Smurfit Paper Company (SPC)

Marginal cost and pricing decisions in a commodity industry

Objectives of this case study: To review costing methods To calculate the profitability of an incremental order using a full cost and a marginal cost approach To understand the cost/volume/profit dynamics To determine the break-even point of an incremental order To review and measure the opportunity gains and costs of this additional order in a context of constraining capacity To reengineer a cost structure according to a target costing approach To understand strategic consequences of using a particular costing method. To discuss the pricing issues in the context of a commodity business : the paper industry.

The Smurfit Paper Company (SPC) is the local branch of an international paper giant which manufactures and sells paper-based packaging to various businesses in Spain and increasingly for European accounts. This company uses mainly recycled paper as raw materials. In June 2000, 6000 units of paper-based packaging1 were manufactured and sold. This amount accounted for 80 % of the companys overall production capacity and was considered as an average, in terms of activity, based on the last two years figures. The sales manager, M. Juan Manuel Afonso, has been recently contacted by a new potential customer, the Multilever Food and Beverage Company (MFBC). This group is n 2 on the European market a nd is currently reorganizing its production centres. Spain is going to become the main centre for packaging cold beverages and MFBC wants to replace glass, PET, metal bottles and cans by paper-based packaging. Studies by an independent packaging consultant had shown that attractive paper-based packaging could easily replace other packages and allow for significant cost reductions, paper becoming much cheaper than other sources since the last increases in oil prices. According to MFBCs purchasing manager for Europe, the company is planning to buy between 1 000 and 1 800 units per month, depending on market demand. However, the order had to be taken in full or rejected completely. Given the investment required by Smurfit Spain Paper Co in development and design of this new packaging, he would commit to a threeyear contract. This investment required from SPC would amount to 108 500 per month during the first year2, according to the independent consultant. After tough negotiations, the final price MFBC was ready to pay was 200 per unit. This represented a 20 % discount compared to the current average pricing of SPC, during the last 18 months. Juan Manuel Afonso was not happy with these pricing conditions and was ready to turn down the MFBC purchasing managers proposal, but in the meantime, he learned that MFBC had contacted SPCs main competitor and was about to sign the agreement on the 200 basis. Therefore, he considered more thoroughly the offer, based on the latest information available regarding SPCs cost structure. He knew that, if SPC was offering 200 , he was sure to close the deal because of SPCs outstanding reputation concerning the quality of its operations and services.

Usual macro units in the paper industry are the Million Square Meters or the Thousand Metric Tons, depending on product and regional area. 2 It is a period expense and shouldnt be amortized over three years

As the controller of the company was on his summer holiday, Afonso decided to calculate himself the cost per unit, based on June 2000 financial data report (Appendix A). He considered an average MFBC order of 1 500 units. This was the maximum amount SPC could deal with, according to the manufacturing capacity still available. He decided to present his calculation on a unit basis. This made more sense for a sales manager. He found the result of his calculation astonishing: as of the second year, the profitability ratio (unit profit/unit price) was even better than the actual June figures (30 000 / 1 500 000), in spite of a much lower price for this additional order. Under such circumstances, M.Afonso was considering that MFBC could be given a positive answer from SPC. On the other hand, he was cautious because of a recent article he had read in The Economist on the paper industry business practices and weaknesses. This article which summarizes some of the pricing issues in the industry is attached in Appendix C.

M. Afonso is asking for your advice. The questions he would like you to answer are presented on the following page.

Working plan: part 1 Costing methods

1) Could you present appendix A following a contribution margin statement in value and per unit?

2) Determine the profitability of this additional order using: a) a unit full cost approach b) a marginal approach You will compute monthly results and differentiate year 1 and years 2 & 3. You will also compare the results according to the two different methods. Which one would you choose? For what reasons? Considering only the figures without any strategic consideration, would you accept or refuse that order? Would your decision be different according to the computation method used?

Working plan: part 2 Pricing decisions and strategies

3) Determine the break-even point for this additional order. 4) What would be your calculations and decisions if the company sells to MFBC: a) 1 800 units? b) 1 000 units? You will determine a monthly figure. 5) If the market were to set the price at 200 , what would be the new operating earnings for the company? What is the target unit cost SPC should reach in order to get the same operating earnings as in June 2000? (Base your calculation on an output of 7 500 units)

6) Finally, what are, according to you, the pros and cons of signing the contract with MFBC?

Appendices

A) B) C)

SPC s cost and revenues, June 2000 Article from the Economist: beaten to a pulp Article from Business Week: caveat predator

Appendix A
Cost and revenues, June 2000 ()
Sales Distribution costs Raw materials Supplies, dies and pallets Spread3 Production wages fixed variable production costs Fixed costs
3

Variable costs

1500000 100,00% 75000 5,00% 480000 32,00% 30000 2,00% 915000 61,00%

30000 37500

2,00% 2,50%

Maintenance, repairs and waste disposal fixed variable Energy and water fixed variable Total production costs Administration costs (salaries, rents, other general costs) Depreciation costs Financial costs fixed (Overdraft, working capital interest) variable Total financial costs

67500 67500

4,50% 4,50%

75000 60000 337500 90000 125000

5,00% 4,00% 22,50% 6,00% 8,33%

16500 15000 31500 36000 295000

1,10% 1,00% 2,10% 2,40% 19,67%

Fixed costs Head office overheads

Income before taxes

The spread represents the first level of margin: sales- raw materials. Rough as it is, it is however a relevant indicator of profitability.

Beaten to a pulp
ith all the buzz about virtual economy, perhaps it is no surprise that paper production has been faring badly. In the past decade, Americas paper firms have delivered average annual returns of only about 12 %, lagging the S&P 500 index by five points. European paper firms, whose returns on capital have not exceeded 10 % in recent years, have also done badly. Paper firms everywhere have been destroying realms of shareholder capital. Yet, it is not the arrival of the digital age and the paperless office that is to blame for the industrys troubles. They arise from a classic oldeconomy problem: global over-capacity. The industry is run by engineers who love to build fancy new plants with little concern for their returns. When prices plummet, they try to squeeze every last bit of output from their factories, marginal costs be damned, in hopes of an extra buck. The inevitable result is lower prices, which is good news for consumers but bad news for all producers. This extra tonne problem is common to capital intensive industries such as steel and chemicals, but it is far more acute in paper because the industry is more fragmented. Even the biggest firms usually lack the market power to nudge prices upward. Long-suffering shareholders may finally be in line for some relief. The clearest sign of this is the transatlantic battle between Americas International Paper, the worlds biggest paper firm, and UPM-Kymmene, its slightly smaller Scandinavian rival. UPM had nearly consummated a bold take-over of Americas Champion International, which would have propelled it to the top of the league, when International Paper made a rival bid a few weeks ago. After a fierce bidding war, the American firm snatched the prize on May 12th for $7,3 billion. Juha Niemela, head of UPM, still licking his wounds, vows that he will continue expending, but only on sensible terms. This is only the latest in a wave of acquisitions that has shaken up the industry and promises to

create its first global giants. European firms led the way, UPM and Stora Enso, another Scandinavian giant, which are now two of the worlds biggest paper firms, are the products of half-a-dozen mergers apiece. Consolidation has been speeding up in North America too, with recent deals such as the acquisition of Donohue by Abitibi-Consolidated. Stora Enso is taking over Americas Consolidated Papers; analysts expect many more cross-border deals in coming months. Why is this traditionally sleepy industry consolidating now? After all, many of the forces that made it so parochial are still at work. Paper does not ship well, as it is both bulky and susceptible to humidity. Mergers are unlikely to lead to many savings in overheads, because paper mills are so expensive; headquarters tend to cost a tiny fraction of the total. Families, from Americas Weyerhaeusers and Meads to Irelands Smurfits and Finlands Myllykoskis, have always been very powerful in the paper business. Governments, keen to guard the national patrimony, have also obstructed change. The bosses of the big paper companies explain the merger wave with visionary strategic statements, John Dillon, head of international Paper, offers one explanation: Our customers are going global, and we want to move with them. Big publishers want to obtain all grades of paper from just a few global suppliers. Other bosses say their home markets of North America or Europe are mature, and that acquisitions grease the way into growth markets. Others again see deals as a way to lock in vast quantities of inexpensive feedstock in such places as Brazil. Grand talk aside; there are two less flattering reasons why paper firms are merging. One is that they have no other way to grow. Brian Cote of Andersen Consulting insists that shareholders, fed up with low returns, will punish firms that try to expand by adding capacity in an already glutted market. He points to the strong inverse correlation between capital spending in the industry and share performance. This punishment explains why, for the first time ever, the American paper industry recorded a decline in overall capacity last year: big firms shut down plants after completing takeovers.

Public companies are keen to make better use of capital in Europe too. Jukka Harmala, Stora Ensos boss, explains that firms had just kept building new capacity, and destroyed the market. But now, we must consolidate and shut down plants. Almost all the new capacity in Europe, grouses UPMs Mr Niemela, is being built by family firms that do not have to worry about their share prices. Another reason for consolidation, says Mark Wilde of Deutsche Bank Alex Brown, an investment bank, is the desire to gain pricing power, something that firms rarely discuss for fear of attracting the attention of antitrust regulators. Mr Harmala admits, though, that this is part of the game. Bolstering prices will not be easy, however. That is because of the cruel law of commodity industries: even the most disciplined firms remain at the mercy of the irrational, rogue producer, willing to produce the extra tonne at a loss. Still, deals such as the acquisition of Champion suggest that things are changing. As governments and families float their stakes, paper may become a competitive, global business like any other. And as firms grow bigger, they may reduce the influence of reckless producers. That will take time: even after gobbling up Champion, in the industrys biggest deal ever, International Paper, the giant of the industry, has only a meager 6 % share of the world market. The paper trail to prosperity is paved with pitfalls.

THE ECONOMIST, May 21st, 2000.

The U.S. Justice Dept. is cracking down on predatory pricing

N January, 1995, Vanguard Airlines Inc., an American startup, began offering three round-trip flights a day from its hometown of Kanass City, Missouri, to Dallas. The discount carrier gave passengers a great deal the average one-way fare was $80, compared with $108 on its main competitor, American Airlines Inc. But American, with its largest and most profitable hub at Dallas/Ft. Worth International Airport, quickly declared war on Vanguard. It matched the small startsup fares and boosted the number of daily flights to Kansas City from 8 to 14. After nearly a year of relentless rivalry, Vanguard threw up its hands and decided to temporarily abandon the unprofitable route. American promptly returned to its old ways: the o.2 airline cut back service to Kansas City, to 11 flights daily, and boosted average one-way fares to as high as $147. They basically doubled capacity to keep us from getting into the market, says Vanguard Vice-President Brian Gillman. American denies breaking the law. TALL MOUNTAIN To the U.S. Justice kept, this episode is a clear case of predatory pricing. In a suit scheduled to go to trial in a Wichita (Kan.) federal courthouse next May, the agency is charging that American slashed its fares to discourage competition from Vanguard and two other competitors, Sunjet and Western Pacific Airlines. The evidence may sound pretty compelling, but the Justice Dept. has a big problem: Predatory pricing suits almost always fail. In the 1993 decision, Brooke Group Ltd. V. Brown & Williamson Tobacco Corp., the Supreme Court concluded that aggressive cost-cutting usually helps consumers and emphatically rejected a claim that B&W had broken the law by selling below-cost generic cigarettes. In so doing, the high court set lofty legal standards for proving any predatory pricing claims. Of the 37 cases that have been brought since the Brooke Group decision, plaintiffs havent prevailed in a single case. Indeed, it has been more than 20 years since Justice Has even brought a predatory pricing suit. Thats why many antitrust experts dont think the agency has a chance at nabbing American. The government has a tall mountain to climb, says Washingtonbased antitrust lawyer Mark Schechter, a Justice Dept. veteran. But Justice antitrust chief Joel I. Klein has some experience scaling heights. Just as he did in the Microsoft Corp. Case, Klein is hoping to take advantage of some cutting-edge antitrust thinking to surprise naysayers. While Brooke Group reflected the old intellectual consensus among American legal and economic scholars about predatory pricing, a new generation of scholars has revisited the issue with more sophisticated economic modeling techniques and concluded that the Supreme Court was wrong. They believe there are many situations in which predatory pricing can be profitable for dominant companies and harmful to consumers. The economic premises of Brooke are simply outside of the mainstream of economic thinking today, says Joseph F. Brodley, a professor of law and economics at Boston University who is the co-author of a forthcoming article in The Georgetown Law Journal arguing that courts should adopt stricter standards against predatory pricing.
BAD ODDS of the 37 cases since 1993, plaintiffs have not prevailed in a single one.

If Klein succeeds, other major airlines could well face similar suits a development that would go a long way toward breaking their tight grip on many of the countrys key airports and cutting skyrocketing fares. In March, for example,

Florida-based Spirit Airlines filed a predatory pricing suit against Northwest Airlines Corp., alleging that the carrier exploited its dominance at the Detroit airport.

Unlike their predecessors, a new generation of scholars sees predatory pricing as harmful to consumers
And the reverberations would certainly go well beyond the airline business. Other industries with large dominant players, including cable TV, electricity, and telecommunications, would also have to significantly retool their pricing policies. Corporate Americas basic attitude toward predatory pricing hasnt been anything goes but something mighty close to it, says George Washington University antitrust scholar William Kovacic. This would shake things up in a pretty dramatic way. ONLY NATURAL? Klein may have beaten the odds in the Microsoft case, but Americans executives are hardly trembling in fear. Where the Justice team sees predatory pricing at its worst, the company sees honest competition at its best. When competitors came along and cut prices, the company says, it only did what any other company would do: It fought back. Company spokesman Chris Chiames compares the competition at DFW to the fight for control of the Dallas retail market: When Nordstroms came not the market, were Killards and Foleys expected to stand still? (Competition is) the nature of the free market, he says. Under current law, these arguments are pretty powerful. After all, the U.S. Supreme Court concluded in the Brooke case that predatory pricing almost never works. A company loses lots of money while cutting costs to meet the new competition. But the moment it raises prices anew to recover its losses, new rivals crop up and start the process all over again. The only way a company practices could be called predatory, the Court found, was if the plaintiff met a tough two-part test: proving that the defendant set prices below costs and that the predator later planned to raise prices in order to recoup its losses. American says the government will never meet this standard. The company claims its prices covered all of its average variable costs, including food, fuel, and the salaries of pilots, flight attendants, and other workers. Justice is floating new theories of predatory behavior that have never been tested by the courts and are not supported by too many experts, says Chiames. In fact, American is so convinced its innocent that it hasnt bothered to change its aggressive ways as the case heads toward trial. On May 1, even as attorneys worked on pretrial discovery, it took on Legend Airlines a new startup offering first-class-only service out of Dallas Love Field since April. American returned to Love Field compete with Legend, even thought hasnt served the airport since Dallas/Fort Worth was completed in 1974. Theyre coming here to try to drive Legend Airlines off the map, and the cost of doing that is irrational, says CEO T. Allan McArtor. American says its acting legally.
IN DALLAS: America says that it never see prices below costs

That kind of brazenness could get the company in trouble. Justice plans to argue the predatory pricing can be a highly profitable strategy in the airline industry. Why ? Because if a company acquires a reputation for aggressive costcutting in one market, it can deter other low-cot carriers from taking on the airlines elsewhere. It also scares away potential lenders, on whom low-cost carriers rely to

finance aircraft and support facilities. This so-called reputation effect can alter the cost-benefit calculation for a major carrier, says Justice Dept. Deputy Assistant Attorney General John Nannes. While most economists were dubious about such theories two decades ago, recent scholars armed with bigger computers and more complex economic models have come to a different conclusion. In particular, they have use game theory, a form of analysis that converts corporate strategy into

mathematical variables, to demonstrate how a fierce reputation can be profitable. Will the court buy Justices effort to rehabilitate the concept of predatory pricing? Its too early to tell. But if Klein succeeds, hell have once again stretch the boundaries of antitrust. By Dan Carney in Washington, and Wendy Zellner in Dallas

A TALE OF THREE CITIES

Accusing American Airlines of predatory pricing, the Justice Dept. claims that the carrier sharply cut fares at its Dallas hub when it faced competition from startups. Heres the frequency and average one-way cost of Americans flights to three key cities before, during, and after competition from low-cost airlines Vanguard, SunJet, Western Pacific

BEFORE Flights Price

DURING Flights Price

AFTER Flights Price

Kansas City Long Beach Colorado Springs

8 0 5

$108

14 3

$80 $86 $81

11 0 6

$147

$150

$137

DATA BUSINESS WEEK

Business Week / May 22, 2000