Eliminating inefficiencies in the fiber value chain could present many companies with a realistic chance to boost profitability

To restructure or to be restructured

But there are other areas that could prove useful in boosting margins and improved fiber procurement is one area that appears to present rich opportunities. Fiber accounts for between 10-30% of paper manufacturing costs, 40-60% of pulp manufacturing costs, and 70-80% of saw timber manufacturing costs. Yet, somewhat surprisingly, many companies have resisted a profound rethink of their traditional fiber procurement approach.

People in the industry often explain that fiber procurement is "different", or that fiber procurement is a local business based on relationships. Despite these strong feelings though, fiber procurement can be managed as strategically as any other kind of procurement. In fact, fiber usually offers more avenues for cost reduction, information sharing and partnering than most other spend categories.

Typically, the sector assumes that devising a sound sourcing strategy in each 'basin', or geographical fiber catchment area, is a precondition for improving fiber procurement. Companies must answer some key questions in each basin where they operate such as:

• what is the growth/drain in the basin of fiber we need?
• what is the appropriate mix of wood from our own land, contract purchases and what skills and information in the basin can we leverage?
• are we making use of partners in the basin outside of our company?

The answers to these and other related questions drive a coherent, basin-specific, sourcing strategy. However, creating a sensible strategy is only part of the battle. Companies must go right to the inefficiencies that riddle the fiber value chain since collectively these represent enormous untapped potential.

The forest products industry generally acknowledges that there are opportunities to be exploited. But the preliminary steps taken to address them have either failed to reach across the value chain, or they have overlooked the possibility of partnering with others in the basin who may possess better skills or information.

There are two emerging trends that will push companies to restructure the fiber value chain - increasing sophistication on the supply side and increasing power on the demand side. To examine these trends further, the first step is to outline some of the most important inefficiencies, then present a model for using strategic basins to conduct a total fiber procurement restructuring effort. The models were developed in a North American context, but they should be broadly applicable to other regions.

Two-sided

Attacking inefficiencies in this programmatic and aggressive way changes the very core of the forest products industry. But this course of action gives companies an effective way to compete on costs while the entire industry struggles to achieve attractive price levels.

The main issue here is the double-edged sword of rising prices and diminishing power. As both timber owners and end-users increase their buying power and sophistication, forest products companies are facing a real challenge to their ability to earn acceptable returns. Supply and demand conditions are pushing the price of timber higher, while the relative power of forest product manufacturers is declining in comparison to their suppliers and customers.

In addition, there have been some significant changes in the structure of timber ownership and the intermediaries that operate between the various parties involved. Over the last 10 years, the industry has seen a change in timber ownership as TIMOs (timber investment management organizations) have been actively buying out timber assets from forest products companies and successfully "monetizing" them. Often, TIMOs take a more opportunistic approach to harvest timing and may reduce wood supply in a basin. This approach helps TIMOs meet their return objectives over longer periods, but it also puts upward pressure on fiber prices.

Timber consultants have also emerged as an intermediary providing value-added services directly to landowners. Typically, they will identify buyers, acquire market price information and manage bids. Accordingly, from a mill's perspective, consultants ensure that the highest possible price will be paid for virtually every timber tract.

More demanding

While mills have always looked to their customers when their costs increase, customers have become less and less willing to accommodate price rises. The forest products industry has seen continuing consolidation among the companies they sell to and this has helped re-shape the power balance between the parties.

In paper, there has been consolidation among distributors and the growth of retailers such as Office Depot. Solid wood product distributors have also consolidated, while manufacturers such as Canfor have forward integrated. Added to that, major retailers such as Home Depot and Lowe's in the do-it-yourself market and Carolina Builders and Pelican in the commercial building sector have joined forces. As a result, forest products companies find it increasingly difficult to pass on fiber cost increases.

Moreover, the industry as a whole is facing increasing environmental pressures. Powerful customers have begun to expect environmental performance guarantees and have the clout to enforce them. For mills, these requirements raise process complexity and often result in increased delivered wood costs.

Inefficiency sources

Trends in fiber procurement have also had negative effects on profits. Inefficiencies exist in each phase of the fiber value chain (Figure 1), as well as across phases, due to the increasing "silo-effect" of the procurement process.

Figure 1 identifies the key drivers of fiber value chain efficiency. The most notable inefficiencies in tract purchasing come from the duplication of effort built into the procurement process. From the 1970s through the 1990s, a bidding system emerged as an important part of procurement. Today, multiple suppliers commonly bid on the same tract for the same mill, increasing the apparent demand for wood and driving stumpage prices higher. At a minimum, multiple bidders ensure the maximum price will be paid for each tract.

The negative effects of this redundant bidding ripple through other cost areas. For example, negotiated and gate wood prices track bid prices closely. As a result, inefficiencies that drive costs higher in one purchase type potentially raise costs across all wood categories. Studies carried out by McKinsey in the southeastern USA and other areas have shown wood price reduction opportunities created by increased bidding efficiency in excess of 5%.

Some forest products companies have looked at the high cost of wood and tried to intervene directly with price controls. For example, Georgia-Pacific calculates what it believes to be a fair price, publishes it, and asks suppliers to match or beat it. This strategy forces prices down in the short term, but it does not address the root cause process inefficiencies that drive wood prices up in the first place.

Other forest products companies in the southeast and northwest have developed a system for controlling wood prices designed to get better performance from suppliers. For example, Weyerhaeuser has initiated a tiered, preferred supplier program. Top-performing suppliers are identified and offered performance incentives such as access to company land, extra quotas and price premiums. This approach encourages better performance, but it leaves the inefficiencies created by multiple, fragmented suppliers in place.

The inefficiencies in bidding and purchasing extend into tract solicitation as well. When mills use multiple outside fiber suppliers for tract solicitation, all parties search for potential sellers of wood. Therefore, all parties are simultaneously identifying possible tracts, cruising the land and developing relationships with landowners through direct sales calls.

In much the same way, having both suppliers and mill foresters cruise tracts creates costly duplication. In fact, 30-50% of an average field forester's time is spent cruising land. Yet the returns on this time investment are low and the 'win rate' per tract is no higher than 20% on average. Eliminating duplicated efforts may allow mills to cut the total cost of internal and external procurement by over 50%.

Logging and merchandising

Since a logger's performance depends on equipment, skills and management oversight, the degree of inefficiency in a region depends on how merchandising and logging are actually conducted. In the southeastern USA, loggers are typically small "mom and pop" entrepreneurs who cut a few tracts at a time. These entrepreneurs are capital constrained, using technology selectively and making small, incremental equipment purchases.

In the southeast, logging capacity has been built to meet the requirements of peak demand. Since demand is hard to predict, most areas have significant excess capacity through most of the cycle. In fact, the practice of creating work to prevent the best loggers from serving competitors - and sometimes just to keep them financially solvent - creates an artificial demand for capacity that does not fully serve the needs of the mill. Our analysis indicates an opportunity to reduce logging costs by approximately 10% by transferring best management practices, improving equipment utilization and increasing scale in equipment purchasing.

Once trees are cut and ready to be delivered, another set of inefficiencies emerge. To get value from timber, the right log has to make it to the right mill. The merchandising process should deliver wood to its highest value end use. Simply put, saw timber should never be merchandized as pulpwood given the price difference between the two products.

Yet loggers have little incentive to optimize merchandising decisions. In areas where the technology for automated assessment of merchandising value is not available, loggers must make the judgement by eye. And while some are good at it, their motivation is often to maximize volume rather than value for the mill. Depending on the quality of merchandising, mills may capture 5-15% more value by aggressively improving the process.

Some companies have taken steps to measure logger performance though. For example, Weyerhaeuser has instituted performance contracts. Yet most mills cannot efficiently track value creation and therefore do not reward loggers based on their impact on the mill's bottom line.

Restructuring basins

To fully address the inefficiencies described above (and in some cases to capture the total potential value), incremental, isolated efforts are insufficient. The entire fiber value chain must be restructured, but if it is done well there are significant gains to be made.

Forest product companies need to organize their restructuring efforts around strategic basins. We define a strategic basin as the natural procurement area of a mill or integrated network of mills. The actual area is determined by logistics costs, available wood mix and the proximity of competing mills.

As an initial step, a forest products company must assess its scale and skills in the basin. Scale assessments involve looking at fiber purchase volumes, the breadth of the contractor network, and the size/efficiency of the field procurement force. Skills include the ability to source and market fiber to different users (pulp mills, sawmills etc), the development and application of sophisticated, proprietary analytical tools, and the management of contractors and the supply chain.

On the basis of a mill's specific situation and challenges, one of four possible models will emerge as the preferred alternative for restructuring each basin (Figure 2).

Do it yourself

The first model revolves around a do-it-yourself (DIY) approach. In basins where a company has both the scale and skills to dominate, it has the option to manage its own procurement. A company with a large share of the total wood resources in a basin that uses both pulp and saw logs will be a good DIY candidate. By discontinuing the use of intermediaries, companies eliminate inefficient duplications of effort. In addition, when they leverage their own skills to upgrade the quality of procurement functions they can improve execution across current functional boundaries.

A company using this strategy has to make investments in technology, tools and people to strengthen and defend its position. The DIY company must build its own low-cost procurement organization aggressively and use its proprietary transaction information to improve efficiency. Furthermore, it must look for opportunities to improve logging and merchandising, whether these activities are run in-house or contracted out.

On the other hand, while this strategy will create returns, building expertise around procurement can distract a mill and potentially result in a lack of focus on core competencies.

In partnership

That point leads us neatly into the second model - partnering with skilled suppliers. This model is suitable for a company with large-scale operations, but only limited skills in a basin. The mill may outsource the actual procurement activities (cruising, bidding, and negotiating), but continue to manage logging and transportation.

Partnering is generally the preferred option, rather than building skills organically. The fiber procurement processes at large companies usually suffer from powerful organizational inertia. Most of the organization has been geared toward Œwooding the mill' and therefore may find a Œtotal cost of ownership' mentality difficult to adopt. Often, the lines of communication between field and mill have long since frozen over. Moreover, the staff at large companies are often numerous, high cost, and change-resistant.

Partnering with a skilled partner works because it neutralizes inertia and resistance. A company can close its skill gaps quickly in areas such as stumpage acquisition while still maintaining control over the coordination of the procurement process.

But executing this partnership model seamlessly on a daily basis requires the development of strong institutional skills for managing service suppliers. In addition, the partnership must benefit both partners. Only with a trust-based relationship will a partner be willing to invest in building skills and serving the mill effectively over the long term.

Third way

A third potential model involves partnering with other users. In situations where a company lacks sufficient scale in a basin, but has institutionalized unique and effective procurement skills, it makes sense for complementary fiber users to combine purchasing and reduce inefficiencies across the value chain.

The most obvious example would be a case where a small or medium-sized sawmill partnered with a pulp mill in the same basin. Together, they could optimize the wood flow. Equally, multiple sawmills or multiple pulp mills could combine procurement operations.

Obvious disadvantages of this model include the complexity of coordinating between and across multiple partners and the need to manage potential conflicts of interest between fiber users.

Final option

The fourth model is to let someone else do the work. Companies should consider outsourcing all fiber procurement activities when they lack scale and skills in a basin. The advantages of this approach include a reduction in procurement costs and an increase in operating flexibility. Successful implementation, however, requires a detailed supply agreement. Otherwise, few companies would be comfortable outsourcing the supply of their most important raw material.

To be successful, this strategy requires careful measurement of supplier performance as well as incentives that tie contractor compensation to value creation or destruction. Outsourcing is generally rare in the forest products industry, but it provides a workable solution that has already proven effective in a host of other industries.

These strategies may seem radical to some. But for companies frustrated with the lack of success shown by their more targeted efforts to capture inefficiencies, restructuring the fiber value chain is the only option. For potential partners, including wood suppliers and loggers/merchandisers, an investment in building up best practice industry skills in analytical expertise, negotiation and supply chain management will lead to increased productivity and insight.

Today, several paper and forest products companies are working with partners to pursue exactly the basin-focused restructuring efforts outlined here. Companies and partners that lead these efforts will flourish, but those who sit and wait do so at their own peril.

Robert Yanker is a director in McKinsey & Company's Atlanta office.
James Nahirny and Heikki Malinen are consultants with McKinsey & Company based at the same location.

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