the first group are likely to shape the industry by virtue of their competitive customer offers and their financial flexibility to pursue mergers and acquisitions. Some freight forwarders have the same aspiration: Kuehne & Nagel International, for instance, bought USCO Logistics in the United States and completed a cross-equity holding with SembCorp Logistics in Asia.

Companies in this first group have already been consolidating. Exel as it currently stands was created through the merger of the Ocean Group and Exel, in February 2000. DPWN has made a string of acquisitions: Danzas in 1999, the European Transportation and Distribution division of Nedlloyd and ASG in 1999, and Air Express International (AEI) in 2000. This trend will probably continue as larger players buy up smaller ones that can't meet the industry's cost and service challenges but do fill geographic or capability gaps for the big players. Mergers of logistics providers present their own special hurdles—foremost among them the fact that in acquiring a 3PL, the purchaser is actually buying a pile of contracts (with change-of-ownership clauses), not a streamlined business. It must then find ways to integrate a multitude of administrative, transport, and warehousing systems, all built around customized solutions.

The second group of 3PLs comprises companies that have the potential to dominate at least one sector, often in a single region. TDG, for example, gets more than 60 percent of its revenue from the fast-moving consumer goods and retail sectors, and 75 percent of its total revenue comes from the United Kingdom. Microlog concentrates on small and midsize German companies in the automotive and industrial sectors. The challenge for such providers will be to maintain their lead in specific sectors and geographies and, given their limited focus, to grow. They will have to prove that local, specialized operations can meet the challenge of more global generalists that might try to leverage size and global skills to encroach on their territory.

The worldwide trend toward outsourcing noncore activities plays directly to the strengths of the logistics industry. But as the 3PLs have discovered, growth and healthy profitability don't necessarily go hand in hand. Logistics companies have much work to do if they are to rewrite a business model dulled by ever more demanding customers and bolder competitors.

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Opportunities in Asia

More and more, customers are demanding that logistics companies follow them around the globe. That is particularly true in Asia, the source of so much of the world's manufacturing, especially in electronics. The region holds huge potential for logistics providers: annual sales of third-party logistics services are forecast to increase at three to four times Asia's overall rate of economic growth through 2010. At just over $1.1 trillion, Asia's logistics markets are probably half the size of those in Europe or the United States, but the potential savings—more than $140 billion a year—are far greater.

Three forces are firing up logistics demand in Asia: the spread of wealth beyond its major cities, the emergence of modern retailing, and global demand for its manufactured goods. Until now, Asia's major manufacturers and retailers preferred to set up in-house logistics chains rather than use local operators that offered neither efficiency nor an integrated, quality service.¹ Yet those manufacturers and retailers, hoping to free up capital for their core businesses, now want to outsource logistics.

Direct logistics costs—transporting, handling, and storing goods—are ripe for pruning in Asia, since they account for an average of 13.7 percent of total revenues, compared with an estimated 10.4 percent in Europe (exhibit). Closing only half of that efficiency gap could create a business opportunity worth $90 billion to $120 billion, an assessment based on industry cost structures in comparable economies, on pilot initiatives that have reduced costs by 40 to 60 percent, and on interviews with manufacturers to confirm their current and potential practices. Several companies reported that in Asia their stock spends an average of 30 days between manufacture and sale to consumers, but very little of that time is spent on store shelves; transportation, storage, and processing take up a full 27 days. The introduction of hub-and-spoke transport networks and of centralized dispatch functions is the most immediate step needed to reduce this lengthy period.

Improving the efficiency of logistics would also reduce stock obsolescence problems and missed sales—indirect, information-related costs that are 25 to 50 percent higher in Asia than in Europe, depending on the product. Goods that remain unsold and are then superceded by new models cost manufacturers, wholesalers, and retailers in Asia some 4 to 5 percent of their combined revenues. Sales lost when goods aren't in stock represent a further 5 to 7 percent hit to revenues. The more quickly and reliably stock is delivered, the less must be held on premises and the more likely it is that sales orders can be filled. A 15 percent improvement in the efficiency of logistics would cut indirect costs by $50 billion to $60 billion.

To capture these savings, logistics providers must first configure their vehicle fleets, containers, and warehouses to an industry's requirements and develop industry-tailored IT systems that could manage the flow of goods through those fleets, containers, and warehouses. Then the providers will have to learn how to use their customers' real-time inventory data in their IT systems. Even in Asia, it is no longer enough to compete on the cost or even the quality of basic freight and warehousing services, since their cost and quality are easy to replicate. The crying need is for logistics providers and their customers to build insights and loyalty around shared information. This need is especially strong in a region characterized by unreliable data sources, fragmented supply chains, bureaucratic information and payment systems, and uncertain regulation. Integrity of information is extremely valuable.

The attractive targets in Asia include electronics, fast-moving consumer goods, chemicals, automotive, and textiles because in these industries logistics accounts for a relatively high proportion of the value chain. Third-party providers are thought to be more fragmented and less efficient than those in Europe, so providers that made quick and lucrative inroads there will have a ready base of knowledge and some assurance of a profitable future role in Asia.

—Kaushik Das, Benoit Dumont, and Karsten Schween

Notes

Kaushik Das is a consultant in McKinsey's Singapore office; Benoit Dumont is a consultant in the Amsterdam office; Karsten Schween is a principal in the Munich office.

¹See the Quarterly Web exclusive "Moving goods in China."

About the Authors

Bernard Bot is a principal in McKinsey's Amsterdam office, and Carl-Stefan Neumann is a director in the Frankfurt office.

The authors wish to thank Steven Vossepoel and Jan Willem Breen for their contributions to this article.

Notes

¹For the purposes of this article, our definition of logistics excludes independent freight forwarding (the contracting of land, sea, or air transport for customers) and contract land, sea, and air transport services. Nonetheless, many of them are rapidly converging under the logistics umbrella.

²AutoLogic, TNT Logistics, and Wallenius Wilhelmsen Lines.

³TNT acquired CTI Logistx; Ocean (now Exel), Mark VII Transportation; and Deutsche Post World Net, AEI.

⁴Deutsche Post World Net.