JOURNAL OF BUSINESS LOGISTICS, Vol. 30, No.

1, 2009

223

IMPACT OF RISING FUEL COST ON PERISHABLE PRODUCT PROCUREMENT

by

Ram N Acharya New Mexico State University

Albert Kagan Arizona State University

and

Mark R. Manfredo Arizona State University

INTRODUCTION One of the primary objectives of purchasing is to ensure a consistent supply of high quality inputs that are essential for effective business operations at optimal cost. Since supplies constitute a major component of operating costs, purchasing related activities consume a substantial share of firm resources. For example, recent estimates indicate that the average revenue share pertaining to purchasing, generally measured as the cost of goods sold, ranges from 52 % for manufacturing operations to more than 70 % for retailing (De Boer 2001; U.S. Census Bureau 2006). Moreover, the impact on profitability derived from a dollar saved in the procurement phase is much higher than a dollar generated through increased sales (Bozarth and Handfield 2006). For these reasons, businesses often focus on procurement practices to control operating costs and to gain competitive advantage (Ellram 1996; Ellram et al. 2002; Fine 1998; Gimenez and Ventura 2003; Hendric 1997; Maltz and Ellram 1997; Zeng and Rosetti 2003). Recently, the ability to ensure a consistent supply of high quality products at competitive prices has become a serious challenge for procurement managers. While some of these challenges relate to product quality and availability, rising fuel costs have become a major obstacle given their impact on transportation costs, and ultimately product prices. This problem is particularly complicated when substitute products can be sourced from various regional markets. It is generally understood that as transportation costs increase, procurement strategies to minimize distance should be employed. However, this tradeoff is not obvious particularly given the often complex interactions between input prices, such as fuel, and prices at and between regional markets. This problem may be even more exacerbated if the productive capacity at one market location is superior to others, or if major infrastructure and capacity enhancements would need to take place at a particular location if it were to truly be seen as a permanent alternative market source. Indeed, a better understanding of the dynamic interactions between input costs, such as fuel, and subsequent product prices at different marketing channels would make it easier for procurement managers to anticipate the likely impacts of price or cost shocks, and allow them to develop alternative product sourcing plans to minimize these costs and avoid supply disruptions. Given this, the objective of this research is to develop a framework for examining the dynamic interactions between product prices at different regional markets and fuel costs, through which cost-price threshold points can be estimated. These cost-price threshold points can then be used to strategically evaluate alternative product sourcing strategies in the face of rising input costs. In doing this, a vector autoregressive (VAR) model is presented to establish the empirical relationship between cost and price variables. VAR models are widely used in establishing the direction of causality and the magnitude of impact from a shock to the system (market). For instance, a number of studies have applied VAR models to examine how prices at different marketing channels react to a particular

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price or cost shock, which is commonly referred to in the VAR literature as innovations (Badinger 2006; Dopke and Pierdzioch 2006; Kim and Coulson 1999; Lastrapes 2006; Pan and Jarrett 2007). While the VAR modeling approach presented is general enough to be applied to a number of different product sourcing situations, the specific empirical application demonstrated in this paper is of the U.S. leafy green industry namely iceberg and romaine lettuce. First, the empirical relationships between production level (shipping point) supply of iceberg and romaine lettuce, fuel (diesel) price, and lettuce prices observed at various shipping points and wholesale markets are estimated with the VAR model. Next, the estimated parameters are used along with hydroponic production cost data to derive the relationship between fuel cost and the prices (cost-price thresholds) for field grown lettuce varieties shipped from California and locally grown hydroponic lettuce varieties at three major wholesale marketsLos Angeles, Atlanta, and New York. Indeed, two of these markets are East Coast markets and involve considerable transportation expense from major production centers located in California. Currently, field grown lettuce varieties dominate these markets. However, as fuel costs continue to escalate, procuring lettuce from high cost local venders, such as hydroponic producers, is likely to be more economical than sourcing from traditional low cost field operations located in California. This research makes important contributions on several fronts. First, the VAR modeling approach presented can be used in virtually any situation where products can be sourced from multiple locations, provided that adequate price and quantity data is available for the specific markets and products examined. Second, the empirical results from the leafy greens (lettuce) example should provide insight to purchasing managers who handle the lettuce procurement as well as other perishable commodities that may be sourced from varying and/or distant locations. Finally, and probably most important, both the general applicability of the modeling framework, coupled with the insights from the empirical results, contributes to the body of academic literature related to procurement managementa field of study which many scholars still consider to be less well developed compared to other closely related business disciplines (Das and Handfield 1997; Heijboer 2003; Morlacchi et al. 2001; Olsen and Ellram 1997; Pooler et al. 2004). The remainder of the paper is presented as follows. A brief review of literature is first presented which highlights applications in purchasing management, and places this study in the context of the extant literature. Next, the empirical VAR model for the leafy green (lettuce) example is developed, followed by a discussion of the lettuce quantity and price data, as well as the diesel fuel price data, used in the empirical example. Empirical results are then reported and discussed, with particular attention placed on the estimated price-cost threshold pointspoints at which levels of fuel costs may prompt consideration to change product sourcing options. Finally, summary and conclusions are presented, with specific considerations of the model and results for managerial uses, as well as future avenues for research.

LITERATURE REVIEW While the importance of purchasing has long been recognized (Chandler 1962), the academic literature related specifically to procurement management is less well developed compared to that of other closely related business disciplines (Das and Handfield 1997; Heijboer 2003; Morlacchi et al. 2001; Olsen and Ellram 1997). This is particularly true since most studies in purchasing or supply chain management are either qualitative in nature, or are based primarily on survey data that reflect respondents perceptions rather than actual business transactions (De Boer 1998; De Boer et al. 2001; Evers 1997; Morlacchi et al. 2001; Rabinovich 2005; Sachan and Datta 2005). In general, studies in supply chain and purchasing management have lagged behind other business disciplines, such as management and marketing, in terms of developing new theories, deriving testable hypothesis, applying advanced tools in analyzing empirical data, and testing hypothesis against real world observations (Dunn et al. 1994; Mentzer and Kahn 1995; Samuel 1997). However, a number of recent developments including increasing integration of global markets, rapid growth in electronic business activities, and a substantial increase in outsourcing are bringing purchasing management into the forefront (Zheng et al. 2007). Consequently, a wide range of analytical tools that are amenable to hypothesis testing and promote theoretical development are being used to address an increasing number of purchasing management issues (Bolumole et al. 2007; Chin et al. 1992; De Boer 2001; Degraeve et al. 2000; Gentry et al. 1992; Heijboer 2003; Sachan and Datta 2005).

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In terms of methods for selecting suppliers and making final procurement decisions, De Boer et al. (2001) provide a comprehensive literature review related to the topic, and develop a classification of the procurement process. They classify the procurement process into four stagesproblem formulation, formulation of criteria, qualification, and final selectionand present a list of qualitative and quantitative decision tools applicable in each stage of the selection process. In particular, they suggest conducting a qualitative analysis using visual and brainstorming tools in the first two stages of the vendor selection process, and recommend the use of quantitative methods such as data mining, multi-criteria decision analysis, and optimization in the last two stages. Recent studies show that a wide range of quantitative tools are being applied particularly in supporting the final stages of the decision making process (De Boer 2001; Degraeve et al. 2000; Sachan and Datta 2005). For example, Degraeve et al. (2000) examined the relative efficiency of supplier selection decision models from a total cost of ownership perspective. This approach accounts for all costs incurred throughout the products life cycle in calculating the total cost of ownership. Using this approach, the selection model with the least cost is the most efficient method for making the procurement decision. In particular, Degraeve et al. (2000) compared the performance of single item and multi-item models and reported that single item methods failed to account for interdependencies among products and performed poorly when compared to the multi-item optimization models. In considering the specific empirical application proposed for this study, logistics management applications have also offered a number of innovative approaches to develop optimal shipping and product distribution strategies in managing the fresh produce supply chain (Abshire and Premeaux 1991; Bardi et al. 1989; Carter et al. 2000; Crum and Allen 1990; Dooley and Akridge 1998; Johnson 1998; Olavarrieta and Ellinger 1997; Saddle Creek Corporation 2007; Taylor 2005). For instance, to minimize the cost of delivering smaller and more frequent shipments, many firms are using a variety of supply chain management options including consolidation warehousing, cross-docking, and multi-vendor aggregation (Perosio et al. 2001; Saddle Creek Corporation 2007; Sobeck and Frost 2005). However, the effectiveness of these alternatives depends primarily on the availability of supplies from multiple manufacturers/producers with common destinations. Given the inherent climatic advantage over other production regions, as well as the availability of an efficient produce distribution network, California has become the major production region for many produce commodities. However, if these market conditions are not maintained, California producers could loose the relative advantage in marketing their products particularly in distant markets. For instance, if the current trend in energy prices continues, the cost of shipping fresh produce from California to Chicago, Atlanta, New York, and other distant markets may become prohibitively high and produce buyers in these markets may need to look for alternative sources of supply such as local suppliers with seasonal field operations or local operations which incorporate greenhouse or other controlled environment technology in growing produce commodities. EMPIRICAL VAR MODEL A clear understanding of the dynamic interactions between product prices and fuel cost is essential to evaluating the economic viability of procurement sourcing options. In this regard, the relationship between observed product prices and supply costs should be analyzed using a system approach because fuel costs may have a direct and indirect effect on prices. In general, a cost change (shock) or any other disruption in the product distribution system may affect the price of a particular product directly by increasing processing and/or shipping costs for the product, and indirectly by raising the price of other inputs used in producing it (McKinnon 2006). In the empirical application presented (leafy greens) a rise in fuel cost would increase wholesale prices directly by increasing the shipping cost, and indirectly by increasing the price(s) for other inputs such as labor, equipment operations, as well as the costs of other inputs. Thus, modeling the primary and secondary impacts of rising fuel costs on product prices using a systems approach is essential. A vector autoregressive (VAR) model that accounts for these direct and indirect interactions among regional market prices and fuel costs can be used to analyze the U.S. leafy green industry. VAR models are commonly used for forecasting economic systems and for analyzing the dynamic impacts of random shocks (innovations) on a system of equations. In this modeling approach, every endogenous variable is defined as a function of lagged values of all of the endogenous variables in the system and other important exogenous variables, i.e.,

yt = + A1 yt #1 + Ap yt # p + Bxt + ! t

(1)

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where yt is a vector of endogenous variables, xt is a vector of exogenous variables, and the is a vector of intercepts that account for the possibility of observing nonzero means. A1, , Ap and B are matrices of coefficients to be estimated and t is a vector of error terms, which are often referred to as white noise or innovation processes (Ltkepohl 2005). The system has k equations, each containing p lags on all k variables. A number of steps are involved in deriving an empirical model from the pth order VAR system depicted in equation (1). First, an appropriate lag length that adequately measures the interactions among the variables of interest should be determined. One of the most common approaches used in determining the lag length is Akaike information criteria (AIC). This approach is based on the concept of entropy and attempts to find the best fitting model that explains the data with a minimum number of free parameters. The test procedure involves calculating the AIC values for all relevant lag lengths and selecting the model with the lowest AIC value. In addition to the AIC, numerous other approaches such as likelihood ratio (LR) test, final prediction error (FPE) criteria, Schwarz criteria (SC), and Hannan-Quinn criterion (HQ) are also used for determining the optimal lag length. Second, since most time series data are non-stationary, each variable included in the system should be tested for stationarity. This issue is important because models based on non-stationary variables may lead to spurious regression (finding an evidence of a relationship when none exists). Generally, the roots of the characteristic polynomials are analyzed to determine whether the variables included in the system are stationary. The VAR system is considered to be stationary if all roots associated with the VAR system fall inside a unit circle (Ltkepohl 2005). If all variables included in the model are stationary the system can be estimated using observed variables in level form (i.e., without applying any other transformation techniques required to convert non-stationary series into stationary ones). Third, variable exogeneity tests such as Wald statistics are implemented to determine whether the variables of interest are truly endogenous to the system being analyzed. If not, they are either treated as exogenous variables or considered as insignificant factors and removed from the model. Most studies follow these three steps very closely in deriving the empirical model from the pth order VAR system depicted in equation (1). The empirical VAR system derived from this process can be estimated using an ordinary least squares method, without any loss of efficiency, if the lag operators included in the model are identical. However, if different lag lengths are involved, a more generalized estimation procedure is required (Hafer and Sheehan 1989; Ltkepohl 2005). Estimating Equations In the U.S. leafy green industry, production level supply and prices (product price and quantities measured at shipping points immediately after harvesting), shipping costs, and the prices at regional wholesale markets are closely related. In particular, a supply shortage is likely to increase both firm level as well as the regional wholesale market price(s). On the other hand, an increase in the price of fuel, which is one of the primary sources of energy used in shipping perishables, is likely to increase transportation costs and subsequently wholesale prices in the short run. If the increase in fuel cost persists in the longer-term, it may affect both firm and wholesale level prices, however, the magnitude and direction of firm and wholesale level impacts may differ. While rising transportation costs are likely to increase the consumer price, retail demand, mainly in distant markets where prices are prone to escalate faster than in local markets, is likely to fall. This increase in wholesale and retail prices and decrease in total product demand may have a ripple effect on shipping point prices and production levels. This dynamic interaction between production level supply and price, transportation cost associated with fuel prices, and leafy green prices at regional wholesale markets can be effectively modeled by using a VAR approach. Moreover, unlike other manufacturing goods, there may not be a two-way relationship between total supply and market prices in the case of fresh leafy greens in the short-run. The total supply for a specific week are fixed because production decisions are made months in advance and the current production must be utilized because it cannot be stored for future use. Moreover, since the leafy green distribution system is a relatively negligible component of the U.S. freight industry, any changes in the leafy green market is not likely to have a significant impact on fuel prices. Thus, both leafy green shipments and the fuel (diesel) cost might be exogenous variables in the VAR system presented in equation (1). However, this is an empirical issue and specific variable exogeneity tests should be conducted to determine whether these two variables are truly exogenous to the leafy green system.

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In the case of the fresh leafy green market, the endogenous variables may include total weekly shipments (production level supply), shipping point prices (production price), regional wholesale market prices (Los Angels, Atlanta, and New York), and the average U.S. fuel price. However, as described above, the VAR order, stability, and variable endogeneity are empirical issues and should be settled by conducting a number of statistical tests. Once the empirical system is determined through these testing procedures, a trend variable and intercept terms are added to the model to account for the effect of time trend and the possibility of a nonzero mean. Assuming that a) a second order VAR system adequately approximates the relationship among leafy green industry variables and the fuel cost and b) both product supply and the fuel costs are exogenous, the VAR system in (1) can be expressed as production and wholesale level price relationships: Production Level Price Relationships for Iceberg (Ipp,t) and Romaine (Rpp,t) Lettuce
2 2 3 2 3 2 2

I pp ,t = a03 + b31I q ,t + c31Rq ,t +

i =1

d3i I pp ,t # i +
i =1

e3i R pp ,t # i +
j =1 i =1

f 3 ji I wp ,t # i +
j =1 i =1

g3 ji Rwp ,t # i +
i =1

h3i F i p ,t + r1T + ! Ipp ,t

2

R pp ,t = a04 + b41I q ,t + c34 Rq ,t +

i =1

d 4i I pp ,t # i +
i =1

e4i R pp ,t # i +
j =1 i =1

f 4 ji I wp ,t # i +
j =1 i =1

g 4 ji Rwp ,t # i +
i =1

h4i F i p ,t + r2T + ! Rpp ,t

Wholesale Level Price Relationships for Iceberg (Iwpj,t) and Romaine (Rwpj,t) Lettuce
2 2 3 2 3 2 2

I wpj ,t = a05 j + b51I q ,t + c51Rq ,t +

i =1 2

d5 ji I pp ,t # i +
i =1 2

e5 ji R pp ,t # i +
j =1 i =1 3 2

f 5 ji I wp ,t # i +
j =1 i =1 3 2

g5 ji Rwpj ,t # i +
i =1 2

h5i F i p ,t + r3T + ! Iwpj ,t h6 ji F i p ,t + r4T +

(2)

Rwpj ,t = a06 j + b61I q ,t + c61Rq ,t +

i =1

d 6 ji I pp ,t i +
i =1

e6 ji R pp ,t i +
j =1 i =1

f 6 ji I wp ,t i +
j =1 i =1

g 6 ji Rwpj ,t i +
i =1

Rwpj , t

where j indexes regional wholesale markets (1=Los Angeles, 2=Atlanta, and 3=New York) and the endogenous variables are defined as average production level prices for iceberg, Ipp,t, and romaine lettuces, Rpp,t; wholesale prices for iceberg lettuce at Los Angeles, Iwp1,t, Atlanta, Iwp2,t, and New York, Iwp3,t, markets; and wholesale prices for romaine lettuces at Los Angeles, Rwp1,t, Atlanta, Rwp2,t, and New York, Rwp3,t, markets. The exogenous variables are the weekly supply of iceberg, Iq,t, and romaine lettuce, Rq,t; average U.S. fuel (diesel) cost per gallon, Fp,t, and a linear trend variable used to account for the effect of a time trend on the leafy green price system, T. The VAR system (2) contains eight equations reflecting the dynamic interactions among production and wholesale level prices, weekly supply of leafy greens (iceberg and romaine lettuce), and fuel cost. As discussed earlier, fuel cost is specified as an exogenous variable and a squared term is included in the model to test whether the interaction among leafy green system variables and the fuel cost are nonlinear. Although, the relationship between fuel cost and lettuce prices could be linear, log linear, quadratic, or any other nonlinear form, the modeling effort experiments with linear, log linear, and the quadratic form in order to conduct statistical tests to determine the appropriate functional form.

DATA Data used in estimating the empirical relationship specified in the VAR system (2) were gathered from various reports published by the Agricultural Marketing Service, USDA. In particular, two price series, weekly production level prices and wholesale prices in major regional markets for both iceberg and romaine lettuce were obtained from the Fruit and Vegetable Market Reports and the production level supply data were gathered from various issues of Weekly Shipment Reports (AMS/USDA). The weekly highway diesel prices were downloaded from the Bureau of Labor Statistics website (www.bls.gov). The sample period ranges from November 20, 1999 to August 20, 2005 which covers 301 weeks. Production level prices are weekly prices for iceberg and romaine lettuce varieties observed at their respective shipping points. Most fresh produce commodities go through initial screening and packaging process immediately after being harvested. Then, the packaged products are shipped directly to different regional wholesale markets. Therefore, the production level prices reflect production and initial packing costs. On the other hand, the wholesale

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market is the link between retail outlets and produce growers. Oftentimes farm products are shipped in bulk quantities from production fields to regional markets and repackaged before they are shipped to retail outlets. Thus, the wholesale price reflects shipping point prices, transportation charges, grading and repackaging costs, and other costs incurred at wholesale level. Among four major categories of leafy greens (lettuce)iceberg, romaine, red leaf, and green leafmarketed in the U.S., iceberg has been the dominant product for many years. However, the increasing awareness among consumers that iceberg lettuce is relatively less nutritious than other leafy varieties has been pushing the demand for romaine and other leafy varieties up at the expense of iceberg lettuce (Cook 2001). For instance, while the per capita utilization of romaine lettuce has increased by more than 1000 percent from 0.73 lbs. per capita in 1985 to 8.1 lbs. per capita in 2004, iceberg utilization decreased by approximately 5 percent from 23.7 lbs. to 22.5 lbs per capita during the same time period. Due to the strong and rising demand, romaine lettuce draws relatively higher production level prices than iceberg lettuce (see Table 1).

TABLE 1 SAMPLE SUMMARY STATISTICS Variable Production Level Supply Iceberg (1,000 Cwt.) Romaine (1,000 Cwt.) Diesel Cost ($/Gallon) Production Level Price Iceberg ($/Lb.) Romaine ($/Lb.) Wholesale Price: Iceberg Los Angeles ($/Lb.) Atlanta ($/Lb.) New York ($/Lb.) Wholesale Price Romaine Los Angeles ($/Lb.) Atlanta ($/Lb.) New York ($/Lb.) Number of Observations Mean 735.10 212.62 1.60 0.17 0.22 1.15 1.17 1.45 1.02 1.25 1.19 301.00 Maximum 1023.00 336.00 2.59 0.93 0.99 2.19 2.01 2.84 2.07 1.85 2.62 Minimum 401.00 20.00 1.14 0.01 0.08 0.74 0.81 0.92 0.62 0.89 0.52 Std. Dev. 99.00 49.18 0.30 0.12 0.13 0.24 0.17 0.29 0.23 0.15 0.25

However, the gap between romaine and iceberg prices disappears at the wholesale level. Since leafy varieties such as romaine have a relatively shorter shelf life than the head lettuce (iceberg), retailers prefer a local supplier (when possible) than those from California. The relatively lower average price for romaine than for iceberg lettuce in the New York market reflects the higher costs of shipping iceberg lettuce from the west coast. EMPIRICAL RESULTS A number of statistical tests were conducted to derive the final estimating equation system (2) from the pth order VAR specified in (1). In particular, order, stability, and variable exogeneity were tested before selecting the final model specification (Ltkepohl 2005). The likelihood ratio (LR), final prediction error (FPE) criteria, Akaike information criteria (AIC), Schwarz criteria (SC), and Hannan-Quinn criterion (HQ) were used to determine the order of the VAR (Table 2). All order tests, except for SC (which supports order one), corroborate that the empirical leafy green system is of order 2 (VAR(2)). Next, the inverse roots of the characteristic polynomials were estimated

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and the results showed that all inverse roots lie inside the unit circle implying that the selected VAR(2) process (i.e., the VAR equation system in 2) is stable (Figure 1).

TABLE 2 VAR LAG ORDER SELECTION RESULTS Lag LogL LR FPE AIC SC HQ 0 1302.922 NA 3.04e-14 -8.422294 -7.826789 -8.183919 1 2068.822 1459.837 2.73e-16 -13.13304 -11.74353* -12.57683 2 2223.503 286.5223* 1.49e-16* -13.74163* -11.55811 -12.86759* 3 2263.716 72.33028 1.75e-16 -13.58199 -10.60446 -12.39011 * Indicates lag order selected by the criterion. The column headings are defined as LR: sequential modified Log likelihood Ratio test statistic (each test at 5% level); FPE: Final prediction error; AIC: Akaike information criterion; SC: Schwarz information criterion; HQ: Hannan-Quinn information criterion.

FIGURE 1

Inverse Roots of AR Characteristic Polynomial

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Wald test statistics, which determine the Granger causality and block exogeneity, were also calculated to examine whether the variables included in the model are exogenous to the overall VAR system. The estimated 2 statistics for iceberg lettuce, romaine lettuce, and fuel cost, which measures the joint significance of all other lagged endogenous variables in an individual equation, are 21.18, 21.96, and 10.98, respectively. In all three cases, these estimated values are less than the critical 2 value of 26.29 at a 5 percent level of significance with 16 degrees of freedom implying that all of these variables are exogenous to the leafy green pricing system. On the other hand, the estimated 2statistics for production level prices for iceberg (39.55) and romaine lettuce (59.23), wholesale level prices for iceberg lettuce in Atlanta (43.77), Los Angeles (96.47), and New York (129.03), and wholesale prices for

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romaine lettuce in Atlanta (36.77), Los Angeles (128.41), and New York (99.04) are highly significant (p<0.05) indicating that these variables are endogenous to the leafy green pricing system. Based on these results, a VAR(2) system with fuel cost, weekly shipments, and a time trend as exogenous variables is used to examine the impact of rising fuel cost on leafy green (iceberg and romaine lettuce) prices. Estimated model results are reported in Table 3. R2-values for individual equations, which measure the goodness of fit, are reported in the second last row of Table 3. Although some of the R2-values are relatively lower than expected particularly for time series models, when compared with other studies they seem to reflect a reasonable fit to the leafy green price series (Galdeano-Gomez 2007; Moschini and Rizzi 2007). For instance, Moschini and Rizzi (2007) analyzed the market share and prices for nine different produce commodities including lettuce and observed R2 -values to range from 0.27 to 0.94. As expected, all significant (p<0.05) production level price coefficients in the wholesale price equations are positive indicating that an increase in production level prices eventually leads to higher wholesale prices. The results from the impulse response functions, which track the impact of a one-time shock to one of the endogenous variables to both current as well as the future values of all endogenous variables, are also consistent with this interpretation of estimated parameters (Figures 2 and 3). While Figure 2 shows the impact of a 1 standard deviation shock in production level price of iceberg lettuce on its wholesale market prices in all three regional markets, Figure 3 displays the similar relationship among production and wholesale level prices for romaine. Thus, a one-time innovation (shock) that increases the production level price of iceberg lettuce by one standard deviation continues to boost its wholesale price in Los Angeles until the fourth week. Although the impact starts to decline after the fourth week, it does not completely dissipate until the 18th week. A similar response with a relatively shorter time span (about 15 weeks) is observed in New York. However, in the case of Atlanta, the wholesale price responds to a shock in production level price only after a week but its impact persists even after the 20th week (Figure 2). The impact of a similar shock in production level price of romaine lettuce also has a positive impact on its wholesale market prices but this effect dissipates during the fourteenth week in the case of the Atlanta wholesale market and by the sixteenth week in both Los Angeles and New York markets. Figures 2 and 3 also plot 2 standard error bands for impulse response functions. The width of these bands determines the sensitivity of the estimates. A narrower gap between these bands and the impulse response function would indicate a relatively more stable relationship than a wider band. Cross price relationships are displayed in Figure 4. A one-time shock in Los Angeles romaine wholesale price increases romaine wholesale price in Atlanta instantaneously, then decreases the price by the same magnitude in the second period and the impact dissipates from the third period onwards. However, this price impact on New York romaine wholesale price is relatively smooth. Price increases price initially and declines slowly reaching the initial state by 12th week. As expected, an increase in romaine wholesale price in Los Angels also increases the wholesale price of iceberg lettuce in Los Angeles, Atlanta, and New York markets.

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TABLE 3 MODEL RESULTS Production Level Price Iceberg Romaine Iceberg Wholesale Price Romaine Wholesale Price

New New Los Los Atlanta Atlanta York York Angeles Angeles Ipp, t-1 0.7403** -0.0589 0.2471** 0.0346 0.0363 -0.0219 -0.0688 0.1270 (11.23) -(0.76) (2.41) (0.37) (0.27) -(0.26) -(0.83) (0.99) -0.1760** 0.0440 0.4251** 0.3045** 0.6879** -0.0856 0.1427 0.0713 Ipp, t-2 -(2.47) (0.53) (3.84) (2.98) (4.67) -(0.92) (1.59) (0.52) 0.0606 0.7556** -0.0812 -0.0536 0.1102 0.1859** 0.0866 -0.0117 Rpp, t-1 (1.12) (11.91) -(0.96) -(0.69) (0.99) (2.64) (1.27) -(0.11) -0.0300 -0.0828 -0.0393 -0.0805 0.0462 0.4249** 0.0280 0.4461** Rpp, t-2 -(0.52) -(1.22) -(0.44) -(0.97) (0.39) (5.62) (0.38) (3.96) -0.0650* 0.0427 0.2929** -0.0140 0.2279** 0.0180 0.0030 0.0856 Iwp, LA, t-1 -(1.71) (0.96) (4.95) -(0.26) (2.90) (0.36) (0.06) (1.16) -0.0206 -0.0397 0.2656** 0.0688 -0.0717 -0.0234 -0.0185 -0.0085 Iwp, LA, t-2 -(0.56) -(0.92) (4.64) (1.30) -(0.94) -(0.49) -(0.40) -(0.12) -0.0352 -0.0581 -0.0370 0.3658** -0.0990 -0.0784 0.0513 -0.0360 Iwp, AT, t-1 -(0.88) -(1.24) -(0.59) (6.37) -(1.20) -(1.50) (1.01) -(0.46) ** 0.0129 0.0510 0.0091 0.2696 0.0475 0.0740 -0.0350 -0.1207 Iwp, AT, t-2 (0.33) (1.12) (0.15) (4.85) (0.59) (1.47) -(0.71) -(1.60) 0.0576* -0.0079 0.0579 0.0052 0.3170** 0.0607 0.0375 -0.0124 Iwp, NY, t-1 (1.96) -(0.23) (1.27) (0.12) (5.23) (1.59) (1.01) -(0.22) 0.0831** -0.0157 0.0330 0.0214 0.0357 0.0106 -0.0606 0.0145 Iwp, NY, t-2 (2.89) -(0.47) (0.74) (0.52) (0.60) (0.28) -(1.67) (0.26) 0.1312** 0.1429** 0.2097** 0.0277 0.0112 0.6300** -0.1568** 0.1851* Rwp, LA, t-1 (2.93) (2.72) (3.01) (0.43) (0.12) (10.82) -(2.78) (2.13) -0.0988** -0.1357** -0.0583 0.0399 0.1294 0.1573** 0.0983* -0.0235 Rwp, LA, t-2 -(2.23) -(2.61) -(0.85) (0.63) (1.41) (2.73) (1.76) -(0.27) -0.0642 -0.2502** -0.1088 0.0085 0.1032 -0.2501** 0.4702** 0.0048 Rwp, AT, t-1 -(1.36) -(4.53) -(1.49) (0.13) (1.06) -(4.08) (7.91) (0.05) 0.0500 0.3254** 0.0832 -0.0554 -0.0502 0.1305* 0.1750** 0.1026 Rwp, AT, t-2 (1.07) (5.92) (1.14) -(0.82) -(0.52) (2.14) (2.96) (1.13) -0.0041 0.0535 -0.1014* -0.0434 0.0415 -0.0885* 0.0737* 0.3042** Rwp, NY, t-1 -(0.13) (1.48) -(2.12) -(0.98) (0.65) -(2.21) (1.89) (5.09) * -0.0495 -0.0456 -0.0531 -0.0434 -0.0388 -0.0740 -0.0319 0.1530** Rwp, NY, t-2 -(1.65) -(1.30) -(1.14) -(1.01) -(0.63) -(1.90) -(0.84) (2.63) -0.0002** 0.0000 -0.0003** 0.0000 0.0000 -0.0002** -0.0001 -0.0001 Iq,t -(4.76) -(0.69) -(3.41) -(0.46) (0.09) -(3.21) -(1.56) -(0.91) 0.0002 -0.0002 0.0002 -0.0002 -0.0003 0.0001 0.0001 0.0002 Rq,t (1.41) -(1.49) (0.92) -(0.81) -(1.13) (0.28) (0.56) (0.62) -0.1599 -0.0528 -0.0492 0.2375 -0.9048** -0.3083 -0.5275** -0.0881 Fp,t -(1.05) -(0.30) -(0.21) (1.09) -(2.89) -(1.56) -(2.75) -(0.30) 0.0314 0.0100 -0.0188 -0.0332 0.2890** 0.1027* 0.1714** 0.0214 Fp,t * Fp,t (0.71) (0.19) -(0.28) -(0.53) (3.19) (1.80) (3.09) (0.25) 2 0.68 0.61 0.81 0.65 0.76 0.85 0.66 0.72 R LLF 375.22 327.82 243.31 267.70 158.48 296.58 305.45 177.16 Note: t-statistics are in parenthesis. The intercept and trend variable coefficients are excluded to save space. **, * denote significance at 1% and 5% level.

Variable

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FIGURE 2

Response to Cholesky One S.D. Innovations 2 S.E.

Response of W ICLA to PIC B
.06

.04

.02

.00

-.02 2 4 6 8 10 12 14 16 18 20

Response of W ICAT to PIC B

.04 .03 .02 .01 .00 -.01 -.02 2 4 6 8 10 12 14 16 18 20

Response of W ICNY to PICB

.10 .08 .06 .04 .02 .00 -.02 -.04 2 4 6 8 10 12 14 16 18 20

Note: The impact and response variables are defined as follows: WICLA=wholesale price for iceberg lettuce in Los Angeles, PICB=production level (shipping point) price for iceberg lettuce; WICAT=wholesale iceberg lettuce price in Atlanta; and WICNY=wholesale iceberg lettuce price in New York.

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FIGURE 3

Response to Cholesky One S.D. Innovations 2 S.E.

Respons e of W RO LA to PRO M
.08

.06

.04

.02

.00

-.02 2 4 6 8 10 12 14 16 18 20

Response of W RO AT to PRO M
.025 .020 .015 .010 .005 .000 -.005 -.010 2 4 6 8 10 12 14 16 18 20

Response of W RO NY to PRO M
.08

.06

.04

.02

.00

-.02 2 4 6 8 10 12 14 16 18 20

Note: The impact and response variables are defined as follows: WROLA=wholesale price for romaine lettuce in Los Angeles, PROM=production level (shipping point) price for romaine lettuce; WROAT=wholesale romaine price in Atlanta; and WRONY=wholesale romaine price in New York.

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FIGURE 4

Response to Cholesky One S.D. Innovations 2 S.E.

Response of WROAT to WROLA
.02 .04 .03 .02 .00 .01 -.01 .00 -.02 -.01 -.02 2 4 6 8 10 12 14 16 18 20 2 4 6 8 10 12 14 16 18 20

Response of WRONY to WROLA

.01

-.03

Response of WICLA to WROLA

.030 .025 .020 .015 .005 .010 .005 .000 -.005 2 4 6 8 10 12 14 16 18 20 .000 -.005 -.010 2 .020 .015 .010

Response of WICAT to WROLA

10

12

14

16

18

20

Response of WICNY to WROLA

.04 .03 .02 .01 .00 -.01 -.02 2 4 6 8 10 12 14 16 18 20 .020 .015 .010 .005 .000 -.005 -.010 2

Response of PICB to WROLA

10

12

14

16

18

20

Note: The impact and response variables are defined as follows: WICLA=wholesale price for iceberg lettuce in Los Angeles, WROLA=wholesale price for romaine in Los Angeles, WROAT=wholesale romaine price in Atlanta, WRONY=wholesale romaine price in New York; WICAT=wholesale iceberg price in Atlanta; WICNY=wholesale iceberg price in New York; and PICB=production level (shipping point) price for iceberg lettuce.

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Significantly negative coefficients of iceberg shipments in the production level and wholesale price equations re-enforce the negative price quantity relationship as postulated by demand theory. Although the coefficient is not significant, a similar relationship is observed between romaine supply (shipments) and the shipping point price. On the other hand, a significantly negative relationship between the weekly shipments of iceberg lettuce and the wholesale price of romaine in the Los Angeles regional market shows that iceberg and romaine lettuce might be substitutes in this market. Moreover, none of the iceberg wholesale price coefficients is significant in the romaine wholesale price equations but two of the romaine wholesale price coefficients contained within the iceberg wholesale price equations are significant (p<0.05). The significantly positive impact of the romaine wholesale price on the iceberg wholesale price equation for Los Angeles reinforces the argument that bagged salad processors often substitute iceberg lettuce for romaine when romaine is in short supply. However, the coefficient associated with the New York romaine wholesale price in the Los Angeles wholesale price equation carries a significantly negative sign. Since most lettuce varieties are primarily produced in California and marketed throughout the U.S., an increase in the romaine wholesale price in New York is not likely to reduce the wholesale price of iceberg lettuce in Los Angeles. As pointed out by Nannestad and Paldam (2000), individual coefficients in VAR models are often insignificant or carry unexpected signs. However, this is not necessarily a problem because the main interest in analyzing a VAR system is to evaluate both direct as well as indirect effects of change of a variable on all other variables within the system. Even if the direct effect of a variable, as reflected by an individual coefficient, is not significant it may affect indirectly through its impact on other variables (Nannestad and Paldam 2000). The relationship between fuel cost and regional wholesale market prices, however, is relatively less ambiguous. This relationship was hypothesized to be non-linear and a quadratic function (relationship) was estimated. The results are generally consistent with this characterization and the estimated coefficients are statistically significant for wholesale prices of iceberg lettuce in New York and for romaine in the Los Angeles and Atlanta markets. In the next section, these results are used as an empirical basis in evaluating the impact of an increase in fuel cost on leafy green prices.

COST-PRICE RELATIONSHIPS Using the VAR parameters and the Greenhouse Enterprise Budget data developed by Ohio State University researchers (Donnell et al. 2005), a simulation model is developed to derive the relationship between rising fuel cost and the price for field grown and hydroponic lettuce varieties. The cost-price relationships are generated for two scenarios(a) when the cost of producing hydroponic lettuce remains constant as fuel cost rises, and (b) when the hydroponic production cost rises with the escalation in fuel price. The estimated relationships between fuel cost and leafy green prices under the first scenario are displayed in Figure 5. The graph illustrates how wholesale prices for leafy greens in New York, Atlanta, and Los Angeles markets change as the fuel cost escalates from $1.00 to $7.00 per gallon. As expected, the impact of rising fuel cost on the leafy green price is predictably higher in New York than in the other two regional markets. Likewise, the Atlanta market price is consistently higher than the price in Los Angeles. This finding is consistent with the fact that Los Angeles is much closer to the major production regions (California and Arizona) than Atlanta and New York. Results also indicate that a 50 % increase in the fuel cost, in this case rising from $2.0/gallon to $3.0/gallon, would increase iceberg prices in New York by more than 38 % (from $1.41 to $1.95 per pound). However, if the fuel cost increases from $3.00 to $4.00 per gallon (a 33 % increase), the wholesale price would rise by more than 57 % (to $3.07 per pound). Moreover, as fuel cost exceeds the $7.00 per gallon mark, a price level less than currently observed in many European countries, including the UK, the wholesale price for iceberg lettuce in New York would approach $10.00 per pound. For instance, the average monthly price in the U.K. for January 2008 was $9.66/gallon ( 1.09/liter; www.theaa.com/motoring_advice/fuel). Although the average weekly wholesale price has reached $2.84 per pound in the past, a price of $10.00 per pound may be too high for many customers which present an interesting dilemma for retail procurement managers.

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FIGURE 5 FUEL COST AND LEAFY GREEN PRICE THRESHOLDS: CONSTANT HYDROPONIC PRODUCTION COSTS

12.0 Iceberg Wholesale Price in New York

Iceberg and Romaine Prices ($/Lb)

10.0

Romaine Wholesale Price in Los Angeles Romaine Wholesale Price in Atlanta Cost of Hydroponic Lettuce

8.0

6.0

4.0

2.0

0.0 1.0 2.0 3.0

3.41

3.98
4.0

5.02
5.0 6.0 7.0

Fuel Cost ($/Gallon)

Although U.S. fuel prices are less likely to reach the level currently observed in many European countries, it has been rising much faster than in the past. For instance, the average weekly fuel cost has increased by more than 360 percent from $0.956 on March 1, 1999 to $3.44 per gallon on February 4, 2008 (Energy Information Administration 2008). Since this rising trend may continue in the future, an objective analysis of the likely impact of rising fuel cost on regional market prices would help procurement managers to develop an effective sourcing plan. One of the possible alternatives to address the rising transportation cost would be to shift production closer to major markets. However, in many regional markets such as New York, producing leafy greens particularly during the winter months is not feasible without developing weather controlled production facilities. Although the cost of producing certain leafy green varieties under controlled environment conditions is much higher than field production, a substantial increase in transportation cost may make greenhouse production more economical particularly in distant markets such as New York. Recent estimates indicate that the average cost of producing lettuce in a greenhouse environment is $0.72/head (Donnell et al. 2005; OARDC/Ohio State University 2006). Moreover, the greenhouse lettuce production cycle (35 days) is much shorter than the field production cycle (90-120 days), which may provide more flexibility in matching supply with the changing market demand. On average, a harvest ready hydroponically produced lettuce head weighs 5 ounces (CEA/Cornell University). Although, there are various controlled environment production systems available and the average cost and weight of an individual lettuce head may vary, these two figures can be applied in developing a tentative production cost estimate. Applying these two cost and weight measures, the average cost of producing one pound of lettuce under controlled environment would be $2.34/lb. Assuming that all field grown leafy green products are produced in California and transported to markets throughout the U.S. and field grown and hydroponic lettuce are perfect substitutes, a fuel cost of $3.41/gallon would make hydroponic lettuce more attractive than field-grown lettuce in New York wholesale markets. Likewise, hydroponics would be more economical than field grown in Atlanta and Los Angeles as the fuel cost rises beyond $4.00 and $5.00 per gallon respectively.

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Simulated results under the second scenario are reported in Figure 6. This scenario is exactly the same as the first one except for the variation in the cost of producing hydroponic lettuce as fuel costs rise. This change in the model scenario only alters the cost-price thresholds beyond which hydroponic lettuce becomes a more economical option. In particular, the switching point changes from $3.41, $3.98, and $5.02/gallon to $3.77, $4.63, and $6.18/gallon for New York, Atlanta, and Los Angeles, respectively. FIGURE 6 FUEL COST AND LEAFY GREEN PRICE THRESHOLDS: VARIABLE HYDROPONIC PRODUCTION COSTS

10.0 10.0 10.0 9.0 9.0 9.0 8.0 8.0 8.0 7.0 7.0 7.0 New New York Iceberg Price New York Iceberg Price Iceberg Price Atlanta Romaine Price Atlanta Romaine Price Atlanta Romaine Price Los Los Angeles Romaine Price Los Angeles Romaine Price Romaine Price Cost Hydroponic Lettuce Cost of Hydroponic Lettuce Cost of Hydroponic Lettuce

Lettuce Price ($/Lb) Lettuce Price ($/Lb) Lettuce Price ($/Lb)

6.0 6.0 6.0 5.0 5.0 5.0 4.0 4.0 4.0 3.0 3.0 3.0 2.0 2.0 2.0 1.0 1.0 1.0 0.0 0.0 0.0 2.0 2.0 2.0

3.77 3.77
3.0 3.0 3.0 4.0 4.0

4.63 4.63 4.63

6.18 6.18 6.18

6.0 6.0

5.0 5.0 4.0 5.0 FuellCost ($/G ll ) F C t ($/Gallon) Fuel Cost ($/Gallon) Fuel Cost ($/Gallon)

6.0

7.0 7.0

7.0

Empirical relationships between fuel cost and leafy green prices displayed in Figures 5 and 6 are based on a number of simplifying assumptions and should be used with caution. First, the study is based on the assumption that there is adequate greenhouse production capacity to increase the supply and satisfy the rising demand for hydroponic lettuce as fuel cost continues to escalate. Although demand and supply forces are expected to maintain a balance in the long run, factors such as periodic fluctuations in fuel prices, inadequate supply of production capacity, and other market imperfections are likely to increase volatility in the short run making it difficult to sustain a smooth transition from field grown to hydroponic lettuce as depicted in the graphs (Figures 5 and 6). Future studies should address these issues for a better understanding of this adjustment process and to avoid negative impacts of these market imperfections. Second, a rise in the diesel price will also increase the cost of all fuels and other factor inputs subsequently increasing the cost of hydroponics. Third, an improvement in greenhouse production technology may reduce the production costs, making hydroponics a more attractive option much earlier than depicted in Figure 6 for leafy green production as opposed to growing lettuce in the traditional field setting.

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SUMMARY AND CONCLUSIONS Purchasing managers ability to obtain and ensure a consistent supply of quality products at competitive prices remains, and likely will continue to be a critical management challenge. This is particularly true in the presence of rising fuel costs, given the direct and indirect impact that fuel costs have on transportation costs and product prices respectively. When substitute products can be sourced from alternative market locations, procurement managers must decide on which location to source from. In the presence of rising fuel costs and subsequent price differentials, the choice of which market to source products from is not immediately obvious. Therefore, this research attempts to provide a framework for better understanding the interactions between input costs, namely fuel price, and product prices among alternative markets. Specifically, this study presents a vector autoregression (VAR) model to establish the empirical relationship between cost and price variables, and establish cost-price threshold points which can be used to evaluate product sourcing from alternative markets in the presence of rising fuel costs. This process demonstrate the use of a VAR model for the leafy greens market (lettuce), an important perishable produce commodity, which is primarily grown domestically in California and Arizona, yet shipped to various points throughout the U.S. In addition to illustrating the VAR modeling approach, the empirical results provide practical guidance to procurement managers that work with perishable commodities such as lettuce. For instance, if fuel prices continue to escalate beyond $3.77/gallon, produce managers in New York and Atlanta wholesale markets, who currently procure leafy greens and other perishable products primarily from California, may need to look for alternative sources such as local suppliers with seasonal field production or those with greenhouse operations to meet consumer demand and maintain a smooth transition from field grown to hydroponics based products. In this context, the fuel cost thresholds estimated in this study provide a reference point for fresh lettuce buyers in identifying nontraditional suppliers as well as in developing alternative sourcing plans. The VAR modeling framework presented here is flexible enough to be used in estimating and examining the cost-price interactions for products beyond that of leafy greens, provided that an adequate series of product price and quantity data is available. Since most produce commodities are seasonal, produce managers need to evaluate numerous supply sources and make optimal procurement decisions for each season on a regular basis. For instance, fresh market oranges are procured from global market sources including Australia, South Africa, Dominican Republic, and Mexico, particularly during the summer months (June-September) when domestic supply is limited. However, as fuel costs continue to escalate, the cost of procuring oranges from distant sources such as Australia and South Africa may become relatively more expensive than sourcing from the Dominican Republic or Mexico. A VAR model, similar to the one developed in this study, can be used to derive the cost price thresholds that may provide an empirical basis for procuring oranges from the global market. While the VAR modeling framework used in this paper can serve as a guide for other applications, the exact specification of the VAR model will likely be different than the one presented here given the idiosyncrasies of the specific markets and data examined. Nonetheless, this research helps to fill a perceived void in the purchasing management literature by adopting and applying theory and methods from other disciplines, analyzing supply chain management issues from a systems perspective, and in using innovative research tools to analyze secondary data (Sachan and Datta 2005).

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ACHARYA, KAGAN, AND MANFREDO

ABOUT THE AUTHORS Ram N. Acharya (Ph.D. Auburn University) is an Assistant Professor of Agribusiness Management at New Mexico State University. His current research interests include issues related to product marketing, ecommerce, and supply chain management. Dr. Acharyas publications have appeared in numerous journals including the Journal of Economics and Business, e-Service Journal, Applied Economics Letter, American Journal of Agricultural Economics, Journal of Internet Commerce, Applied Economics, Communications in Statistics: Simulation and Computation, and Educational and Psychological Measurements. Albert Kagan (Ph.D. Iowa State University) is a Professor of Management at Arizona State University. His research activities are in the area of entrepreneurial design, and business processes of procurement. Representative publications have appeared in: Entrepreneurship: Theory and Practice, Journal of MIS, Journal of Marketing Research, Applied Economics, Journal of Economics and Business among others. Professor Kagans funded research projects have totaled over $11.0 million. He has edited one book and is on the editorial board of a business innovation journal. Mark Manfredo (Ph.D. University of Illinois at Urbana-Champaign) is an Associate Professor in the Morrison School of Management and Agribusiness at Arizona State University. His research interests include commodity price analysis, forecasting, forecast evaluation, futures and options markets, and financial risk management. He has published in the Journal of Supply Chain Management, Energy Economics, American Journal of Agricultural Economics, Applied Financial Economics, and Journal of Public Policy and Marketing.

Contact author: Ram N. Acharya, E-mail: acharyar@nmsu.edu