What Is “Index-Based Pricing” in Transportation and Logistics and How Can It Help My Organization?

Index-based pricing (IBP) is a method of contractually pricing transportation costs that blend several key elements of other pricing methods, but for the right mix of shipper needs, it captures the best of all worlds. IBP establishes baseline rates and ties periodic rate adjustments to an objective, third-party pricing index.

Some common pricing methods include: dedicated contract, annual contract, quarterly contract, and spot market bids. Each of these methods has benefits and drawbacks and therefore, are of varying fits to the different needs of shippers.

Spot Market

There is a great deal of savings to be found in the spot market during loose capacity conditions, and an equal amount of vulnerability during tight capacity conditions. One of the benefits of spot market pricing is supply. The price will always rise or fall to the point of optimal supply. However, price volatility and service issues are the primary drawbacks.

The degree to which shippers are able to capture savings in loose markets while mitigating risk in tight markets is a function of several factors but the primary factor is schedule sensitivity. Take lumber shippers for instance. The cost of a truckload of lumber is relatively low meaning that the transportation cost is a relatively high portion of the total cost and is therefore, typically more cost-centric.

Lumber is also not usually very schedule sensitive. A load of lumber can sit for several days while awaiting the right truck, at the right cost. This allows lumber shippers to capture the most savings while avoiding the peaks of the spot market. It also generates a revolving door of transactional providers with little incentive to provide high levels of service. Therefore, the spot market is a great fit for lumber shippers and other non-JIT (Just-In-Time) commoditized cargo shippers.

Contract Approach

The OEM (Original Equipment Manufacturer) JIT environment is by definition, schedule sensitive. Minor issues can snowball into supply-chain interruptions that can shut a production line down, send thousands of workers home, and cost the shipper millions per hour.

These products tend to be of higher value so the focus is less cost-centric and more service and capacity-centric. Therefore, most OEM’s choose a dedicated contract approach. Supply is captive, predictable, and cost is known and largely static. However, market rates do continue to move so shippers miss some opportunities for savings in soft markets.

They also risk major supply chain interruptions if a key provider were to become insolvent. These drawbacks are known, however, and are largely trade-offs OEMs are willing to make and have many strategies to mitigate.

Index-Based Pricing

Many other shippers fall in between somewhere and choose an annual or quarterly, non-dedicated contract approach. This allows the shipper to blend several different types of providers: asset-based of all sizes, 3PL’s, IMC’s, etc.

Shippers are able to move seamlessly between providers as it best suits their needs, while still leveraging their volume with a relatively small group in order to yield optimal service and better contract rates. They are also able to enjoy some efficiencies and soft cost savings inherent in dealing with fewer providers.

However, these contracts rarely include ‘forced dispatch’ and shippers often find that they are under-supplied in tight capacity markets, or find themselves leaving savings on the table in soft, loose capacity markets. This is where a role for index-based pricing may exist. 

IBP is a method of pricing lanes or a group of lanes with a baseline line haul that changes periodically (weekly, monthly or quarterly) based on an objective third-party index measure to which both the provider and the shipper agree.

For instance, if a provider is awarded a lane with a monthly index-based adjustment, at the end of the first month, the provider will send an update to the shipper that shows the percentage change of the index, then apply that same percentage change to the baseline line haul.  

When a shipper issues an RFQ, they often invite new participants. They never truly know what they are going to get from these new providers. Some will bid aggressively with no intent to meet expectations if the spot market offers better rates elsewhere or dictates cost too high to profit. Others will bid conservatively knowing that they fully intend to meet expectations and, therefore, bid for all reasonable contingencies.

Neither outcome is preferable. The shipper wants aggressive rates that will be adhered to through the term of the contract. Index-based pricing encourages aggressive, measured, and accurate bidding. The provider is protected from unanticipated changes in the market and therefore encouraged to bid aggressively.

The shipper creates a safe harbor for providers to bid aggressively while encouraging adherence to routing guides. The shipper also retains the ability to capture savings in a soft market, and all but guarantees that their capacity supply will remain uninterrupted by market forces.

Index-based pricing is an innovative and potentially valuable tool that captures a unique combination of benefits that encourages favorable pricing, transportation provider compliance, and fosters strong shipper/carrier partnerships. BR Williams is one of just a few providers offering IBP. Contact BR Williams for more information and let’s talk about how IBP can help you and your organization.

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