Ups Facing Increasing Fuel Costs

UNITED PARCEL SERVICE, Inc.

BACKGROUND INFORMATION

In 1907, 19-year-old James E. Casey established the American Messenger Company in Seattle, Washington, which would be known six years later as the United Parcel Service (UPS). Despite stiff competition and a timeframe of hundred years, this “messenger” company transformed from a business located in a basement with deliveries made by bicycle to the world’s largest package delivery company, delivering today to 6.1 million customers in 200 countries by air, sea and land.

With such a large cliental and major domestic competitors like USPS and FedEx, UPS has had the opportunity to reinvent itself throughout the years and continues to lead the pack in logistics, supply chain management and e-commerce. However, reinventing continuously a 42.6 billion dollar corporation is obviously not an easy task and presents its share of problems…

PROBLEM IDENTIFICATION

UPS has been experiencing increasing fuel costs lately, as a result of energy prices that are escalating around the world. As a logistics provider, fuel costs account for a significant part of operating costs at UPS. Thus, an increase in fuel costs jeopardizes directly the organization’s profitability (see Exhibit 1).

MEASURE

From 2006 to 2007 UPS experienced an increase in fuel costs of 12.0% on top of the 20.2% increase from 2005 to 2006. Indeed, according to the 2007 Annual Report, fuel costs went up to $3 billion last year (see Exhibit 2). These increases in operating costs would have been even higher, 27.3% from 2005 to 2006, had UPS not experienced gains from hedging this commodity.

ANALYZE

There are many possible strategies that UPS could utilize to cope with the escalating fuel costs. Given the size of UPS, the worldwide freight industry, and utter significance of not proactively addressing this issue (which is always an option), it seems that UPS has three prominent methods for combating this increase in operating costs.

The first alternative is to use less fuel. One way to achieve this goal is to use vehicles powered by alternative fuels or hybrid technology. While this would require substantial investment in the short-term, the effect would be a long-term fuel savings that is very likely to supersede the initial investment. In May 2007, UPS acquired 50 hybrid electric vehicles (HEVs) to operate in Atlanta, Dallas, Houston and Phoenix. The new trucks joined roughly 20,000 low-emission and alternative-fuel vehicles already in use. "We're excited to be among the first to deploy the latest in HEV technology because it promises a 45% increase in fuel economy in addition to a dramatic decrease in vehicle emissions," said Robert Hall, director of UPS Ground Fleet Engineering. The 50 new HEV package cars are expected to reduce fuel consumption by roughly 44,000 gallons over the course of a year compared to an equivalent number of traditional diesel trucks. The UPS alternative fuel fleet currently includes trucks powered by compressed natural gas, liquefied natural gas, propane and electricity. UPS has also been testing hydrogen fuel cell vehicles and hydraulic hybrid technology in partnership with the Environmental Protection Agency and others. The other way to use less fuel is to streamline package flow on a worldwide basis by pinpointing opportunities for efficiency gains. Indeed, by streamlining shipments and eliminating any unnecessary handling, there is potential to consolidate loads and eliminate package travel.

Another option is to simply pass on the increase in operating costs to the customer. This is done in the form of a fuel surcharge. UPS is using this as a method to avoid absorbing increased costs but continued increases to customers will eventually affect demand. As a result, it seems that UPS must attempt to minimize the amount of fuel surcharges that are passed along to customers as the latter will become more sensitive to price increases (and as they will also undergo price increases with their own consumption of gas). In this highly competitive industry, customers can easily choose between competitors based strictly on price. This strategy would require extremely close monitoring of competitors’ strategies to make sure that pricing and surcharges are in line with the industry. Nonetheless, we should bear in mind that the industry acts like an oligopoly. As a matter of fact, FedEx said last December that it would increase the standard list rates for FedEx Ground and FedEx Home Delivery by an average of 4.9 percent, which went into effect on January 7. In October, FedEx, on its part, announced it planned to increase the net average shipping rate for its FedEx Express unit by 4.9 percent, which also took effect on January 7. In November, DHL announced it would increase the net average shipping rate for DHL Domestic Air Express and International Express by 4.9 percent. And finally, UPS also announced in late November that it was raising its rates for UPS Ground and UPS Standard to Canada services, as well as its Air and International express services by 4.9 percent. On the other hand, as long as technological improvements will be made without surcharge, UPS will be able to adopt fuel surcharges. "We are continuing to improve service to our customers and to provide the latest technology," said UPS Freight President Jack Holmes in a statement. "On Jan. 1, UPS began offering on-time guarantees at no additional charge to customers on the current base UPS Freight tariff for shipments moving within the continental United States."

Finally, the third choice is to use options to hedge, and in turn, manage pricing of fuel in the future. This is a strategy currently used by UPS to manage its commodity price risk just as a heavy machine manufacturer may try to control the price of steel in the future. UPS designs the use of these derivatives to hedge predicted cash expenditures related to the purchase of fuel in the future. One way this strategy can work to UPS’ advantage is to recognize the gains as income over the hedge term through the end of the year.