6 Supply Chain Linkages
6.1.1 An important issue raised in the brief for this study was to consider the supply-chain linkages that are particularly dependent on freight movements and trace how higher ferry fares impact on these sectors and the wider island economies. There are thousands of individual supply chain linkages and interactions in the islands involved in the RET pilot and central to understanding the incidence of increased ferry fares is to understand the dynamics of the key island markets. While it is not possible to discuss each of the individual supply chains across the islands, the chapter highlights those supply chains which are likely to be particularly affected by the removal of RET for commercial vehicle ferry fares.
6.2 The Supply Chain
6.2.1 The length of the supply chain for any particular good varies but will typically involve a number of links upstream, downstream or horizontally. Each link within this supply chain will attempt to take the input from upstream, process / convert / improve it (ie add value), and sell it to the next supplier downstream with a profit mark-up (ie a margin). The final outcome of this process is the sale of the good to an end customer, from which the retailer will recover all of the costs within the supply chain as well as an acceptable margin per unit. The key to the success of this complex chain is that the retail price of the individual product covers all of the production costs and allows each supplier within the chain to receive an acceptable margin. Where an increase in costs at any point in this chain erodes the end margin to the point where it would become unviable for one or more parts of that chain to continue supplying its input, there are two potential outcomes:
- the end retailer can negotiate the costs with suppliers or, if the market permits, increase the price of the good to restore the margin per unit; or
- immediate or gradual withdrawal from producing and selling that product.
6.2.2 In terms of the islands in the RET group, the increase in the ferry fare for CVs will impact on every good (finished or otherwise) that is imported to the islands and exported from the islands. That is, every unit moved by a CV on the ferry will have an extra cost element in it equal to its proportional share of the total additional ferry fare.
6.2.3 The key question for this study is to understand the incidence of that extra cost - ie on whom does it fall. If the additional cost rests with Western Isles businesses, for example, it can be argued to some extent that the removal of RET for CVs will have a negative impact on the islands. If, however, the additional cost falls on mainland businesses, then the removal of RET will have a limited, if any, impact on the islands. A key aspect to the analysis is the extent of the market power for individual businesses within the islands' supply chain.
6.2.4 In general firms will tend to protect their own interests and the incidence of any cost increase will normally fall upon the weakest player in that market - ie the firm with the least market power. There are various sources of market power which typically stem from:
- barriers to entry - a firm is able to command prices in excess of marginal costs because it has created and / or can maintain barriers to entry;
- business scale - a firm has sufficient scale to command low input prices, volume based discounts and adopt differentiated pricing strategies where it chooses to do so; and
- lack of substitutes - a firm can command high prices for its goods because there is a strong demand for them and few, if any, substitutes.
6.2.5 The previous chapter explained that the Western Isles, Coll and Tiree economies are dominated by firms of small scale and are therefore unlikely to have a significant, if any, degree of market power. They are also likely to be operating in sectors where there are relatively high levels of competition and product substitutes eg agriculture. This suggests that industries will be unable to pass on any higher costs from transport charges onto their customers. This is backed up by the results from the business interviews and survey where 42% of respondents explained that they had been unable to pass on higher transport charges introduced since the withdrawal of RET fares for commercial vehicles and 88% claimed they would not be able to pass on any future cost increases.
6.2.6 This perhaps reflects the size of the businesses that responded to the survey and the size of businesses in the Western Isles more generally. Small firms are particularly vulnerable to the removal of RET for CVs because they do not have sufficient scale to buy in bulk, set prices or negotiate effectively. They are essentially price takers and would generally expect to find the full cost of the RET related rises passed onto them, either directly from haulage firms or through the wider supply chain.
6.2.7 In understanding how such market power comes into play in the Western Isles, it is prudent to split trade flows into exports and imports.
6.2.8 As explained in Chapter 5, the majority of exported goods from the Western Isles, Coll and Tiree are of relatively low value, homogenous products that in many cases are easily substitutable. Large volume exports are limited to livestock, fish and, to a lesser extent, textiles and food and drink. As these goods are, for the best part, competing in highly competitive markets and are already carrying an additional island cost-burden, there is, as a rule, limited scope for increasing the final market price.
6.2.9 The findings from the research suggest that a possible exception to this rule is perhaps the tweed industry which is experiencing strong demand and relatively high levels of sales. While the ferry fare, and therefore transport charges are, similarly to other sectors, an important element of the industry's cost base, the tweed industry may be better placed to absorb higher transport costs through reducing margins or through higher prices to customers. In addition, many tweed products are being transported all over the world, particularly the far east, and the ferry fare makes up a relatively smaller percentage of total transport and business costs.
6.2.10 Given the majority of products are low value and homogenous, the only option in the short‑term is for businesses to reduce costs and hence, without efficiency improvements, the margin per unit for one or more suppliers within the chain. With regards to exports, the evidence suggests that the impact of this tends to vary as follows:
- Firms moving small volumes (eg a single pallet) will likely bear the full increased cost of that pallet from the haulier; and
- Firms moving larger volumes have more negotiating power because of the overall low volume of outbound goods and thus the haulier tends to absorb at least a portion of the additional cost. Indeed, there is likely to be some competition amongst hauliers to transport these goods which could potentially drive down transport charges.
6.2.11 In terms of the two options outlined above, the evidence from the industry profile of the island communities suggests that the vast majority of businesses are relatively small and will therefore fall within the first category. These firms are therefore more likely to be in a situation where they will have to absorb the costs as it is passed on through the supply chain, therefore having a negative effect on island businesses exporting to the mainland.
6.2.12 There are exceptions to the low volume example. For example, there are companies moving high volumes of fish from the Uists to the mainland. However, there is only one operator offering a chilled service to Glasgow ie there is no competition to transport the goods. Therefore, in the short‑term at least, these companies still have limited market power when negotiating charges with the haulier ie they have to pay the haulier's going rate if they want to move their product. Moreover, in many cases these companies are unable to pass on the higher costs to their customers because of the high level of competition in the market.
6.2.13 Imports make up the vast bulk of freight traffic to the islands, with products as diverse as fuel, food, furniture, animal feed, construction materials, and raw materials for manufacturing. Given that the majority of these goods are supplied from mainland firms whose markets will typically be much wider than the islands alone, there will be little room for negotiation on price. Except where contractual agreements prevent it, mainland firms will typically pass the increase in the ferry fare straight on to the island firm or will leave the island firms to negotiate separately with the haulier. There is some scope for moving custom to other suppliers, while trade bodies for independent retailers, such as Nisa, do provide some cover for small firms. However, as a rule, the evidence gathered suggests there is limited scope for negotiating the price of inbound goods, partly because it is delivered by island hauliers.
6.2.14 The inbound haulage market does tend to involve higher volumes than the export market, but again the evidence suggests those volumes are split amongst a large customer base of relatively small firms, providing the hauliers with an element of market power. The findings from the interviews suggests that, in most instances (ie pallet traffic), the haulage firms will pass the increased ferry fare straight on to their end customer. However, the hauliers need to operate a delicate balancing act, in that they must protect their own margins but at the same time not compromise the viability of their customers, a point made by many of the hauliers on the smaller islands.
6.2.15 The only referenced exceptions to this trend are where firms moving large volumes (Tesco for example) have sufficient buying power to set the terms of the contract. In addition, it is important to revisit the point that companies like Tesco and the Co-op employ national or regional pricing models. This means that while prices in these stores may not have gone down when RET was introduced, the model also means that prices were unlikely to have gone up when RET was removed. While this may have impacted on local retailers, it would not have impacted on consumers who use these large retail supermarkets.
Importing and Exporting Firms
6.2.16 A key issue which was raised during the interviews is that a number of marginal businesses could, through the supply chain, end up paying all or a proportion of the increased ferry fares on numerous occasions for a single unit of product. A good example of this is the seafood industry, where businesses have to pay higher fares for directly imported products (eg fish feed); directly exported products (eg fish); and ancillary inputs (ie plastic and packaging). This issue is common across a number of sectors, including agriculture, manufacturing and textiles. Where the incidence of these costs all rest with the end supplier, and that supplier cannot easily pass on these costs to the end customer (seafood again being a good example), that business' margin per unit is reduced, potentially to the point where cost exceeds price and the product or business is no longer viable. While discussing specific examples is difficult due to the commercial nature of the information, examples were given in the business interviews of companies making a decision to enter a market after the introduction of RET and then withdrawing after its removal as the increase in costs due to higher fares could not be passed on and made the new venture unviable.
6.3 Impact on Sectors
Agriculture / Crofting
6.3.1 Chapter 5 explained that the primary sector is a key sector in the Western Isles accounting for 23% of registered businesses, 12% of employment and 22% of turnover. Within the sector, the area of agriculture and crofting plays a significant part. The interviews with businesses confirmed the importance of the sector. The interviews also confirmed the key role that individual farms can play in driving the local communities, such as being the main employer. It has also been explained however, that many of the firms bear those characteristics which can make them very vulnerable to increases in transport charges eg they are operating in competitive markets, transporting low value goods, and have little market power. This suggests they are price takers and have little opportunity to negotiate the level of transport charges or pass on them on in terms of higher prices.
6.3.2 The evidence gathered showed that a number of firms in this sector have seen an increase in transport charges since the removal of RET in April 2012. The evidence also suggests that firms have been unable to pass these costs on and will be unable to pass on further rises. Due the scale of the industry, as a proportion of the Western Isles, Coll and Tiree as a whole, the impacts on this sector may have important repercussions across the islands. A number of firms and geographical areas are highly dependent on the successful performance of this sector, in terms, for example, of employers / income providers and purchases of local products.
Fishing, Aquaculture and Seafood
6.3.3 The fishing, aquaculture and seafood sectors also play an important role in the local economies. It was explained during the interviews with businesses that the recent fare increases are an important issue for firms as they operate in very competitive markets and can't pass on higher transport charges. Indeed, a number of the companies have seen increased competition from a number of businesses withdrawing from the struggling European market. This is creating issues of short-term over-supply and is driving down prices at a point when costs are going up. It was claimed that further cost increases due to the removal of RET could impact on employment in the sector.
6.3.4 It was also explained by companies in this sector that the ability to pass on cost increases to customers is highly seasonal. The buoyant market between July and September provides some scope for passing on cost increases. Christmas, Easter and festival days / holidays in Spain also allow some price flexibility. However, out with these peak periods, there is little scope for passing on increases in haulage costs.
6.3.5 The companies interviewed had noticed an increase in the price of inbound goods, particularly bait. The cost of a pallet of bait increased from approximately £56 to £59 between July 2011 and August 2012. This is seen to be clearly related to the removal of RET because fuel surcharges are listed separately.
6.3.6 Most of the firms in the sector are transporting goods to the mainland on a regular weekly basis. An increase in transport charges will have a marked impact on the cost base of many of the firms. Businesses explained that this will directly impact on profitability as it is not possible to pass on the costs - many goods eg a number of fish and scallop prices have been declining in real terms for a number of years.
6.3.7 A downward spiral in the island economies could also put pressure on the supply chain for staple products. The analysis above explained the fragility of many island businesses and it can be argued that even where a business is performing well, the failure of one or more of its island based suppliers could undermine that business. From discussions with hauliers and businesses, a god example of this could be the seafood industry, which procures much of its packaging locally. Therefore, the failure of a local packaging supplier, due to higher import prices as a consequence of RET, could disrupt the supply chain and introduce a new cost of importing such products from the mainland.
6.3.8 An issue that was raised in the discussions with businesses was the importance of the construction industry, not just in its own right, but also how it supports many businesses and jobs in numerous ancillary industries. It was claimed that there has been a notable reduction in the turnover of construction firms since the removal of RET. There is some evidence that prospective builders moved purchases forward to "beat the RET deadline". However, the turnover of construction businesses overall is down and there was little evidence to suggest this would change in the near future.
6.3.9 The ferry fare, if passed on in transport charges, has an important impact on the performance of firms involved in the construction industry. A number of materials are imported from the mainland and are generally bulky goods. An increase in transport charges can therefore feed through to significant increases in construction raw materials, which then feed through to impacts on residential and commercial property building as well as other infrastructure. This can result in a downturn in activity in the construction indutry, as well as many other dependent sectors. For example, one stakeholder on Coll noted that the price of a full load will increase by £400 and it typically takes 20 loads to build an average house. The £8,000 increase in cost will either by absorbed by the contractor (depending on when the contract was signed ie before or after the price increase) or the client. This would again likely represent a net loss of wealth from the islands. This is a particularly pertinent point in the construction sector, where, in the current mortgage market, an additional £8,000 of costs could easily prevent the construction of a property going ahead. When one considers these impacts across the entire construction sector (both commercial and residential) and ancillary industries, this could have a relatively large negative impact on the overall sector performance.
6.3.10 The previous chapter set out figures showing the importance of the retail sector. While the wholesale, retail trade and repair of motor vehicles and motorcycles sector as a whole makes up 16% of registered businesses, 22% of employment and 33% of turnover, the retail sector alone makes up an important share of this.
6.3.11 It is clear that the impact on the retail sector is not uniform across geographic areas and type of goods being sold. It is also clear that the retail sector is being affected by a number of different factors at the same time eg the slowdown in economic activity, higher fuel prices, increased competition from internet shopping, lower RET fares for passengers and vehicles meaning that trips to the mainland that take in shopping are more affordable etc. The latter in particular is having an impact on the sale of 'big ticket' items.
6.3.12 It is also clear that many of the larger stores, such as the co-op and Tesco, operate a regional pricing structure where costs are absorbed within a central overhead. This means that cost increases specific to a particular area have less impact on prices in that particular area.
6.3.13 Despite the limited impact on the larger stores, the vast majority of stores in the Western Isles, Coll and Tiree are not in this category and it is clear from speaking to a number of retail businesses that the withdrawal of RET for CV fares, if passed on through higher transport charges, will have an adverse impact on this particular sector. Indeed, many of the small retailers have already seen an increase in transport charges since RET was removed for CV ferry fares. Many of these shops are operating at very small margins which cannot absorb higher charges, and the higher costs will therefore have to be passed on to customers in terms of higher prices. These higher prices will ultimately feed through to lower demand (as people stop purchasing certain goods or switch to the larger supermarkets) and / or reduced levels of disposable incomes in the local communities as people's outlays increase.
6.3.14 A key point of note here is the disproportionate impact of the fare increases on the unit price of large / bulk goods. The majority of pallets tend to contain tens or indeed hundreds of units on a single pallet, meaning that an increase in the pallet price tends to have a very small impact on the unit cost of each item.
6.3.15 In contrast, however, retailers of large and often low margin goods will feel a disproportionate impact of the RET related price increases. Furniture is a good example of this but there are many other examples including fish feed, fertiliser etc, where the end purchaser will bear the full cost of the increase. This will have direct impacts on these sectors as well as knock-on impacts up and down the supply-chain. For example, the increased cost of agricultural materials will increase the cost for farmers of rearing livestock. With little flexibility on price, this will reduce the farmer's margin per animal which in turn is a net financial loss to the local community in which the business is located.
6.3.16 There is evidence from Comhairle nan Eilean Siar that the number of houses being built or seeking planning consent has declined significantly in recent months. It is difficult to isolate the impact due to RET. This situation is common to housing markets and construction activity across Scotland, and it may be too early to attribute to the removal of RET in April 2012, but the evidence from the business interviews and online survey suggests that the increase in fares for commercial vehicles will further dampen construction activity in the islands.
6.4.1 Many of the businesses across the islands involved in the RET pilot are transporting low volume, low value, and in many cases, homogenous products in very competitive markets. Indeed, even those businesses exporting a number of high volume goods are still operating in very competitive industries. This can make the opportunity to pass on higher costs, in terms of transport charges, to their customers very difficult. This was very much borne out by the responses to the business surveys.
6.4.2 The economies of the Western Isles, Coll and Tiree are dominated by businesses with these types of characteristics eg agriculture / crofting, fishing / aquaculture, retail and construction. The evidence has shown the dominance of firms in the primary sector on the Western Isles economy, in terms of number of businesses, turnover and employment. In addition, the vast majority of these businesses are small, typically with less than five employees. Consequently, they are unable to pass on higher transport charges to their customers. The evidence from the business surveys confirms this, with the vast majority explaining that costs cannot be passed on. This means they will have to absorb these within their current margins or reduce their operations.
6.4.3 In many cases, firms are being affected more than once, through importing inputs and exporting finished goods. A number of the companies in this situation are of relatively small scale and therefore have limited power and therefore opportunity to pass on to their customers through the supply chain.