The Operating Ratio Paradigm

Feb 26, 2014 | Articles

by Leo J. Lazarus

For 25 years or longer, operating ratio (the ratio of operating expenses to operating revenue) has been a common measure of profitability and efficiency in the truckload transportation industry. Historically, most truckload carriers have established operating ratio goals ranging from 88% to 92% and have measured financial success based on this one simple indicator of profitability. From a return on investment perspective, this traditional paradigm of a specific operating ratio being profitable, regardless of the characteristics of the operation, is simply not accurate.

In my experience, a typical truckload operation is characterized by tractor utilization of 2,200 to 2,500 miles per week and between two and three trailers per tractor. The historical operating ratio standards of 88% to 92% are based on this typical operating model. Unfortunately, because of its simplicity, operating ratio does not account for the carrier’s comprehensive financial model, especially in situations where the operating model is significantly different from the “typical” truckload operation.

The general paradigm is that the lower the operating ratio, the more profitable and efficient the carrier. For example, a truckload carrier with an operating ratio of 85%, regardless of the underlying business model, is very likely to be considered more profitable and efficient than a carrier with an operating ratio of 89%. The risk with this common interpretation is that a number of critical variables about each carrier’s operation are not taken into account. If the two carriers serve different market segments, different length of haul levels, and different customer requirements, the 89% carrier can easily be even more efficient and more profitable than the 85% carrier.

While I believe a variety of operating and financial variables can impact the accurate interpretation and application of operating ratio, the two most important considerations are weekly utilization (productivity in miles) and the trailer-to-tractor ratio (capital investment). In specialized trucking operations, as is often seen with many dedicated and shorthaul fleets, the operation may have extreme trailer needs or utilization requirements outside those of the typical truckload operation. When a specialized operation requires an extremely high number of trailers per tractor (above average capital investment), the “standard” operating ratio is not appropriate for measuring or pricing the operation. Likewise, when a specialized operation can generate only 1,000 miles per tractor per week (below average productivity), the “standard” operating ratio is again no longer an accurate guideline for the operation.

For all truckload pricing and profitability benchmarking, the operating ratio expectation must be adjusted relative to the characteristics of the operation, particularly investment level and asset utilization. A carrier’s standard operating ratio expectation is likely to provide an accurate guideline for “typical” operations. However, for specialized operations, the correct operating ratio expectation could range from 70% to 93% depending on the requirements of the individual operation.

The most straightforward illustration of the risks of the operating ratio paradigm is seen in the common process for pricing dedicated fleets. All too often, carriers base dedicated pricing on a simple cost-plus approach. For example, the carrier may have a stated goal that all dedicated fleets must achieve an operating ratio of 88.0%. The carrier simply estimates the operating cost of providing the dedicated fleet then computes the revenue necessary to achieve the target operating ratio.

Using a static operating ratio goal and cost-plus approach to price every fleet, regardless of specific characteristics, will often result in one of two critical pricing mistakes. The potentially most costly mistake occurs when a carrier prices an undesirable opportunity too low. The most common mistake of this type would involve a low utilization fleet requiring a high number of trailers per tractor being priced too low. Not only does the underpriced fleet generate inadequate returns, but because of the low pricing mistake, the carrier also stands a good chance of being awarded a fleet that produces poor financial results.

The second mistake occurs when a carrier prices a very attractive opportunity too high, failing to provide competitive pricing for the business opportunity. A common mistake of this type might occur when a shipper requests a fleet of dedicated trucks and drivers but the entire trailer fleet is provided by the shipper, thereby eliminating the carrier’s capital investment in trailers. Carriers that do not adjust pricing and margin downward by the appropriate amount will be priced too high and likely miss out on this financially attractive opportunity.

Because a static operating ratio target is not accurate for all situations, a more sophisticated pricing approach is required. The most accurate way to establish the proper margin and pricing is to apply a more sophisticated, investment analysis approach based on the criteria of Net Present Value and Internal Rate of Return. Instead of a standard operating ratio serving as the primary guideline, the carrier should establish a minimum Internal Rate of Return for each operation and price the opportunity to meet or exceed the required rate of return.

With a minimum required return standard in place, the Net Present Value and Internal Rate of Return investment analysis techniques provide the ideal methodology for evaluating and pricing specialized fleet opportunities. These investment analysis tools will accurately account for the sensitive variables of investment (tractors and trailers) and productivity (utilization) then generate suggested pricing that adjusts the revenue and target operating ratio based on those unique characteristics. These techniques provide a comprehensive analysis of both the operating costs and revenues of the opportunity as well as the upfront capital investment required to undertake the specialized operation, thereby allowing the carrier to consistently price specialized truckload operations to provide the appropriate return on investment.

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