Challenging conventional wisdom: the art of the possible.

ONE TON MORE OR LESS: THE EFFECT ON YOUR PROFITS

One of the biggest and most common mistakes that mill management makes is relying on average costs to assess the financial success of a mill. Instead of striving to run a mill at full capacity, you should be trying to answer the questions: "When is more volume going to reduce my profit? And when can less volume increase profit?"

Many managers think that any time an incremental sale provides a contribution above variable costs, it must be a good opportunity. There are two problems with this approach:

Using average or standard costs disguises the true incremental cost of manufacturing that next ton of product.

Many managers fail to include all true variable costs in the analysis because they have historically been included in overhead costs.

Average Costs

First, you should be looking at the profitability of each product line by customer. Two examples make the case. In one instance, the contribution margin of a mill looked reasonable, and, on average, each ton produced a contribution. Further analysis, however, showed that for one product, the cost of raw material alone represented 91% of the sales price. Replacing this product with any other in the mill increased profit.

In another case, a large customer purchased additional tons of product at a predetermined contract favorable rate. Raw material for the additional tons had to be purchased from farther away thereby increasing freight-in costs and eliminating contribution margin.

Special note: If your mill runs colors, average costing is especially dangerous. Changeover can be particularly costly, and certain colors are more difficult to run, resulting in increased costs from quality problems.

Variable Costs

If you look deep, you will find that some costs currently classified as overhead or fixed costs really are variable. You will also find that variable costs change as volume increases. In analyzing whether to produce additional tons to meet a customer's needs, make sure you include factors such as:

* Wood purchased from zones located farther from the mill.

* A change in raw material to accommodate the volume requirement.

* A change in furnish to improve overall throughput.

* All applicable labor. In one instance, a mill hired additional process engineers to increase productivity to meet the additional sales volume. Their compensation was not included in variable costs, but it more than offset the contribution margin provided by the additional volume.

* A non-linear increase in consumption of chemicals as throughput increases.

* Additional maintenance and clean up costs as throughput increases.

* Changes in sales policies or sales personnel.

One mill increased profits substantially by shutting down one machine and dropping the three least profitable product lines. Costs that were eliminated in addition to traditional variable costs included advertising, promotion and sales, maintenance cost reduction, and environmental costs (because it became an acid free plant).

Action Steps

I urge every mill manager to gain an understanding of the profitability of each customer. Do this analysis in a two step process. First, determine the true profitability as you are currently running product. In this exercise, be relentless about determining the true and complete cost of servicing each customer.

Second, consider the art of the possible. Ignore for a moment the current scheduling of machines. Instead, schedule your machines to run optimally--fewer grade changes, most efficient run for the type of product, etc. Then, do a second analysis of your customer profitability. You may find that your ranking of customers by profitability changes significantly. There may be many possible options for your action steps, but they are only available once you have a clear understanding of your current product/customer profitability matrix.

It is important to be accurate in your analysis, and, except in very basic operations, this type of exercise goes beyond spreadsheet applications. You should use a model that incorporates your process manufacturing capabilities and captures the relationship between certain operating decisions and their effect on costs and profitability. With a good understanding of true variable costs and how they react to incremental changes in volumes of specific products, you may be able to make decisions that increase profits.

Doug Daniels bases his columns on a 40-year career in the pulp and paper industry. He currently serves as an advisor to Heads Up Systems, a company whose methods and tools enable operating managers to make better and faster decisions which, at times, challenge conventional wisdom while leading to greater profits. Send questions or comments to Doug at [e-mail].