JIM ROWLAND, is the editor/publisher of Canadian Paper Analyst, a Montreal-based newsletter that covers the economics of the Canadian pulp and paper industry. His e-mail address is: rowland@accent.net

Comment Column

Cost curves: Let the buyer beware

A popular management tool used
in the pulp and paper industry is the product-line cost curve. It ranks, usually on an anonymous basis, the costs of a cross section of mills producing a particular
commodity.

The costs are usually defined as mill-level costs including depreciation, mill-level cash costs excluding depreciation, or delivered cash costs to a particular region. Theoretically, this tool could be applied to any commodity grade, but, in
practice, it is used for high-volume, slightly differentiated grades such as newsprint, coated groundwood (LWC), NBSK market pulp, linerboard,
corrugating medium, etc. A number of consulting companies are active in this area.

There is a variety of end users for these cost curves. First and foremost, cost curves help mill-level management to appreciate where they fit in the cost hierarchy of competing mills and, by
inference, help to motivate their mill employees to improve their relative position. If a mill is
relatively high on a cost curve, mill-level management will also use this as a bargaining chip in gaining concessions from outside suppliers and local governments. In the worst-case scenarios, mill-level employees will be asked to share in the pain by reducing their hourly earnings and/or by making changes in their labor agreements that help improve productivity.

If a company's mill(s) are considered cost-competitive, corporate head offices employ these cost curves in a number of areas. Chief financial officers pass along the good news to their bankers, who should derive some comfort from the fact that one of their accounts has laid the foundation for a healthy future. Senior
marketing staff are not shy about telling their customers about their favorable cost position, thereby reinforcing the notion that, in the long term, they can be counted on as a dependable supplier. This is, of course, particularly important during an economic downturn when mills or machines might be shut down or converted over to other grades. Investor relations executives are quick to inform the investing public about a company's favorable cost position. If investors are convinced a company is a low-cost producer, a company's share price should trade at a
premium over the share price of a competing company that has higher-cost facilities.

Cost curves certainly play a role in making investment decisions. A good part of the justification for installing new capacity is based on how competitive the cash costs of any new machine are compared to existing capacity. It is almost essential that, to secure financing, any new project, once operational, must be deemed to be well down the cost curve of existing producers. (Because of the hefty depreciation charges associated with newly installed capacity, the total mill-level cost comparison is obviously not very appropriate as an analytical tool.)

Theoretical? Users of cost curves should be aware of their inherent weaknesses. Most of the data is based on a "theoretical" cost estimate, using regional averages for woodfiber, energy, labor, chemicals, and other inputs. Other factors that obviously have a bearing on a mill's cost structure are age of the equipment, machine size, etc. Unless a company is prepared to come clean with detailed cost data, cost curves are only very approximate and, in many cases, reflect reality only for a limited period of time. For instance, because many newsprint mills depend on recycled paper (old newspapers and coated groundwood) for a significant portion of their furnish, swings in the prices for these grades can have a major impact on the relative cost position of a mill. Transfer pricing can
distort the placing in the cost hierarchy for a particular grade. For the kraft component of LWC printing paper, a non-integrated producer pays market prices, of course; for an integrated producer, the kraft component is transferred at market prices, at out-of-pocket costs or some combination of the two. In multi-product mills, a further complication is the division of overhead costs among the different grades produced at the mill.

In the last few years, the cost curves for these commodity grades have generally flattened out. The higher-cost producers have either left the business or have worked hard at cutting out some excessive cost elements. Much of the improvement at higher-cost mills has resulted from less stringent labor practices. Trades flexibility and contracting out have both helped to reduce the labor content in producing a ton of pulp, paper or board. More efficient labor practices in the woodlands operations have also helped to reduce fiber costs at a number of mills.

Cost curves still serve a purpose, but it is important that the end users and the people whom the end users are trying to influence should be aware of their inherent weaknesses. They should accept the reality that the cost hierarchy for a particular product is only a rough approximation for a
certain period of time. As with any other
product or service, caveat emptor.