Getting a Handle on Freight Cost

Guidelines for developing an effective freight management program.
By Nalin Kulasekara

IDN contracting professionals consider negotiating the cost of products and services to be their core objective. But what about freight? How do you negotiate and manage freight costs? And who controls freight — you or your suppliers? By implementing a good freight management program, you can help your organization take control of the information aspect of the supply chain, unbundle freight costs and aggregate freight expenses to lower supply chain costs.

In some supplier agreements, freight is still either a pre-negotiated amount or an amount determined by the supplier at the time of shipment. As a result, many IDNs have seen their freight costs escalate. Some suppliers use freight as a revenue center by negotiating their own freight agreements with carriers and marking the price up when they ship their products to hospitals. Others may pass the actual shipping cost on to the hospital, but there is no way to know if that cost is high or low. You may also find that you incur more freight costs with your traditional med/surg, lab or radiology distributors than with direct manufacturers, because of special orders, overnight or emergency orders and capital purchases. Because of these reasons, many IDNs have not been in a good position to validate and improve their freight costs.

The process
In order to get a handle on freight cost, you will need to start from scratch and develop an in-house program or outsource freight services to a third-party-logistics (3PL) company. Regardless of which method you implement, success depends on the number of suppliers who take part in your program.

Begin to develop your process by looking at how you internally account for freight, then establish benchmarks. Develop a new process for freight accounting based on your freight strategy. Your strategy may be to contract with shippers directly or to use a third-party company that specializes in managing freight. Finally, you will need to negotiate with your suppliers to use your process.

Once you implement your program, you will need to closely monitor the process to determine vendor compliance and cost savings.

Scope of program
Inbound freight is the cost charged by suppliers to ship their products to you. Outbound freight is what you pay to ship products to external constituents. Distribution (med/surg, pharmacy, radiology, lab) is a form of freight, but it is well managed and contracted separately from freight by most healthcare providers.

Freight management programs typically cover prepay and add (that is, line items that you can see in an invoice), and products that are delivered next day or managed. Typically excluded are same-day deliveries, suppliers’ own trunk stock and freight costs that are bundled into the cost of the product.

Begin your freight-management program by looking at how you account for inbound and outbound freight in your general ledger. Many hospital organizations lump mail, same-day deliveries, trunk stock deliveries, and inbound and outbound freight costs into one freight G/L account, says Rick Bayer, CEO of HLS MedFreight, Westerville, Ohio. But this practice makes it very difficult to identify where the highest freight costs are and how to manage them, he adds.

How is it currently being managed?
Do your suppliers separate freight in the invoice? If so, is it a negotiated and predictable amount, or is it determined by the seller? Are freight costs completely visible and manageable? Do you have benchmarks in place? If freight is not separated out when accounting performs its functions, how will you know that your program is effective? Where do you account for freight in your accounting system? Do you consistently spread cost of freight to the ordering department, or do you have a common freight account? Why have you selected your current process?

If the answers to any of these questions are “No” or “Don’t know,” then you have an opportunity to improve your freight management program.

Important considerations
In order to develop an effective freight management process, you must clearly define what you are trying to achieve. For instance, if you just want to reduce freight cost, you may not need to develop a new freight process at all; perhaps you can simply do a better job of negotiating rates with a freight carrier. The disadvantage of this strategy is that you will never be able to track the effectiveness of the process.

But if your goal is sustained cost reduction by improving reporting, vendor compliance, appropriate utilization and complete visibility into inbound and outbound product movement, your goal statement will need to be far more detailed and well thought out. The resulting process should be clear, simple and efficient.

Accounting policy
You should begin by developing some freight accounting guidelines so that you can accurately monitor cost. There are many different types of freight and distribution costs, and each must be separately accounted for:

    • Managed freight charges: Shipping costs incurred through a managed freight program, for in-bound as well as outbound freight.
    • Med/surg supply distribution fees: Fees charged by primary medical/surgical distributors for the delivery of medical and surgical supplies. These fees exclude managed freight charges.
    • Other distribution costs, including pharmacy,

radiology, laboratory, maintenance/repair/operations, etc: These are typically excluded from managed freight programs.

  • Non-managed prepay and add-freight charges: Shipping costs outside the managed freight program, which have not been included in the price.
  • Handling, restocking and minimum order fees: Fees posted to an account, which needs to be monitored if freight costs are shifted by suppliers from traditional cost of freight to other revenue-generating forms.

Separate general-ledger numbers may need to be created for each of these categories, and staff must be trained on accurate use of these accounts.

After developing accounting guidelines, you should identify how to go about reducing freight costs. There are three typical ways to do so:

  • Standardizing to one freight carrier: The greater the volume through one freight carrier, the better your discount rate. You may find better rates by employing a 3PL because of their ability to aggregate more volume than individual hospitals or even IDNs.
  • Optimizing mode of shipment: Reduce your costs by optimizing the mode of shipment, such as overnight, second day air, standard five day delivery, etc.
  • Increasing the number of suppliers using the freight program: The more suppliers that take part in the program, the greater the impact on your freight management program. You need to generate enough leverage for suppliers to take part in your program. Include participation in your freight program as part of your criteria for awarding contracts.

One caveat is that some suppliers may have negotiated a very favorable shipping rate on their own with a certain carrier, and then passed that actual cost on to the customer. In this case, you may want to eliminate them from the freight program. In most cases though, “the shipping price a vendor charges a hospital isn’t necessarily the actual price to deliver the good” (Neil, 2005, 17). These are the suppliers you will need to enroll in the freight program.

Outsource or develop an internal program
One of the important decisions you’ll need to make is whether to go it alone or contract with a third party logistics company to handle your program. The following are some points to consider when making your decision:

  • Knowledge of the industry
  • Number of vendors taking part in the program
  • The process for adding vendors to the participation list
  • Level of compliance by manufacturers
  • Startup and ongoing cost of the program
  • The freight carrier being proposed by the 3PL company
  • Your discount on freight.

You may incur a startup cost with a 3PL, but in general, these companies make their money through the freight carrier’s discount rate.

Enhancing your ERP system
Regardless of whether you decide to go it alone or to outsource your program, you will need to enhance your enterprise-resource-planning system to completely implement it. Vendors will need to be coded in order to bill the third party. Depending on your ERP system and who controls the vendor master changes, you will need to change the vendors who initially take part in the managed freight program. You will then need to manage it on an ongoing basis as vendors are added to the program.

You will also want to incorporate language in your contracts and purchase orders that inform vendors to bill the third party. Eric McGlade, vice president, HLS MedFreight, recommends using the following language in your master contracts with suppliers: “FOB Destination, Freight Bill Third Party: Standing Hospital X terms for the purchase of goods shipped via a package carrier (e.g., FedEx, Airborne, UPS, U.S. Postal Service, etc.) and/or a common carrier (e.g., Yellow Freight, Roadway, etc.) are FOB Destination Freight Bill Third Party.” This means that title passes to the hospital when the goods are delivered and signed for at the destination. The IDN pays the freight carrier directly for the shipping services. Under these terms, the vendor is responsible for the condition of the goods in transit, insurance and filing claims with the carrier…. Hospital X does not pay for handling fees without prior approval.

One of the ways to maximize the savings opportunities of your freight management program is to request that every vendor who ships to you on a prepay-and-add basis (i.e. they bill you for shipping) use your third-party FedEx account number. You should also instruct the shipper to place your purchase order number in the shipper’s reference field and include the same shipping instruction on your fax cover sheets.

Benchmarking and measuring success
The first step in measuring success is determining your baseline information. If you already have baseline information that you can pull from your ERP or accounts payable systems, you will be able to monitor savings soon after you implement the program. Furthermore, if you currently separate freight charges to a single general-ledger number and don’t lump them in with other costs, such as mail deliveries or truck deliveries, you have a good chance of obtaining baseline information.

If you haven’t separated freight components in your general ledger, the new program will allow you to develop baseline information, thus exposing the different cost components of freight for the first time. In this case, you will have to estimate your baseline information by estimating the current discount rates you are receiving from your freight carriers, numbers of shipments, and average shipping mode; then calculate an estimated freight cost.

Once you implement your program, you will need to use an external benchmark to determine its effectiveness. A well-implemented freight management program should yield 20 percent in freight savings. Hospitals typically spend $1,000 per licensed bed ($1,500 for teaching institutions) in freight. This may be contrary to what the hospital’s accounts payable system shows, because in most cases it only captures prepay and add lines on an invoice (Grieger, 2005, 31). You will also need to monitor handling, restocking, and minimum order fees in a separate general ledger account to make sure supplier-charged freight costs are not shifted to other forms of charges.

About the author:
Nalin Kulasekara, MBA, is the director of supply chain management for SSM Health Care, St Louis

Greiger, James. On The Road To Efficiency – Materials Management in Health Care. September 2005, 30-32.
Neil, Robert. Planes, Trains And Automobiles – Materials Management in Health Care. February 2005, 16-19.