Cascade Trucking and Freight

Cascade Trucking and Freight: Relevant Costs for Decision Making

 

Cascade Trucking and Freight has a long-established and mutually beneficial business relationship with a
major international automotive parts company, FHP Technologies. Management at FHP has approached
Cascade with a request to provide additional routes that are important to the efficiency of its supply chain.
Cascade’s management wishes to nurture the business relationship with FHP but is concerned about the
available capacity to service the new routes, potential risks, and profitability associated with FHP’s request.

Alan Frank founded Cascade Trucking and Freight in 1968 and has grown the business into a sizeable
operation with 90 trucks and 180 trailers. His largest customer, FHP Technologies, has submitted a proposal
to him to add delivery routes that would improve the efficiency of FHP’s supply chain. Alan was not certain
that Cascade could handle the additional routes since the company currently was operating at (or near)
full capacity.

FHP offered a total of $2.15 per mile (including fel service charge and miscellaneous fees) for the new
route. But Alan knew that to accept the offer he would have to add more trucks and perhaps incur additional
debt. The question was whether the rates offered by FHP were high enough to offset the associated risks of
growing the fleet. Although the business had been grown organically through the years by reinvesting
profits, it incurred debt from time to time to replace older equipment (usually in blocks of five trucks). Alan
knew the slim profit margins associated with trucking, coupled with a downturn in the economy, could spell
disaster if saddled with too much debt. See Exhibits 1 and 2 for the company’s most recent statement of
income from operations and the balance sheet, respectively.

Roger Simmons, Cascade’s operations manager for the past 16 years, had been reviewing the FHP
proposal and approached Alan. “Alan, we need to discuss this offer from FHP. I think it is a great
opportunity for our company, and we need to find a way to make it work.” Within 10 minutes Alan and
Roger were in a closed-door meeting discussing the pros and cons of FHP’s offer. Roger began by stating
the obvious: “Alan, this is a huge opportunity for us to grow the business. Not to mention, as FHP becomes
more dependent on our services, we will be in a stronger position to negotiate future rate increases. I know
you are opposed to debt, and I understand the risks of carrying more debt, but there is more than one way
to grow our fleet. If you would consider using independent contract drivers, we could grow the fleet enough
to accept FHP’s offer without incurring more debt.”

Alan cringed at the thought of using independent contract drivers. Although independent contractors
owned their own trucks, Alan viewed them as difficult to deal with and not worth the headache. “Roger, I
hear you, but this new route will not last a week if we cannot give FHP great service. Independent
contractors call the shots, not us. They own the rig and will sit at home if they want to. I would rather deal
with our own company’s rigs and drivers. The rewards just do not justify the risks of damaging our
relationship with FHP.

“But I am not sure we should take on any more debt at this point to purchase additional rigs. The
economy is in the tank, and it is a bad time for us to leverage the balance sheet any further. Roger, my
success in this business was not built by jumping on every offer that came along. Sometimes you have to
say no, even to your biggest customer. Unless you can find a way to squeeze out more capacity within our
current fleet, I just do not think we can accept FHP’s offer at this time,” Alan concluded.

As the two men left the room, Roger was convinced that Alan was wrong. Roger knew that Alan was
leaving money on the table. He just needed to prepare a financial analysis that would prove it. Was it
possible to squeeze out more capacity from an already fully utilized fleet? Perhaps they could shift trucks
from another account. Was taking on more debt truly “risky” given the profit potential of this new route?
Roger knew he had to make a convincing argument before FHP took its offer to another truck line.

Industry Terms

*A tractor-trailer rig is a truck that consists of a tractor attached to a trailer. The tractor typically is powered
by a diesel engine.

* A flatbed trailer is long flat platform with no sides.

* A dry van trailer is a boxed cargo compartment designed for nonrefrigerated freight.

«Trucking companies often have a revenue-generating load in one direction but need a revenue-generating
contract for the return trip. The return trip is known as a backhaul. Often trucking companies contract with
treight brokers to acquire backhauls.

Trucking firms generate a variety of revenue types from hauling goods for their clients. Presented next is a
brief overview of key types of revenues included in the 2013 income from operations of Cascade Trucking
and Freight.

Line haul revenue is earned from hauling freight.

Fuel prices in recent years have been volatile. Because trucking companies are exposed to fuel price
volatility when they sign a long-term contract with their customers, they may charge an additional fee
associated with fuel costs when prices exceed predetermined levels. Thus, the primary purpose of the fuel
surcharge (FSC) revenue is to protect the truck line from fuel price increases during the contract term.

Included in miscellaneous revenue are the following:
Storage fees are collected when Cascade stores a loaded trailer on its lot for a customer.
Lumper revenue is collected if a driver assists with unloading a trailer.

Certain flatbed loads, such as drywall, unpainted steel, and some types of wood products, that would be
damaged by rain must be covered. Trucking companies typically charge a tarping fee for such loads.

Additional insurance is required when transporting high-value cargo. Practices vary throughout the
industry. If a load is above a company’s standard cargo insurance limits, many companies simply will not
haul it. Trucking companies that are willing to bind additional cargo coverage normally do so for a fee that
covers only the extra cost of insurance. (Alternatively, this revenue line item could have been booked as a
reduction to the “Insurance” expense account.)

Loads transported on flatbed trailers must be secured by straps or chains. These types of loads often are
associated with higher worker’s comp claims. Thus, an extra strapping and chaining fee is charged only
for a flatbed load.

Ifa truck sits idle at the dock for more than two hours, customers can be charged a fee that is classified
as detention revenue. Placing a detention revenue clause in the contract encourages customers to load
trailers efficiently in order to avoid further constraints on Cascasde’s tractor capacity.
Types of Business Arrangements with Drivers
Cascade has potentially two arrangements with drivers. They are classified as employees or as

independent operators. Employees receive traditional employee benefits and a Form W2 for tax purposes.
These persons are typically engaged in work for the company that is considered “permanent.”

Alternatively, independent operators are not considered employees and receive a Form 1099 (rather than
a Form W2) for tax purposes. These operators typically provide the tractor but generally do not provide the
trailer. In addition to driver salaries and depreciation on trucks, expenses incurred by independent
contractors include:

* Tags (known as International Registration Plan (IRP)) — The independent contractor buys the IRP tag for
the tractor, while the shipping company buys the tags for the trailer.

* IRS Form 2290 — Heavy Road Use Tax.

* Diesel fuel, engine fluids, and all maintenance-related parts and items.

* Physical damage insurance.

* Non-trucking “bobtail” Liability Insurance (needed for when the truck is not transporting a trailer).
* Tolls and scale fees.

Independent contractors generally control their own working hours, unlike an employee. Further,
independent contractors’ work generally is considered temporary, rather than permanent (unlike for an
employee). In the trucking industry, an independent contractor often signs a one-year contract for a
temporary job. But an employee is hired permanently under the assumption that he or she will make
deliveries until further notice. This arrangement constitutes a permanent job.

Cascade Trucking typically assigns one driver to one tractor. But this practice can constrain the available
hours the tractor can operate. For example, laws require a driver to take a 10-hour break after 11 hours of
driving. Further, a driver cannot work more than 70 hours in an eight-day period without taking a 34-hour
break. To improve tractor utilization by avoiding constraints based on legal driving time requirements,
some trucking companies use “slip seating.” This is a practice that permits greater tractor utilization by
placing a fresh driver behind the wheel at the end of the former driver’s shift. Slip seating is similar in
practice to an airline company that keeps its planes flying longer by inserting fresh flight crews as the
previous crew goes off duty. It also is efficient to utilize “team drivers” that are commonly husband-witfe
teams. One person drives while the other sleeps. Relative to a single driver, this arrangement basically
doubles the amount of miles driven in a given week. Typically, teams are paid more, but additional line
haul revenues offset the extra labor costs.

Another strategy to improve tractor utilization is to use trailer pools, commonly referred to as “drop and
hook” systems. For example, trucking companies will leave an empty trailer with customers, who will load
it with products as units are produced. When the trailer is filled, a tractor arrives, drops an empty trailer to
replace the trailer just filled, then immediately hooks onto the loaded trailer and departs. Tractor utilization
improves because tractors are not sitting idle while a customer loads a trailer. This approach is economically
feasible because trailers are far less expensive to purchase and operate than tractors.

Most trucking companies keep some tractors ‘ton the fence” as spares, in case one breaks down. There
is considerable disagreement, however, over what constitutes too many spares. Some owners believe a truck
line should put all available equipment on the road and rent a tractor if a spare is needed. Others disagree

3
and maintain a small number of tractors in reserve. Currently, Cascade Trucking and Freight keeps a small
number of tractors and trailers out of service but prepared for duty in case a rig breaks down. Some
managers believe this policy is an expensive luxury and that some of these idle rigs could be used to add
the new routes requested by FHP. When estimating a tractor’s practical capacity, management at ~
use 85% of total potential miles driven in a period. Theoretical (or 100%) capacity utilization is virtually
impossible in the industry because of factors such as traffic and loading delays.

Management at FHP has asked Cascade to consider adding two dry van loads per week; each load would

require 1,500 round-trip miles. Because FHP is a long-term client with a strong financial position, the

company’s management has asked for a very favorable rate of $2.15 per million including FSC and all

miscellaneous fees. Roger believes the potential volume of freight from FEp can be used to grow

Cascade’s business and profitability. There is also risk associated with not takiny we wew uues. |f Cascade
does not accept the new routes, another trucking line will, thus building loyalty with FHP.

FHP is a stable, solvent company that presents no question of collection, thus ensuring a reliable cash
flow. If FHP decides to restructure its supply chain in the future, Gascade © could find itself in the
undesirable position of holding dedicated assets (trucks and trailers) for routes that no longer exist. The
owner’s aversion to increased debt levels further exacerbates concerns about acquiring additional fixed
assets. Perhaps Cascade ~ could service the initial demand with existing equipment. But, as additional
routes are added in the future. Gascade © Must acquire more tractor-trailer rigs or consider outsourcing the
miles by using independent contractors.

Exhibit 1 presents Cascade Trucking and Freight’s income from operations for the year ending
December 31, 2013. This statement is not prepared in accordance with Generally Accepted Accounting
Principles (GAAP) but presents costs by behavior. Exhibit 2 presents Cascade Trucking and Freight’s
balance sheet for the year ending December 31, 2013.

Cascade’s management is considering the proposal from FHP. There are many issues involving strategy,
cost, risk, and capacity. Prepare a recommendation to management. Use the following questions to guide
your analysis.

1. Assume Cascade could service the contract with existing equipment. Use Exhibit 1 to identify the
relevant costs concerning the acceptance of FHP’s request to add two additional loads per week. Which
costs are not relevant? Why?

2. Calculate the contribution per mile and total annual contribution associated with accepting FHP’s
proposal. What do you recommend? (Use 52 weeks per year in your calculations.)

3. Consider the strategic implications (including risks) associated with expanding (or choosing not to
expand) operations to meet the demands of FHP. Analyze this question from a conceptual point of view.
Calculations are not necessary.

4. After a closer examination of capacity, management believes an additional rig is required to service the
FHP account. Assume Cascade’s management chooses to invest in one additional truck and trailer that
can serve the needs of FHP (at least initially). Assume the annual incremental fixed costs associated with
acquiring the additional equipment is $50,000. Further, FHP would agree to pay $2.20 per mile (total
including FSC and miscellaneous) if Cascade would sign a five-year contract. What is the annual
number of miles required for Cascade to break even, assuming the company adds one truck and trailer?
What is the expected annual increase in profitability from the FHP contract? (Use 52 weeks per year in
your calculations.)

5. Cascade has business relationships with independent contractors, though Alan is reluctant to use them.
Another possibility for expanding capacity is to outsource the miles requested by FHP. One of Over-
land’s most reliable independent contractors has quoted a rate of $1.65 per mile. As with question 4,
assume FHP would agree to pay $2.20 per mile if Cascade would sign a five-year contract. Further,
assume Cascade would incur incremental fixed costs of $20,000 annually. These costs would include
insurance, rental trailers, certain permits, salaries and benefits of garage maintenance, and office salaries
such as billing. How many annual miles are required for Over-land to break even if the miles are
outsourced? What is the expected annual increase in profitability from the FHP contract? What are your
conclusions?

6 a. Why might Cascade use an independent operator if the variable cost per mile is higher than if the
company had purchased a rig and hired a driver?

b. At what point would management be indifferent between the scenarios illustrated in questions 4 and 5?

Based on your analysis, would you recommend adding capacity by purchasing an additional rig or by
utilizing the services of an independent contractor? Why?
 

Exhibit 1
Income from Operations

(All financial information in the case has been scaled and disguised for educational purposes.)

! Cascade Trucking and Freight
Income from Operations

For the year ending December 31, 2013

 

 

Revenue FYE 12/31/2013 Per Mile
“Line Haul – $20,925,280 – $1.86
Fuel Surcharge 4,950,160 0.44
Miscellaneous 450,120 0.04

Total Revenue $26,325,570 $2.34
Variable Expenses
Insurance 675,120 0.06
Fuel 8,775,190 0.78
Oil Lubricants 112,700 0.01
Tolls 112,550 0.01
Parts and Small Tools 787,630 0.07
Hourly Wages: Drivers 4,950,160 0.44
Trailer Pool Expense 255,120 0.02

Total Variable 15,638,480 1.39
Fixed Expenses
Insurance

General Liability 112,620 0.01

Physical Damage 225,010 0.02

Workers Compensation 226,000 0.0?

Health Insurance 224,500 0.02
Security 111,750 0.01
Depreciation 2,137,500 0.19
Salaries, Benefits (Garage) 675,000 0.06
Salaries, Benefits (Office) 1,012,520 0.09
Bad Debt Expense 113,500 0.01
Permits 111,520 0.01
Rental Equipment 1,013,000 0.09
Payroll Taxes 562,500 0.05
Accounting Fees, Supplies, Computer Maintenance 112,350 0.01
Miscellaneous 337,510 0.03

Total Variable 6,975,280 0.62

Income from Operations $3,681,810 $0.33

Note: Permile values are based on 17,250,000 miles and have been rounded to two decimal places.

 

Exhibit 2

Cascade Trucking and Freight
Balance Sheet
For the year ending December 31, 2013

 

 

 

Assets
Current Assets

Cash $200,000

Accounts Receivable 300.000
Total $500,000
Property Plant and Equipment

Land 1,000,000

Buildings 3,000,000

Accumulated Depreciation Buildings (1,250,000)

Tractors, Trailers, and Equipment 18,650,000

Accumulated Depreciation (4.750.000)
Total $16,650,000
Total Assets $17,150,000
Liabilities and Equity
Current Liabilities

Accounts Payable 150,000

Taxes Payable 65,000

Current Portion of Long-Term Debt 35,000
Total Current Liabilities $250,000
Long-Term Liabilities

Notes Payable 1,865,000
Total Long-Term Liabilities $1,865,000
Total Liabilities $2,115,000
Owner’s Equity

Contributed Capital 3,550,000

Retained Earnings 11,485,000
Total Owner’s Equity $15,035,000
Total Liabilities and Owner’s Equity $17,150,000