This article is sponsored by Realterm
The pandemic that has disrupted health and economic systems around the world is having a profound impact on global supply chains. In April 2020, 91 percent of the world’s population lived in countries with restrictions on mobility intended to minimize the virus spread. These precautions initially caused supply shocks as manufacturing facilities ran at limited capacity or shut down entirely.
Meanwhile, guidance for consumers to avoid all but essential shopping led to a sharp decrease in brick-and-mortar retail sales in the second quarter of last year. In response, retailers and consumers have become much more reliant on online shopping.
The spectacular rise of e-commerce is accelerating and reinforcing a shift in supply chains that prioritizes delivery of products directly to the consumer instead of stores. The share of total retail sales volume accounted for by the non-store segment (a proxy for e-commerce) increased from 11 percent in the final quarter of 2019 to 16 percent in the second quarter of 2020.
Over the last four quarters, the impact of covid-19 on consumer behavior has effectively driven volume to a level not expected for another five years in pre-pandemic forecasts. Though a recovery in store-based sales has caused a minor shift back down since then, the general upward trend of this share will get steeper as a greater number of consumers with increasing frequency embrace the convenience and higher perceived safety of shopping online.
E-commerce demand fueling inventory growth
Consumers’ desire for convenience and faster delivery at little to no cost, and retailers’ consequent need to manage operating and inventory costs, are combining to realign retailers’ need for space. A key economic metric that helps to understand this shift is the inventory-sales (I-S) ratio (a measure of how much inventory businesses keep on hand per unit of sales). Between 1995 and 2011, the retail I-S ratio fell from 1.72 to 1.35, as retailers sought to cut the cost of unneeded warehouse space by adopting just-in-time delivery.
Just-in-time production techniques had enabled retailers to increase inventory turnover and sales velocity, better matching their wholesale purchase of merchandise with consumer demand. To retailers, inventory represents opportunity cost. The value held in inventory is not available to buy new merchandise for sale, invest in expansion, or return to shareholders.
As e-commerce captures a growing share of total retail sales, the inventory requirements for this emerging channel are becoming significant. The need for retailers to hold more stock in inventory to minimize fulfillment delays caused the I-S ratio to increase from 1.35 in 2012 to 1.45-1.50 in 2019. (Retail sales in 2020 have been exceptionally volatile, causing analysis of recent I-S ratio values to be less instructive.) The rise in the I-S ratio is adding inventory costs to retailers both in terms of rising opportunity cost and in higher warehouse costs.
Rising inventory requirements have resulted in record-level warehouse demand over the past five years. Since 2000, occupied warehouse space has typically increased by 1.4 percent annually. Since 2014, this growth has averaged 2.1 percent annually, despite the deep recession that started in early 2020.
Warehouse rent growth, which typically increases by around 2-2.5 percent annually, averaged 5.8 percent over the past five years. The increase in warehouse usage from e-commerce is adding significantly to retailers’ warehousing costs, and this expenditure will accelerate over the next five years.
Retailer warehousing cost analysis
Realterm has analyzed the impact of these rising costs on the retailer through 2025. Examining historical drivers of warehouse demand, such as retail sales, manufacturing output and housing starts, we isolated the impact on warehouse demand attributable to the retail sector alone and analyzed the two major factors expected to contribute to retailer cost growth: growth in e-commerce operations and increase in safety stock.
Retailers and associated users occupy a little over three-quarters of the nation’s warehouse space. While only around 20 percent of this retail-use warehouse space is occupied by e-commerce operations, this share should grow to the mid-30 percent range by the end of 2025 based on annual e-commerce volume growth strengthening to the 15-20 percent range.
Supply chain disruptions from covid-19 outbreaks prevented consumer goods from getting to market, leading to empty shelves and calls to add resiliency to supply chains by keeping more inventory on hand. For purposes of this analysis, we assumed a 10 percent increase in inventory on hand of this ‘safety stock,’ in line with consensus estimates.
We assumed trend-level retail sales growth through 2025 and an increasing shift from store-based retail to e-commerce leading to an increase in occupied warehouse space of approximately 24 percent (4.5 percent annual growth) over that time. We further assumed that increased supply in the warehouse sector would marginally ease rental pressure, with rents projected to increase by 3-4 percent annually over that time, a slight decline from the prior five-year average.
Based on these inputs, our analysis indicates that additional space needs and leasing costs would likely result in an annual increase in retailer-based warehousing logistics costs of $25-$30 billion, or an approximate 9 percent increase in logistics costs annually.
Logistics spending explained
Logistics spending comprises two primary components: warehousing and transportation. Warehousing (including both the opportunity cost of merchandise not sold, and the associated space needed to store this merchandise) typically comprises 25-30 percent of overall logistics costs. Rising retailer warehousing costs should lead to a modest increase in this segment’s share of overall logistics costs to around 30 percent, up from an average of 28 percent over the last five years.
Overall logistics spending in the US, relative to GDP, has remained remarkably steady for the past decade in a very tight range of around 7.6 percent of GDP. If that relationship remains steady, the rising share of warehousing costs implies that annual transportation spending increases will need to be slower for logistics operations to retain the same overall cost structure.
Transportation operations (typically 65-70 percent of logistics spending) will need to become dramatically more efficient, even as some elements of transportation spending face their own significant cost pressures from rising labor and equipment costs, and the rising number of inefficient final-mile deliveries.
This last element presents the most significant challenge to retailers needing to hold the line on logistics spending. Retailers’ logistics operations are experiencing significant transportation cost increases, owing to the proliferation of e-commerce. The final mile of delivery imposes, by far, the highest per-mile supply chain cost for consumer goods. A shift to direct-to-consumer delivery boosts the number of these expensive final-mile deliveries.
In the traditional brick-and-mortar retail model, the final-mile cost is borne by the consumer, who transports the product from store to home. The e-commerce business model has shifted this cost partially or fully to the retailer and, by extension, the trucking, logistics and parcel delivery companies making the bulk of these deliveries on behalf of retailers.
Several supply chain consultants have estimated that these final-mile costs comprise 40-50 percent of total supply chain costs. Adding safety stock for each unit of sale will increase operators’ total logistics costs, particularly in the final-mile segment. Retailers must build this cost into the product or mitigate this cost through a more efficient distribution network.
Efficient final-mile distribution is essential for retailers to fulfill their service promise to the consumer for fast delivery while maintaining price competitiveness by minimizing their cost of shipping. To achieve a neutral impact on overall logistics costs relative to GDP, annual transportation cost increases will need to be kept below 3 percent. For the sake of comparison, annual growth has typically measured in the 4-5 percent range.
Because of their highly infill locations close to the freight’s final destination, high-flow-through facilities are key to managing this cost. HFT properties enable transportation and logistics users to dramatically increase their inventory throughput, enhancing revenue growth and profit margins.
The ability for logistics companies to build density through the final mile of their supply chain represents the key for managing rising logistics costs. From the perspective of the transportation user, HFT facilities are revenue multipliers, speeding fulfillment and increasing inventory turnover.
In 2019, freight flowing through HFT properties totaled around seven times what is handled in the nation’s warehouse inventory, on a per square foot basis. The growing need to ship retail goods direct-to-consumer will only increase this intensity ratio because of the structural supply constraints inhibiting new HFT supply.
Increasing velocity of products moving through HFT properties is the key to unlocking efficiency advances in transportation operations. By increasing the number of parcels delivered per mile, unit transportation costs will fall. The intensity of use of these HFT properties, as measured by tonnage that passes through them, must necessarily increase to accommodate this growth in parcel delivery.