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Inflation in Production and Operating Costs V. R. BECHTEL American Cyanamid Co., 30 Rockefeller Plaza, New York 20, N. Y. ‘ I
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Today, when owners bf venture capital decide to invest in a new fleld of production or to expand an existing one, it is not enough to conceive a useful product with a wide market and a technically perfect process and production plant. It is also necessary to prove that production, selling, promotion, taxes, ond all other costs of operating the business can be met within the obtainable sales price, with enough left to remunerate those who put up the capital and to reward management for the energy expended. Management, in the future, therefore, should insist on a careful calculation, by experts, of the flnal net proflt prospects on every proposed capital investment both before and after federal income taxes.
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MERICAN industry, particularly the chemical section, has A again embarked on the largest and most costly increase in production capacity in its history (total and unit basis). Investment of the huge amount of money required is concluded to be essential to maintain our country’s world position and also to maintain as much as possible of our national high standard of living. Profits from this huge outlay will be subject to price controls that will be firmer than on labor andothercosts; renegotiation of contracts will be another feature, and the federal income tax, which now has a 45% base and also puts a 77% bite (with a 62% over-all top) on incorrectly labeled excess profits, is certain to be raised before the end of 1951 and probably again in 1952. In addition to these taxes, the average large business has franchise and capital taxes equal to about 3% of net income before federal taxes. Any net profits earned by partly-owned subsidiaries are subject to special federal taxes when dividends are drawn; these range from 6 3 / 4 to 9 3 / ~ %depending on the excess profits tax position of the subsidiary operation. To carry out this enormous expansion in production capacity or as much of it as is finally concluded to be essential, owners of private capital must directly or indirectly provide the funds if a free enterprise system is to survive. The sole purpose of an investment made under the free enterprise system is to secure a fair return to the owner or owners who provide the capital. This risk or venture capital is so designated because of the constant exposure to hazard or loss. When owners of venture capital decide to invest in a new field of production or to expand an existing one, it is not enough to conceive a useful product with a’wide market and a technically perfect process and production plant. It is also necessary to provide beyond any shadow of doubt that production, selling, promotion, taxes, and all other costs of operating the business down to the net profit line can be met within the obtainable sales price, with enough left to remunerate those who put up the capital and to reward management for the energy expended. A great many detailed studies and calculations must be prepared, torn apart, and reworked before a decision can be made to proceed with a new construction project. The penalty of any other procedure is to consume both energy and capital on a large percentage of projects before “dead ends” are discovered. New projects vary from relatively simple ones to major and complex ones with far-reaching effects on the future of a business. This is truer in the chemical industry than in most other industries. The development of a new product or process in the chemical field may be limited to a narrow future, or it may be the
opening to a series of new ventures requiring years of work and enormous amounts of capital. The latter is the much sought for situation but astute recognition and planning are essential if the greatest and longest term benefits are to be secured. Seldom does a first appraisal indicate the full extent of a successful development. It can, however, indicate which projects are likely to be simple, single issues and which have the basis for extensive future ramifications. During the past 20 years the major factors in the cost of doing business have constantly risen and become less flexible-particularly wages, taxes, and depreciation. These items are reflected in suppliers’ costs, making them high and rigid. The net effect is that raw material costs also have been promptly increased. In other words, production and operating costs continue to take a bigger and bigger bite of the sales dollar, and business, therefore, is more and more dependent on the ingenuity of management and larger sales volumes to maintain adequate profit margins. This ingenuity is called into action each time a new construction venture is proposed. In fact, it must be built into each step in the development of a process, product, or idea. Continual measurements of the probable success of a development must be made from the birth of the idea leading to the development and must be intensified at each step in its growth until preparation of the final evaluations and estimates that propose the capital outlay preparatory to commercial exploitation. Historically, the chemical industry has been one of the socalled high margin profit producers. So much so that it is yet not uncommon to find responsible executives in the chemical field who are willing to sponsor and approve large expenditures for new plant construction on the basis of a presentation that boasts only a sound process or product which seemingly will serve a useful commercial purpose. The period during which this type decision could be made profitably has passed-even for the chemical industry. Inflated costs of production and operating costs have narrowed manufacturing and net profit margins steadily as the chemical industry and as its internal competition have grown. An excellent illustration of this bigger bite was presented by Robert S. Aries in an address before the Chemical Market Research Association on February 10, 1949. His subject was “Break-Even Points and Chemical Industries.” Based on a survey of 200 units in the chemical industry, Aries pointed out that in 1940 the average median break-even point was at less than 50% of plant capacities. In May 1948, about 7 years later, the break-even point had risen to almost SO%, a rise of 60%. The breakdown presented by Aries from a survey made by R. S. Aries & Associates is worth reviewing at regular intervals:
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Break-Even PointQ (Capacity), Yo Less than 40 40-50 51-60 61-70 71-80 81-90 91-100 e
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1940 18 48 21 9 4 0 0
Chemical Process Companies, % CumulaCumulative 1948b tive 18 0 0 66 0 0 a7 14 14 96 23 100 33 25 95
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Defined as capacity at which income and expenditures just balance. As of May 1948, probably reflecting mostly 1947 conditions.
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I N D U S T R I A L A N D E N G I N E E R I N G CHEMISTRY
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Iii 1U40 [ \ y o thirds of the 200 chemical process eompunies surveyed could break even operating a t 50% or less of capacity, 87y0 at, less than TO%',, and all at less than 80%. In 1948 none could break even at 50yo,only 14% at less than 60%, only 37% at less t>han7oa/,, and 70% at lem than 80%; 3070 of all companies were in the group that must, operate at 80 to 100% of capacity in order to break even. The survej- made by Aries also showed that in the chemicals industries between 1940 and 1948, cost increases occurred more rapidly than they could be recouped t,hrough technical improvements and price increases. On a unit basis wit,h 1940 at par or 100, the coniparisons provided are:
Raw material cost,s Labor costs Cost of pew plants Sales price N e t profits
1940
1948
100 100 100
190 210 250 170 110
100 100
Since 1948 new products, huge volun-m, improved technique., price increases, and other factors have resulted in a better cost and piofit picture (especially during 1950) than was possible in 1947 and 1948. However, this favorable position is probably only temporary as controls on prices of chemicals are expected to be tighter than controls on cost factors, and a gradual over-all squeeze of manufacturing and selling profit margins could result. Then the excesfi profits or other tax scheme mill take its share of what iu left. That the chemical industry is not greatly affected by wage inweases (on the basis that only a small percentage of its costs represent labor costs) is true only of those labor costs directly within the indufitry's control. With our present national economy held rigidly within a series of federal and state wage laws, increases in wage rates granted to large national unions quickly work their way through to other wage and salaried payrolls. Suppliers of raw materials, equipment, and other new plant items quiclcly reflect these increases in their price levels. There may be a slight lag at some points--for example, amortization of nev plant facilities reflects its higher cost in product costs slowly--but other items, such as plants, taxes, insurance, raw materials, and even the discovery values of materials in the earth, are largely of paproll origin. Each round of wage increaseb, therefore, is just more fuel for inflation in our economy, made taut over the past 20 years by laws and man management. However, the problem is to take the good with the bad and continue to work toward industrial progress. To that end, when a process has been developed and it is time to design production facilities, prepare cost estimates and otherwise assemble the economics of a new construction project for evaluation and presentation to management for approval of a capital funds expenditure, it is necebsary to compile detailed and scientifically accurate production and operating cost estimates. These projections must be shown in relation to net profit before and after federal income taxes. In a small business one or a few persons are masters of all its phases and necessarily make the decisions regarding new construction, except when it is practical to secure advice from outside experts. In a highly complex business-for example, a large chemical company-there must be specialists in every category of work. It is essential to coordinate the thinking and action of all the specialists concerned with a project in order to produce a successful operation. The preparation of production and operating cost estimates to show the soundness of a proposed capital venture cannot be delegated to an individual or group directly sponsoring the project, because of personal interests and personal concern in the project. A complctrly disinterested fact-determining job by experts is re-
Vol. 43, No. 10
quii~ecifor protection of the spoi~soi'sairti for protection of management in its final decision, The knowledge and experience of technical, production, anti cost accounting staffs must be brought together by the neut,ral party; t'he resulting cost and operating figures must be as accurate as possible on the basis of determinable facts, plus sound and safe judgment where facts are not determinable. Establishing a reliable production and operating cost estimate involves careful consideration of many factors including the following: I . The process to be used must be fully charted with flow diagrams, reactions, and yield factors by the technical staff. 2 . The investment required in new facil'lties, with the value of existing facilities to be used directly or indirectly, requires rareful calculation. 3. Location of the proposed plant must be evaluated in relat'ion to sources of materials, labor supply, services required, disposition or use of waste products (fumes or other basic product peculiarities) and nearness of the consuming market. 4. If the product indicates need for an eventual two or mow producing locations, the initial plant should be spotted accordingly; it might be built in an entirely different,location if only onr> plant is visualized. 5 . Provision must be made for services and maintenance in the plant, for operating personnel, direct and distant. supervision, and overtime and premium rates t o be involved. Quantities anti sources of steam, power, water, fuel, and ot.her utilities should l w established and converted into dollars of production costs. 6. Depreciation, taxes of all kinds applicable at the plant location, insurance, pensions, fringe payroll costs, plant managrnient and service departments including personnel, medical. safety, security, warehousing, purchasing, transportation, scheduling, laboratory, engineering, and a host of other costs must bv visualized in proper proportion to each product. 7 . A large organization usually has a cent'ral office that pi^ forms administrative functions for all parts of the business; a proper share of these costs is applicable to production cost,s 01' must be provided from manufacturing profits to be created by t h c new investment, 8. Selling, promotion, management, and financial costs are also part of the burden to be carried by new products and last but not least the federal state, and local taxes take their biggw bite from what is left belore venture capital realizes any return. Projection of production costs should be viewed in the perspeotive of the probable course of operations over a period of years the estimated economic or physical life, whichever is shorter, ia recommended. These estimates should be revised as the projcct develops technically SO that expenditures on projects doomed to drop by the wayside may be discontinued at the e a r l i d opport,unity. In developing production and operating costs and in estiniatjing plant costs a great deal of cutting and fitting is necessary t>oestablish the proper size and initial capacity of a plant. ProviPioii for prompt and economical expansion when needed is a necessary part, of the plan. Cost estimates should show results at varioub percentage capacity levels and also through the use of alternate raw materials if a choice is available. Types and sources of raw materials are determined early in the planning on a basis to be fully competitive with esist,ing or other foreseeable producers. Production cost estimates include transportation, handling and storage, allowance for losses from rindage, evaporation, and other causes typical of chemical materials. Yield factors are of top importance in determining production costs in the chemical field. Often it is desirable to compute costs within a range of yield to prevent overoptimism until actual large scale production experience has been gained. Experienced chemists are aware of the long and costly periods that may be experienced in securing yields approaching the theoretical in a properly built plant and with a good process, even though complete success was secured and maintained in laboratory and pilot operations. The final report to management on a newly developed project, should be clear and concise and suppprted by fully detailed calculations and reasoning. As such reports are lengthy, a summary, keyed into the detailed report, should provide the essential facts ~
INDUSTRIAL AND ENGINEERING CHEMISTRY
October 1951
and conclusions. Individuals and departments participating in the report should be identified to show conclusively to management that all necessary checks and balances have been made. Each important unreconciled conclusion should be presented on a factual basis with reasoning for and against the minority differences in conclusions. The chemical industry has experienced a long period during which plants generally have operated a t peak capacity. There have been temporary periods of modest-to-sharp recessions in demand, leaving plants partly or wholly idle. Where products are available from more than one source it is possible to gauge capacity to take care of peak demand, and then when demand slacks off, operations can be slower yet remain at a point where reasonably good costs and profits can be secured. Matching capacity with demand is not easy for products that are special to one producer. Considerable overcapacity is often necessary to protect customers who have made large plant investments to use the products and to supply their trade. When demand slacks off, these oversize plants may become unprofitable; two or more plant locations may be a partial answer to this costly problem. The amount of overcapacity needed to maintain “sole producer” items has also increased as it has become necessary to provide greater protection against possible strikes or other prolonged interruptions. Thus, inflation is active in a forceful manner in the chemical industry’s most lucrative field, which has been created by large investments in research and plants. In calculating profit potentials for a proposed new investment, a 100% capacity operation should never be used. An average of 75 to 80% capacity on a sole producer product and 80 to 90% capacity on products where two or more producers are in the field is more realistic. Inflation also is evident in the form of constapt increases in others costs of doing business: Transportation costs have greatly increased; salaries and travel costs of field representatives and clerical and management personnel must necessarily keep pace with the receding value of the dollar. New laws, regulations, and taxes a t the national, state, and local levels have multiplied the paper work of industry, and often require the services of experts
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in finance, law, transportation, purchasing, public and employee relations, safety, and health. The addition of new products and increases in sales volumes through new capital investment will, to some extent, reduce general overhead costs a t plants, but it is not safe to compute potential profits on new products by allowing only for out-ofpocket costs in the overhead and expense categories. Management would create only marginal and fair-weather businesses if new products were introduced on the theory that there would be no additional operating expenses. In considering the funds required to finance construction of plant facilities, allowance must also be made for the added cash that is represented by working capital, inventories, receivables, and reserves. This may range from 20 to 50% of the dollars required for construction depending on the nature of the product. The cost of this added capital must be provided for in the estimates of production and operating costs. Under present economic conditions, the percentage of net profit that can be retained in a business or passed on to investors of new capital funds provides little direct inspiration for the outlay. To the extent that certificates of necessity, which permit more rapid write-off on plant investment, are obtainable, expenditures will be restored t o the corporate treasury, but current dividends are not payable from these more rapidly accumulated reserves. Management and investors should not pursue major expansions unless the economics of the projects are fully and favorably established. On the other hand, it is not possible for industry to stand still. The results of research and development must be utilized, new and lower cost processes must be found and adopted, not always to improve a present profit position but to maintain it. More production is a “must,” and industry neither wishes nor dares to lag. It is not improbable that inflated production and operating costs will become the deciding factor to management in authorizing new construction. Management, therefore, should insist on a careful calculation, by neutral experts, of the final net profit prospects on every proposed capital investment both before and after federal income taxes. RECEIVED April 16, 1951.
PREDESIGN COST ESTIMATES A. r
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predesign cost estimates are defined and several types are described. The value of such estimates in the administration of industrial research and some of the questions that can be answered by them are discussed, bur stress is also laid on the limitations of predesign estimates. A separate group reporting to research management is in a good position to provide impartial, consistent, and reasonably accurate estimates in a minimum time. A study of data from various departments of the company for which the estimate is prepared will result in reports that are consistent with company accounting forms and use cost factors based an company experience. Equipment cost data from the estimator’s own engineering department or engineering firm are preferable to information from the literature. Several methods of presenting the results of cost estimates are suggested.
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URING the past five years, a number of articles have D appeared in the technical literature on techniques that are used in preparing predesign cost estimates. Little would be gained by repetition of these procedures, but it appears worth while to discuss the types of predesign cost estimates that can be
J. WELLS AND S. A. G. SINGER
Technical Division, E. 1. do Pont de Nemours & Co., Inc., Wilmington, Del.
made; the value that these estimates have in guiding industrial research and development; and the methods used by individuals or groups in preparing to make such estimates. For purposes of this paper, a predesign cost estimate is defined as any cost estimate not based on firm design information and made prior to submission of quotations on equipment. An estimate based on firm design information and direct quotations for equipment is termed a construction cost estimate. Predesign estimates include informal “guesses,” semiformal highspot estimates to help select the best of several agailable reseaxh routes, and fairly detailed estimates that are used by research management to persuade general management that a new product is worth the expense of a construction cost estimate. That predesign estimates have a place in the administration of industrial research is evident in the experience of research groups that have started cost estimating sections. In all cases with which the authors are familiar, these sections have been continued and expanded because their work has proved increasingly useful to research directors and general management.
