The 12 Traits of Highly Profitable Trucking Companies: The Courage To Shrink - Establishing a Minimum Margin Threshold

KSM Transport Advisors (KSMTA) has worked with over 200 trucking companies since our inception. Our primary service focuses on guiding trucking company leaders in understanding their freight network and determining strategies to improve the density, velocity, and ultimately the profitability in their geographic footprint. In delivering this service, the KSMTA team has observed and documented 12 key traits of highly profitable trucking companies.

This article is part of a series highlighting the key traits and focuses on trait number six of 12.

The truckload roller coaster appears to have hit a trough. However, no clear prediction exists for how long the industry will remain margin challenged. Many carriers have expressed an eerie familiarity with this market cycle and the one experienced during the Great Recession, and the abrupt fall from the peak market to today has left many organizations shell-shocked. The uncertainty of the economy, combined with a continued oversupply of capacity, will likely push the start of recovery out longer than previous market cycles.

However, despite the macro factors, there are several organizational behaviors and practices that should be utilized in all market cycles. If most carriers incorporate these practices into their culture and DNA, the ebbs and flows of the market would be less precipitous in the future.

Establish a Minimum Margin Threshold To Optimize Profitability

For example, when considering retirement planning, several factors come into play. These include time remaining until retirement, the initial capital available for investment, risk tolerance, and the ability to contribute and invest regularly. These factors establish a minimum required return rate to bridge the gap between the present and future states. If the calculations indicate that assuming too much risk is necessary, the solution is straightforward: either delay retirement or increase savings.

This simple arithmetic is applied more widely in the business world. There are many trucking company owners who, if they pragmatically assessed their current risk profile (which tends to be high) concerning their historical return on capital (typically low), would likely decide to sell their businesses or liquidate them quickly.

Establishing a Minimum Margin Threshold (MMT) for your trucking business is the number one key performance indicator (KPI) that should be established and measured against. Trucking is a capital-intensive business, just like all other industrialized industries. Setting this target will ensure that the necessary cash flow is available to maintain and replenish assets, and keep key people employed and engaged in all market cycles. It’s one thing to establish and another to maintain a MMT. Maintaining a MMT requires significant courage and fortitude.

Before delving into the details of establishing a MMT, exploring a remarkable example of how MMT can effectively steer an organization is worthwhile. Heartland Express always springs to mind when industry executives contemplate examples of highly profitable trucking companies. Michael Gerdin, the CEO of Heartland, is widely sought after as a panelist for industry events, following in the esteemed footsteps of his legendary father, Heartland founder Russ Gerdin. The reason behind this acclaim? Heartland Express has attained an enviable position as the most profitable large truckload company since its public offering in 1986 – with a modest fleet of 125 trucks. Countless anecdotes from current and former Heartland employees attest to the extraordinary discipline interwoven into the organization’s DNA, encompassing both operational and fiscal domains. These narratives have built an allure that captivates numerous industry executives. Bucking the trend of measuring truckload success solely by truck count, Heartland has utilized MMT to inform their network and capacity decisions. This approach has led to substantial profits and is more compatible with the risk of trucking companies.

One notable illustration of Heartland’s effective implementation of a MMT is in this article published in Transport Topics. The article outlines Heartland’s strategic decision to decrease their truck count shortly after acquiring Interstate Distributor Co. The objective of improved network density drove this acquisition while simultaneously expanding their network footprint, especially among franchise customers. Consequently, leveraging their disciplined culture, Heartland determined the optimal scale of operations (trucks) necessary to sustain a minimum acceptable margin. This exemplifies how Heartland utilized their MMT to make informed (but tough) decisions about their organizational size and operational efficiency, yielding sustainable profits.

The Path to Greater Profitability

Establishing a MMT requires significant introspection and inspection. Here is a suggested path:

1. Understand Your Costs

When trucking company leaders want to understand their costs better, a typical scenario is breaking out almost every cost into its own general ledger (GL) account. We’ve seen GLs that consist of 20,000+ accounts and many with less than 25. These extremes typically lead to either analysis paralysis or analysis avoidance. The “right” size is different for all, but every trucking company should have the following critical cost categories built into their GLs:

Revenue Categories

• 1. Revenue
     1.  Linehaul
     2. Accessorial
     3. Fuel surcharge

Variable Cost Categories

• 2. Driver Compensation
     1. Wages/salary
     2. Incentives/bonuses
     3. Per diem
     4. Benefits
     5. Payroll taxes
     6. Workers’ compensation

• 3. Owner-Operator Compensation/Purchased Transportation
     1. Net settlements
     2. Incentive compensation

• 4. Fuel Expense
     1. Fuel purchases including terminal fuel
     2. Fuel taxes
     3. DEF
     4. Additives

• 5. Maintenance
     1. Tractor repair and maintenance (including third-party repairs)
     2. Trailer repair and maintenance (including third-party repairs)
     3. Maintenance labor and overhead

• 6. Insurance
     1. Auto liability and excess liability premium and deductibles
     2. Physical damage premium and deductibles
     3. Cargo premium and deductibles
     4. Self-insurance accident damage

• 7. Variable Driving Expenses
     1. Scales, tolls, and/or fines
     2. Miscellaneous on-road costs

The above costs are those expenses considered “variable” and used to establish a gross margin calculation (revenue minus variable expenses).

Fixed Cost Categories

• 8. Truck Fixed Expenses
     1. Depreciation
     2. Interest
     3. Lease
     4. *Don’t include gain/loss on sale (include in “fixed overhead expenses” below)

• 9. Trailer Fixed Expenses
     1. Depreciation
     2. Interest
     3. Lease
     4. *Don’t include gain/loss on sale (include in “fixed overhead expenses” below)

• 10. Non-Driver Compensation (compensation for all other employees that are not commercial drivers or maintenance staff)
      1. Salaries and wages
      2. Incentives/bonuses
      3. Benefits
      4. Payroll taxes
      5. Workers’ compensation

• 11. Fixed Overhead Expenses (this can easily become a catchall)
      1. Physical plant (facilities maintenance, etc.)
      2. Telematics
      3. Software subscriptions
      4. Non-revenue equipment
      5. Office supplies
      6. Driver screening, etc.

2. Build an Activity-Based Costing Model

Once you have diligently completed the task of accurately segmenting your costs at the GL level – mirroring the practices of high-performing manufacturing companies – the next step entails establishing a method to allocate the variable costs to the freight you have hauled. This model must be comprehensive enough to enable you, upon completion, to objectively evaluate the performance of customers, lanes, and individual loads. It should provide invaluable insights to distinguish between those that contribute to – and erode – the profitability of your network. Moreover, this process will establish a baseline for the current margin of your network’s OTR/one-way and dedicated operations. By monitoring this baseline and comparing it to your resulting operating ratio, a correlated relationship can be established between margin and operating income.

It’s important to note that the ideal activity model varies for each carrier but generally involves a combination of miles and/or transit time as the primary allocators. Additionally, depending on the mode of transport, such as refrigerated freight, applying costs based on ambient, chilled, frozen, and deep-frozen variables can significantly impact profitability. Other factors to consider include trailer pools and cost of local pick-up and delivery.

Prior to constructing your activity-based costing model, we highly recommend reading the book “Islands of Profit in a Sea of Red Ink.” This exceptional resource will furnish you with a structured framework that clarifies the extent of effort required to attain meaningful results, which often turns out to be less daunting than anticipated.

3. Establish Your Minimum Margin Threshold

Similar to calculating the required rate of return for your personal retirement, to ensure long-term viability, trucking company executives must determine an acceptable rate of return on investment given the overall risk associated with the business. A great starting point is to compare the current and historical returns for risk-free (treasury bills) and lower risk (blue chip dividend stocks) investments. If your historical OR/operating income has not exceeded these values, then your MMT is too low. In the truckload industry, the top quartile performers from an OR perspective is < 93 overall. This equates to a minimum of 7% operating income.

Once an activity-based costing model has been implemented, you will have a method to compare gross margin and OR. If there is a deficiency in OR, a good rule of thumb is to increase the MMT on a two-to-one basis. For every one percentage point improvement in required OR, the MMT should be increased by a minimum of two percentage points.

4. Measure Network Profitability

Now that the MMT has been established, the next step is to construct a model to identify the freight that is eroding margin. It’s easier to eliminate the bad apples than simply doing more of the “great freight.” To establish this, the ability to compare loads is critical. This means establishing common market areas. For example, KSMTA has established market areas for all of North America. This standardized geography allows you to establish lanes based on market area origin and destination. This will then allow you to compare the revenue, costs, and related margins of freight for customers on the same lanes, as well as external market rate indexes. Immediately after completing this, you can identify the low-hanging fruit targets for action.

5. Define Your Network

Armed with a list of freights, lanes, and ultimately customers stealing profits from your network, this exercise makes it quite easy to identify your freight network. Taking this one step further, we use another shortcut exploring “power” and “spider” lanes to identify the profitable core network. To identify the spider lanes, count the number of loads in each lane for a specified interval of time and establish quartiles based on density. The top 25% of lanes by density are considered power lanes, while the bottom 25% are considered spider lanes. Our core hypothesis for success in truckload is:

1. Density builds efficiency.
2. Efficiency builds velocity.
3. Velocity builds profitability.

Without fail, this hypothesis is validated with each of our customer engagements. The low-density lanes always generate less margin. This can be attributable to many factors, but the key observation is that spider lanes grow when the truckload market erodes. In order to keep drivers moving and trucks full, the virtual borders of their core network open up, deadhead miles increase, and the carrier is left scrambling for freight (usually broker freight) to get back into the core network. This behavior will erode margin, profitability, and cashflow.

6. Right Sizing Helps With Decision Making

Using a MMT as the starting point to continuously right-size the business is the correct (but difficult) path to sustainably higher margins that combat network creep and margin erosion. In any life pursuit, doing more for less is generally viewed as a negative – but here we are currently facing over-capacity and rapidly dropping margins.

Once you can identify the loads, lanes, and customers that do not meet the MMT, the miles associated with the remaining freight can provide a very quick estimate of the trucks/drivers required to facilitate the profitable freight. That estimate should lead to action – if you have excess unprofitable freight, you also have excess trucks/drivers and likely support personnel. Although this is an uncomfortable reality, you owe it to your employees, stakeholders, and community to take action.

If your MMT requires action, it will likely lead to a series of difficult conversations. These conversations will leave an imprint on each person affected – and provide motivation to not have to do this again. This breeds strategic, operational, and sales discipline that will permeate the entire business. Additionally, if the unprofitable freight is brokerable, and you have a logistics operation, generating margin from those loads is very possible. Unprofitable freight for one company and network can be highly profitable for another.

Establishing a MMT is a way to ensure that your return on investment is commensurate with the significant risk associated with hauling freight.

Our next article in The 12 Traits of Highly Profitable Trucking Companies series will highlight the key trait of “The Strength of Weak Ties – Utilizing Brokers Profitably.”

To learn more or discuss any of the ideas shared above, please contact a KSMTA advisor or complete this form.