FREIGHT EQUALIZATION: A common steel industry practice when a mill sells steel outside its geographic area; the mill will assume any extra shipping costs (relative to the competition) to quote the customer an equivalent price to get the business. —Source: Steel.org

Freight equalization has been an accepted part of the behind-the-scenes steel buy for many years, but recent trends in the steel industry are threatening the practice, driving buyers to focus more on total cost.

According to steel industry veterans, the concept of freight equalization can be traced as far back as the early 1900s, when construction began on a steel plant in Alabama, creating tensions in the Pittsburgh-dominated steel industry. Nervous about their market share, the Pittsburgh mills lobbied for—and got approved—legislation saying the Alabama site had to charge freight as if product were being shipped from Pittsburgh. The legislation was later overturned and the Alabama mill later completed.

Equalization may have a long history in the steel industry, but it happens so far behind-the-scenes that it is virtually unknown to buyers in other industries. For those not in the know, freight equalization works as follows: Joe Buyer at Widgets Inc. needs to buy a certain steel product and the closest steel mill that supplies that product is 20 miles down the road. This fact makes it virtually impossible for every other steel mill in the world to compete for Joe's business, as the freight charges would be much higher than those of the mill down the road from Widgets Inc. To compete with the closest mill, the other distant steel mills will absorb the additional freight cost Joe would have to pay to get the product from the farther mill. In effect, the distant mill charges Widgets Inc. the same freight as it would have cost to buy from the mill down the street. And because it happens between buyer and seller, most carriers do not get involved and know surprisingly little about the concept.

Equalization gets more complicated in different scenarios. For example, imagine Widgets Inc. has been buying the same steel product from a distant mill with equalized rates for 20 years. Suddenly, the closest mill to Widgets Inc. stops making the product and freight rates shoot up because the next closest mill is much farther away. That type of added unforeseen cost can wreak havoc with budgets and expenses, even though Widgets Inc. has not changed its supplier or product.

"You only recognize a steel mill that is making the same product that the customer is buying," says William R. Jacob, executive vice president and chief commercial officer of ADS Logistics in Homewood, Ill. "So it's incumbent upon the supplier to equalize with a mill that is close to the customer, but not if that one does not make the product the customer is buying." So mills have to keep a constant eye on what their competitors are selling and to whom.

Some data suggests equalization is holding strong in the steel industry while other clues point towards its demise. A recent Purchasing.com poll found 88% of buyers reporting that freight equalization is increasing as a factor in their buying, while only 12% say it is declining. That poll, however, assumes that respondents from a variety of industries understand the concept.

Another school of thought says growth of the mini-mill model in the steel industry is putting old-school ideas like freight equalization in jeopardy. The more localized mini-mills have, as an industry, refused to equalize and offer flat prices for products and don't consider freight in their equations. If the customer is farther away, the customer pays more.

So while some industry watchers say comparing the two models is like comparing apples and oranges, others say mini-mills are exposing equalization as archaic and even somewhat deceiving. Jon Putman, executive vice president at Hanna Steel Corp. in Fairfield, Ala., says equalization allows integrated mills to dump steel outside their core market without polluting the prices within their core markets. "The integrated mills will claim to sell the same product to everyone at the same price. That means they may ship it to a guy 2,000 miles away and he is really getting the product for $22 and then the freight is added in while a closer customer pays $24 and less on freight."

Putman says he expects equalization to play a much smaller role in coming years, as mini-mills gain more market share. "Buyers in the steel industry are seeing the reality that these integrated mills are selling farther away from home at lower prices and then when the market gets tight, those are the people they won't sell to any more."

Also changing the way equalization is factored is the trend toward using just-in-time inventory that is not coming direct from a mill. More and more, steel products are shipping from a mill to a middleman for processing and then shipping as needed to the OEM customer, putting equalization in question. Farm machinery maker John-Deere has transitioned nearly all of its steel buying from integrated mills to smaller, more strategically located service centers to serve Deere's build-to-demand manufacturing model. Marianne Collison, director of steel purchasing at Deere, says the company long benefited from equalization, but it did not factor into its decision to move to a build-to-demand model.

Jacob says a large percentage of steel coming out of integrated mills today is being processed in some fashion, driving customers to look into pricing models that include all the processing and adds freight, diffusing freight equalization.

"The freight equalization just evaporates into a single, invoiced price that encompasses all the steps that are required from the mill to the processor or warehouse, especially when you get into processing and laser welding," Jacob says. "If the customer is buying a straight coil product from a major integrated mill, and is on a contract, then that customer is more than likely getting the benefit of freight equalization. If the customer is a major end-user buying a manufactured part or a coil that needs further processing, then it becomes less frequent."

Gregg Troian, CEO at Quadrivius, parent company of Pittsburgh Logistics Systems, says it is only a matter of time before integrated steel mills eliminate freight equalization policies to compete with the more up-front prices and services of mini-mills and service centers. Troian says it is a long-standing practice in the steel industry, but nowhere else, and as the integrated mills lose ground, the practice of freight equalization will disappear.

Troian also says it is often difficult for integrated mills to get accurate rates from carriers serving other mills (their competitors) to equalize against. For example, if Company A is buying steel from a mill and getting freight equalization, the selling mill has to find out what the freight would be from a closer mill (its competitor) to that buyer (via a given carrier) to decide how much to cover in the equalization formula. That rate fluctuates based on time of year, demand at the time, where the carriers are working from and where they serve, all of which requires a lot of monitoring and overhead for the mill offering the equalization. Troian says selling mills should not be afraid to challenge the rates they are provided from the closest mill, and steel buyers should not be afraid to challenge the amount of equalization offered by the seller.

Some industry experts say equalization may last because it makes entering the U.S. steel market more difficult for foreign players. Chris Plummer of Metal Strategies Inc. in West Chester, Pa., says equalizing the difference between mills in Pittsburgh or New Orleans is one thing, but equalizing the freight difference between Pittsburgh and Tokyo is something completely different. Plummer says some Japanese steel suppliers offer equalization to compete with U.S.-based mills, but others have chosen to focus on processed products that U.S. steel mills are not making, avoiding the equalization issue altogether.