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November 18, 2017
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Fighting it out on the ground

Comment
The global air cargo segment is holding its own, but the future of U.S. domestic and air parcel service could be determined by how well those carriers play their ground game.

After several slow years, the global airfreight market is making a modest comeback, buoyed by significant volume growth in international air cargo markets. The International Air Transport Association (IATA) reported 14 percent year-on-year growth in freight ton kilometers (FTKs) on international lanes for May. Air carriers are reporting similar growth in revenue; for instance, United Airlines announced cargo revenue growth of over 20 percent in July. So has the market experienced a turnaround, and are higher prices around the corner?

Several factors suggest this won't be the case. Although demand has demonstrably improved over the past year, it is important to consider this in the context of a market that is rapidly adding capacity to support increased passenger demand. While for carriers, cargo is the "tail of the dog"—beneficial, but not the primary driver—compared to passenger revenue, this capacity increase weakens pricing power because of the danger that it could spill into excess cargo capacity. U.S. domestic markets, meanwhile, are not mirroring international cargo's performance. This is for several probable reasons, including strengthened U.S. ground shipping (discussed below). And, as we will see, external disruption is another factor that should be on the minds of all air cargo providers, particularly those in domestic and intracontinental markets, and especially overnight parcel carriers.

Article Figures
[Figure 1] Freight load factors (2014 to mid-2017)
[Figure 1] Freight load factors (2014 to mid-2017) Enlarge this image

Volumes up, but profits remain low
Global capacity growth will remain a damper on carriers' and freight forwarders' margins for the foreseeable future. As demand rose in May, additional capacity translated that growth into a 3 percent improvement in load-factor levels, according to IATA. (See Figure 1.) New capacity carried nearly half of the year-on-year increase in volume. Meanwhile, moderate yield growth is producing higher revenues for market players but also disappointing bottom-line results. Forwarders like Panalpina are reporting gross profit reductions (9 percent in July) despite seeing airfreight volume increases of 7 percent.

On the domestic cargo front, carriers continue to experience lower load factors than on the international lanes. Based on historical data, the implied load factor for domestic aircraft is just below 30 percent, where it has been for several years. The story is more upbeat for air express carriers. In its 2016 annual report released in June, FedEx announced that its express revenues grew because of higher rates and package volumes tied to growth in e-commerce. However, a closer look at industrywide numbers reveals that overall, air parcel volume was down 0.5 percent. Given that there is underlying weakness in air express volumes, the limited number of options for shippers appears to be a primary driver of better margins and revenues for carriers in that space.

A new challenger on the horizon
With its focus on small package shipments, e-commerce has been a positive force for the air express industry in general, and shippers generally think of building their e-commerce channel around express network infrastructure. But the domestic air market that e-commerce merchants rely on is facing a new and unusual challenger on the horizon: driverless trucks. These automated vehicles will pose an enormous competitive and cost challenge to U.S. and other continental air networks, and they could well reshape the way shippers think about omnichannel distribution.

When it comes to distribution networks, many shippers and carriers have been co-locating distinct e-commerce hubs in the Ohio Valley near the national sortation and shipment hubs operated by FedEx and UPS. Autonomous vehicles will allow them to expand that map. Because these vehicles will be able to operate without stopping, as human drivers must do, their service range will be greatly expanded compared to what's feasible today. For instance, Shreveport, Louisiana, not far from the U.S. Gulf Coast, could serve as a launch area for last-mile solutions reaching as far afield as Los Angeles, Boston, and Winnipeg in 24 hours or less. Overnight services covering almost all of the United States, Canada, and Mexico could therefore be developed with just two or three distribution centers. The best path forward for air parcel companies will be to adopt the driverless technology themselves for all but coast-to-coast routes while investing in a more diffused shipment-sortation infrastructure. Pushing sortation outward from the major air hubs will enable parcel providers to lean on the scale of their national networks to compete against regional or crowdsourced local pickup and delivery solutions.

This strategy would offer opportunities for substantial savings. The cost savings afforded by road freight (especially without labor, the biggest cost component of trucking) versus air, for example, will be enhanced by inventory reduction and simplification, as shippers will be able to achieve the higher service levels their customers demand with fewer distribution nodes. However, service based on the use of driverless vehicles would also come with expectations of pricing that's in line with that for ground service. This could create another challenge for air parcel carriers: Both FedEx's and UPS' ground rates are less than half of their express rates—meaning a significant share of their combined $20 billion express revenue would be at risk. Moreover, customers will come to expect lower ground rates as autonomous technology reduces the cost of operating trucks.

Despite the cost and efficiency benefits of autonomous vehicles, air express and other carriers that want to move ahead with this kind of automation may confront a challenge from within, as labor could potentially influence the ability and speed with which companies can adopt this new technology.

Flexibility will be key
As interesting as these developments will be, they are still at least a few years away. In the meantime, air carriers and forwarders will seek ways to improve their margins, but in a market with rapid growth in capacity and declining domestic volumes, overall improvements in yields are likely to be elusive. Many of our clients are actively reassessing their domestic air networks in light of these predicted changes. We are advising companies to make flexibility a key strategic objective of network design while they invest in the network modeling and procurement analytics capabilities needed to turn these changes into a source of potential advantage.

Joshua Brogan is a vice president in the Analytics practice of A.T. Kearney, a global strategy and management consulting firm.

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