Forest products benchmarking methodology

Fastmarkets RISI’s cost benchmarking methodology normalizes regional cost differences among pulp and paper mills and machines operating around the world. This is done to provide pulp and paper industry professionals with a consistent and reliable basis for comparing the cost competitiveness of one or more mills with others producing the same grades or products in various world regions.

Cost competitiveness in pulp and paper markets is generally determined by comparing cash manufacturing costs of mills and machines. The cash manufacturing cost of a mill is calculated based on the direct manufacturing costs of producing a product — i.e. summing the consumption of all natural expense categories and adjusting for regional cost differences, configuration differences and operational performance:

Cash manufacturing cost = fiber + chemicals + energy + labor + maintenance + materials

The three primary uses of cost benchmarking data are:

Identifying the low cost producers in a given market. These producers are usually the price leaders and can significantly impact market prices.
Identifying mills at risk of closure in a given market. These are high cost producers, greatly exceeding the cost average in a market.
Identifying the source of cost differences between producers. Not only is it useful to identify high and low cost producers in a market, it is also important to identify the driving forces behind their cost differences.

An overview of the cost benchmarking process

Cost benchmarking is a continual process of comparing mill and machine-level costs for pulp and paper producers around the globe. Information derived from this process identifies the cause and degree of variance in cash manufacturing costs among these assets. These data can then be used to improve performance, identify risk and evaluate assets.

The cost benchmarking methodology involves two main stages: data collection and cost calculation.

Stage I: Data collection

Data is typically collected from three main sources: internal sources, original research and external sources.

1. Internal SourcesFastmarkets RISI benchmarking analysts use data from many internal sources to build a basic framework for their cost benchmarking calculations. This mill and machine-level data is seen by many as the most extensive and highly accurate available in the industry because it is collected by a global team of editors, economists and analysts.

Regional costs and market variables tracked by Fastmarkets RISI economists for use in forecasts and market analyses are used by benchmarking analysts as a standard to evaluate mills and machines. Each mill is assessed individually for cost variances that deviate from those market averages. Variances are identified by collecting mill and machine-specific information usually submitted to Fastmarkets RISI in news releases and reports by mills, suppliers and other organizations.For example, an electric company might issue a news release that it plans to buy all excess energy produced by a specific mill. Benchmarking analysts would investigate such a story to find out how much the mill will save on its energy costs in order to make adjustments to that mill’s benchmark report.
News on special mill projects, new capacity, shut downs, capital investments and other important events are reported each day by Fastmarkets RISI’s global news team. This information, when relevant to a mill’s production processes, costs or profits, are used by benchmarking analysts to make adjustments to a mill’s benchmarking report. Fastmarkets RISI’s strong relationships with the world’s top producers and industry suppliers enable us to consistently acquire the details needed to make these adjustments in a timely fashion.
All Fastmarkets RISI benchmarking analysts have spent part of their careers working as process engineers in mills around the world. This experience makes them intimately familiar with the equipment and processes used by different types of pulp and paper mills. It also makes Fastmarkets RISI benchmarking analysts uniquely qualified to identify the impact of new equipment; upgrades and improvements to existing machines; and conversions to new or additional grades and products on existing mill operations. These changes are all added to benchmark reports.Fastmarkets RISI analysts maintain their knowledge of mill processes and learn about the impact of new technologies by regularly visiting mills as well as leveraging relationships with industry suppliers.

2. Original ResearchEach year, Fastmarkets RISI surveys managers, supervisors, and executives working in mills around the world on their company’s production processes, personnel, equipment details and other relevant information. While the data collected is comprehensive and very detailed, Fastmarkets RISI takes additional measures to ensure the data submitted is not only complete, but also accurate.

If a survey is returned incomplete or not returned at all, Fastmarkets RISI makes every effort to speak with the mill contact to collect the missing information. This is often done in the native language of the mill contact to ensure further accuracy. Fastmarkets RISI employs native speakers of a variety of languages including: Chinese, English, Finnish, French, German, Portuguese, Spanish, and others.

3. External SourcesFor comparison purposes and to fill any gaps in data from the above sources, Fastmarkets RISI relies on a wide network of industry contacts. Publicly available information such as government data, company reports, industry directories, and industry literature are also used.

Stage II: Cost calculation

Part I: Identify Costs to Calculate

Once data has been collected, the next step is to use it to calculate cost. The cost calculation phase starts with identifying the data points that have a substantial economic impact on the industry. In the pulp and paper industry, the most important economic factors are cash manufacturing costs, delivery costs, capital costs, and selling, general and administration (SG&A) costs. Cost competitiveness is evaluated by either comparing these costs separately on a mill and machine basis or by summing them to determine the total cost of specific mills and machines.

The definitions for these cost calculations are as follows:

Cash Manufacturing Cost is calculated based on the direct manufacturing costs (i.e. fiber, chemicals, energy, labor and maintenance) of producing a tonne of product.
Capital Cost is calculated based on the mill’s investment (capital expenditure) history, such as upgrading machinery, adding new machinery, adding new product line capabilities, etc. Annual depreciation and capitalized maintenance expenses not captured in cash manufacturing costs are included as well.
Delivery Cost is the cost associated with transporting a finished product to a destination via truck, boat, or railroad. Fastmarkets RISI uses the major destination cities of the global pulp and paper industry and then calculates transportation/delivery costs for all mills to ship products to those locations.
Selling, General & Administrative (SG&A) Cost includes all indirect expenses incurred to run a mill, except for capital and cash costs. These indirect expenses include company salaries (employees that do work for more than one mill, such as sales and marketing people or senior executives), local property taxes not paid on the company level but rather on the mill level, and building overhead not directly related to production, such as heating office space in a production facility. Fastmarkets RISI also includes delivery cost and charge of inventory in its SG&A calculation.

Thus, the equation to determine total cost is:

Total cost = cash cost + capital cost + SG&A cost

Part II: Calculating Costs for Each Mill in the MarketOnce the economic components that have the greatest impact on the industry have been identified, the next step is to calculate those costs for each major mill in the world. Fastmarkets RISI uses a unique approach to calculating costs for each mill it benchmarks. Unlike other companies that use a standard set of formulas to calculate costs for all mills, Fastmarkets RISI’s experienced process engineers create customized flow sheets for each individual mill in order to identify their manufacturing and energy processes (inputs and outputs). This information is the basis for creating material and energy balances used to calculate the mills’ consumption of inputs and, ultimately, cash manufacturing costs and capital costs. These calculations are done manually by Fastmarkets RISI engineers in order to ensure the most accurate mill data is generated. For this reason, Fastmarkets RISI employs experienced and knowledgeable engineers that have worked in mills around the world and are therefore able to accurately map each mill based on its unique configuration.

Once consumption inputs are estimated for each mill by an engineer, they are multiplied by the adjusted regional unit costs for the geographic market to derive cash manufacturing costs for each mill. Generally, mills and machines located in the same countries or world regions producing the same grades or sub-grade products are benchmarked to determine cost competitiveness within specific markets.

Capital costs are modeled according to the capital expenditures of each mill.

The modeling of distribution (delivery) costs is based on different modes of transport, distances and the various freight rates of different regional markets and sea routes. These calculations are done for every major mill in every regional market in order to produce a benchmark report for each. The data are then uploaded into Fastmarkets RISI’s proprietary cost benchmarking software, Analytical Cornerstone 4.0, and used in running mill and machine comparisons based on the various cost variables described above.

1. Calculating Cash Manufacturing Costs

A mill’s manufacturing cost is an important factor in determining its cost competitiveness. When each mill is balanced using a consistent methodology, it is possible to model consumption values for input flows which contribute to the manufacturing cost calculation.

Fastmarkets RISI balances mass (raw materials) and energy based on the most important natural expense categories affecting direct manufacturing costs: fiber, chemicals, energy (fuels and electricity), labor, maintenance and materials. The consumption inputs are then multiplied by the adjusted regional unit costs for the geographic market to derive cash manufacturing costs for each mill.

The cash manufacturing costs of a mill are typically affected by the following: natural expenses (direct manufacturing costs), regional factors, mill configuration, and operational performance.

The Fastmarkets RISI’s mass and energy balance concept is based on the most important natural expense categories affecting direct manufacturing costs: fiber, chemicals, energy (fuels and electricity), labor, and maintenance and materials.

i. Natural Expense Categories — Direct Manufacturing Costs

a. Fiber Costs

Wood fiber consumption is based on typical and/or known yields for the pulping process used at the mill.
Several variables are considered when wood consumptions are calculated for pulp mills: amount of purchased chips; wood species used; debarking method; type of digester; cooking process; and bleaching sequence.
Purchased market pulp, pulp substitutes (subs) and recovered fiber prices are estimated on a regional basis. Pulp subs and other recovered paper prices may be adjusted for delivery costs. Because these prices are prone to volatility, Fastmarkets RISI uses quarterly averages in its cost benchmarking methodology.

b. Energy Costs

Energy costs are determined by the energy balance of the mill. The balance is made up of the consumption of the energy and co-generation capacity of the mill.

For example, the energy balance for a pulp mill would be modeled based on the mill’s consumption of purchased energy and its internal generation of heat and electricity.

Estimates for both fuel and electrical power consumption are based on the grade(s) produced and the process equipment used at the mill. The level of technology and technical age of the machines are also evaluated and the impact on energy efficiency is modeled.

For example, North American pulp mills have significantly lower quality assets and therefore higher power and steam consumption values when compared to the industry average.

If a mill’s co-generation capacity is sufficient, it may produce excess energy compared to the consumption by the mill. In these situations, one or more of the following three assumptions are used:

Energy credits are estimated for sold heat (steam), bio-fuels (hog/bark) and electricity to the extent considered part of normal pulp and paper manufacturing operations.
If it is possible for a mill to sell steam to other companies, then the credits are shown for steam. If this possibility doesn’t exist, the credits are shown for excess hog fuel (bark) and the mill is balanced to cover only its own heat consumption.
Excess electricity can be sold to a national grid if surplus capacity is available and connection to the grid is possible. In these cases, electrical rates are normally adjusted downward to account for market prices of electricity being sold by a third party.

Each benchmarked mill is compared against external public references on an annual basis to validate the consumption values of the energy model.

c. Chemical Costs

Chemical consumption estimates are modeled for various processes involved in the manufacturing of pulp or paper such as: mechanical pulping, deinking, papermaking, chemical pulping, bleaching, drying, and water/wastewater treatment.

The use of chemical recovery is assumed and any revenue from the sale of by-product chemicals has been included in the net chemical costs for each mill. (This excludes sales of tall oil, soap and/or turpentine.)

These chemical costs have been developed on a per ton basis and then proportioned based on the product and fiber furnish at each mill.

d. Chemical Coating

An important point to note about chemical coating is that there is no universal coating formulation. Most mills have developed their own unique formulations for determining chemical consumption cost estimates and are guarded as proprietary manufacturing information.

To account for this, Fastmarkets RISI has made some general assumptions that allow for consistent comparison of coated product manufacturers.

Though grades and ratios vary, most mills use a base composition of clay and calcium carbonate with a small amount of titanium dioxide. Starch and/or latex binders are added to hold the coating together. The mixture is then fine-tuned by adding various enhancements to the final coating mixture, such as optical brighteners, dyes, insolubilizers, defoamers, etc.

Fastmarkets RISI has created a standard assumption of the amount of these chemicals used in the manufacture of coated papers to arrive at a consistent way to benchmark this cost for every coated papers product we study. While the specifics of each coating may change from mill to mill as well as from grade to grade, the cost does not change appreciably.

e. Labor Costs

Labor cost estimates for each pulp mill include hourly labor costs and salaried labor costs.

There are two components for hourly labor costs: operations labor cost and maintenance labor cost. Three variables determine the level of cost for operations and maintenance labor: average regional wage rate, number of hours worked per year and number of days of operation per year.

There are also two components for salaried labor costs: exempt labor cost and non-exempt labor cost. Fastmarkets RISI breaks out salaried overtime-exempt labor and salaried non-exempt labor that is eligible for overtime because each employee type is paid differently, impacting the total cost to the mill. Typical overtime-exempt positions include production manager, plant engineer, technical manager, etc. Typical non-exempt positions include clerical support in such areas as mill administration and accounting.

These costs have been developed on a per ton basis and then proportioned based on the product and fiber furnish at each mill.

f. Material and Maintenance Costs

Material costs are estimated from benchmark data collected year-over-year which combines maintenance material costs, maintenance labor costs, and direct costs specific to the grades being produced. Materials include maintenance parts, contract maintenance, supplies, shipping materials, felts, wires and other incidental costs not included in other natural expense categories.

Fastmarkets RISI uses regional benchmark data on maintenance man-hours per ton to estimate maintenance costs for each mill. If a mill’s actual maintenance man-hours per ton are above or below the benchmark average, an adjustment is made to the maintenance materials calculation to reflect the variance.

ii. Regional factors

Mill location typically determines 15% to 25% of the cost variance among mills, due to regional unit cost differences; exchange rates; and proximity of a mill to its market. If these regional factors are known, a final cost value can be calculated for direct manufacturing costs, such as fiber, energy and chemicals. These regional unit costs are derived from internal and external sources and represent industry averages.

Adjustments are made to a mill’s regional energy and fuel costs when more specific information is available. For example, if a particular mill has an energy contract with a supplier that differs from average market prices, then an adjustment is made in the cost detail for the products manufactured at that mill.

Wood and chemical costs are estimated on a regional basis and are based on quarterly averages. Average regional wood densities are used to convert prices from a volumetric basis to a weight basis if the original value is not available.

Regional wood fiber and chemical costs for a mill are adjusted for extenuating circumstances — such as producers that have plantations or satellite chemical plants.

All cost calculations are made in the local currency of the country where the mill is located and then converted into United States Dollars (USD) by using a regional quarterly average exchange rate. Because crude oil and market pulp are traded in USD in the marketplace, they are the only consumables priced in USD for all mills and are not affected by any currency conversion.

iii. Mill Configuration

A mill’s configuration — process technology, size, fiber integration and energy self-sufficiency — accounts for 60 to 70% of its cost competitiveness among other mills.

This information is captured in the form of a flow sheet and is derived from original research, as well as internal and external sources.

iv. Operational Performance

The operational performance of a mill covers only an average of 10% of its cost differences to its competitors. In order to neutralize differences between mills and achieve consistency in our benchmarking methodology, all mills are benchmarked to full equipment capacity and running conditions are assumed to be optimal.

When determining capacity, market related downtime and catastrophic equipment failures are excluded from the calculations. Fastmarkets RISI does, however, take into account normal maintenance shutdowns.

Summary of calculating cash manufacturing costs

This split between cost drivers offers the possibility to conclude that when regional factors and mill configurations are benchmarked with a consistent methodology, it is possible to accurately estimate 85% to 95% of mill cash manufacturing costs.

When all required input consumption values per ton are estimated, it is possible to calculate cost estimates for each natural expense category by multiplying the unit consumptions by the appropriate unit cost assumptions.

Regional factors are taken into consideration when unit costs are estimated on a regional basis and adjustments are made for specific cases when deemed appropriate.

The calculation for the general production cost component, when both configuration and regional factors are known is:

Input cost = (consumption/ton) x (regional unit cost/consumption)

Cash manufacturing cost estimates are then obtained by summing all natural expense categories. All cost calculations are made in the local currency of the country where the mill is located and then converted into USD by using a valid exchange rate for that period. Crude oil and market pulp are the only consumables priced in USD for all mills and are not affected by any currency conversion.

2. Calculating Capital Costs

This section defines how we calculate capital cost by explaining the elements that contribute to the calculation. Capital cost per ton of pulp or paper produced is determined through an investment history of the mill. A final capital cost value can be modeled when the investment cost and the year of the capital expenditure is known and when the cost of capital and selected depreciation method are also specific to the industry.

i. Investment Types

Investments or capital expenditures (capex) can be categorized in three different ways: replacement, development and strategic investments.

Replacement investments, or maintenance investments, are made to maintain a mill’s production capacity, efficiency, and quality in the short term (one to five years). Usually, if replacement investments are neglected, it causes the maintenance costs of a mill to increase. For example, new cylinders or rolls are usually considered as replacement investments and will reduce the general costs of maintaining the machine.

Development investments, or debottlenecking investments, increase the earning potential of a mill or a machine. For example, a mill that undertakes the rebuilding of a digester or dryer machine is considered to be making a development investment.

Strategic investments are capex which significantly increase the earning capacity of a company by changing or strengthening its strategic direction. In the pulp and paper industry, these types of investments are typically new mills or machines.

ii. Depreciation

Depreciation is a cost that should cover all of the wear and tear of an investment made earlier by allocating the cost of investment over the useful economic lifetime of the asset. The concept of depreciation is to write-down an asset, i.e. create a downward revision of the book value of an asset to reflect its current market value, which makes depreciation a bookkeeping transaction rather than a real cash item. When this write-down is made in the balance sheet, a similar deduction is made to the income statement in a form of depreciation. This affects company’s profit and, consequently, its earnings before interest and taxes (EBIT). Based on annual reports of publically listed pulp and paper companies, the useful economic lifetime of new machinery assets varies between 10 and 25 years. A new pulp or paper mill is usually completely deducted after 17 years.

There are several depreciation methods used in accounting. Fastmarkets RISI uses the most common time-based depreciation method, straight-line depreciation, to calculate the depreciation of assets in a mill.

Straight-line depreciation is a technique which estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life). This method will expense a constant portion of the original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of.

iii. Cost of Capital

The total capital for a firm is the value of its equity plus the cost of its debt. Cost of capital is defined as a weighted sum of equity and debt. The most commonly used term to describe this is Weighted Average Cost of Capital (WACC). The cost for the debt portion of the capital cost is usually based on the long term risk-free lending rate. The cost of equity includes three different components: the risk-free rate of return, the equity risk premium and the systematic risk.

These terms are defined as:

Risk-free rate: mostly the yield of long-term bonds such as government or long-term notes.
Equity risk: the difference between an average market portfolio after tax and the risk-free interest rate.
Systematic risk: the risk of the specific industry compared to an aggregate industry average. For the pulp and paper industry, this usually varies from 0.9 to 1.1.

The WACC value for the pulp and paper industry varies from 8% to 12% depending on the company’s financial structure. The industry average is 10% and that is the figure Fastmarkets RISI uses as the assumed value for all mills in order to allow for consistent comparison among mills.

iv. Investment History

Mill investment histories are collected for each mill benchmarked. They include a breakdown of the cost of capex, the year the investment was made and the allocation percentage of the capex within the mill for each capex event. This summary covers all of the development and strategic investments of the mills.

Approximately 80% of capex with accurate economic values were defined from primary sources but if this was not possible, capex was then estimated using a regression model. When an investment’s impact on capacity is known, it is possible to calculate cost estimation for the capex event as a function of the capacity increase with regression analysis.

Information for investments which did not have a direct impact on capacity (e.g. power boilers, turbines and effluent treatment plants) is also collected. That information is used as a reference table to determine an estimated value for those types of unknown capex values.

v. Technical Age

Technological competitiveness and quality of mill assets are analyzed to measure the impact of age on investments. The comparison is based on the technical age of the production line. The technical age of a pulp line, for example, is defined based on the same collected investment history as capital cost. The technical age of the line is calculated based on the occurrence of rebuilds and machine improvements on the production line. The impact of projects on the technical age of a production line is weighted (0-100%) depending on the magnitude of the investment.

Summary of Calculating Capital CostBased on the mill investment history, straight-line depreciation and cost of capital, it is possible to calculate capital cost depreciation estimates for various assets. Current book values of all of the development and strategic investment events are calculated and then summed together and divided by the capacity and then multiplied by WACC. In addition to this, investments, which belong in the replacement investments category, are also modeled based on the incremental capacity increase and the technical age of the machine.

Thus, the final calculation for Capital Cost is:

Capital Cost = Current Value of Capacity tonne for Pulp/Paper Machine x WACC

3. Calculating Distribution (Delivery) CostsDelivery costs are based on modes of transport, distances and freight rates of regional and sea routes used by pulp and paper mills. In order to provide accurate delivery cost estimates, Fastmarkets RISI works with a logistics company to produce a detailed report that includes delivery cost estimates for each pulp, paper and board mill to the top global market destinations. In addition to this logistics report, Fastmarkets RISI regularly incorporates feedback from producers and shipping companies in its detailed delivery cost calculations.

The delivery cost estimates used in Fastmarkets RISI’s cost benchmarking data include costs associated with five logistical segments (where applicable):

Combination of rail and truck transportation from each mill to most likely domestic port or market
Water transportation from domestic port of entry
Rail and truck transportation from port of entry to market
Loading/unloading charges
Canal passage charges

The mode of transport Fastmarkets RISI uses in its benchmark data depends on a mill’s location and the infrastructure of the country in which it is located. Some mills have their own ports for exporting which significantly improves cost competitiveness. Global sea routes to the end-destination markets also have a high impact on the final delivery cost because different sea routes have different freight rates.