WORKSHEET #19: Project the Direction of Future Prices and Margins
The steps followed in this Worksheet depend on the type of industry. There are separate steps for each of the two types.
For Low Marketing and Sales Industry
Step 1:
Project demand within the area where the Company's facilities may economically ship the product. Note that these demand forecasts are often available from industry associations and consulting firms who track the industry. These are very good starting points.
Step 2:
Project demand for areas outside of the normal shipping areas of the Company. See Step 2 for resources.
Step 3:
Determine the capacity of the industry today. This capacity should be the practical capacity of the currently producing facilities. Practical capacity adjusts for normal down times and maintenance requirements. These figures are also available, in most cases, from industry associations or consulting firms who track the industry.
Step 4:
Gather and quantify the information on capacity expansions already announced by industry competitors. Quantify the amount of practical capacity added and the timing for the addition of the capacity to the industry.
Step 5:
Create an estimate of new capacity added every year through Capacity Creep. These estimates would come from managers of facilities in the Company. You may adjust this estimate for the industry as a whole if your facilities, compared to the industry, are either more or less efficient.
Step 6:
Estimate the practical capacity that could add to the industry with each of the following expansions requiring investments:
Greenfield expansion, new line expansion, line conversion, new shift, and debottleneck investments. These estimates come from the operations side of the Company, complemented where necessary with assistance from the finance department. The estimates for all expansions, other than the Greenfield, should be specific to an existing competitor facility. The estimates should also include the time each expansion would entail in its planning and execution.
Step 7:
Estimate the price required to incite each of the capacity expansions noted in the previous step. Include all marginal cash costs of creating and operating the expansion, including costs for people and purchases. Calculate the annual cost of the capital involved in the expansion by estimating an annuity payment that would pay for the cost of the investment in the expansion at the Company's cost of capital, over the expected life of the new capacity. The sum of the cash operating costs for people and purchases and the annual annuity costs for the capital the investment requires equals the total annual cash cost of the capacity expansion. See Analysis 61
Step 8:
Estimate the per unit price required on the Standard Leader product to incite each of the capacity expansions noted in previous steps. Divide the total annual costs of each expansion calculated in the previous step by the annual practical capacity the expansion provides to yield a per unit of Standard Leader product price required to incite the new industry capacity. See Analysis 62
Step 9:
Compare the current demand, in units of equivalent Standard Leader product, to the current capacity to produce the equivalent Standard Leader product. Determine whether the industry has more or less capacity than it needs to meet current demand.
Step 10:
Project both the demand and the expected capacity additions in each of the next five years. Determine whether industry demand in the Company's economic shipping area, and beyond, is greater than or less than current expected industry capacity.
Step 11:
Estimate total operating costs for all currently operating facilities that can reach the Company's practical shipping area. These costs should be the cash costs of operating the facilities (i.e., people and purchase costs) as well as the working capital investments in the facility (i.e., inventories and receivables less free liabilities) carried at the Company's cost of capital. Where costs of capital must apply to several companies in the industry, use an industry average cost of capital. These estimates may also come from the operations side of the Company. The figures available from the industry associations and consultants to the industry may not include the carrying costs of working capital investments. The Company should add those carrying costs to the operating costs using estimates provided by the operations and financial functions of the Company.
Step 12:
Using the calculations of the previous steps, project industry prices required to balance demand and capacity in each of the coming five years.
Step 13:
Estimate the price levels at which the highest cost facilities operating in the industry today would be withdrawn from the market due to: reallocation, curtailment and shutdown.
Step 14:
Note the specific capacity that is likely to be withdrawn from the market in each of the next five years as prices fall below the minimum cash costs required to allow the facility to operate.
Step 15:
Estimate the likely operating margins for the Company facilities using these price estimates for each of the next five years. See Analysis 54
Step 16:
Evaluate any constraints on current capacity or potential expansion, including legal constraints or access to information, raw materials or critical components.
Step 17:
Note any substitute products that are likely to restrict the rise in prices of the industry Standard Leader product, or to lead to an increase in demand for the Standard Leader product as the Standard Leader product price falls relative to that of the substitute product.
For Normal to High Marketing and Sales Expense Industries
Step 1:
Compare the forecast demand growth for the industry over the next three years to the last three years of actual demand growth. If demand growth is accelerating, the industry may need more capacity. If demand growth is declining, the Company may see margin pressure developing.
Step 2:
Note all announcements of competitors entering the market in the next three years.
Step 3:
Compare the industry's return on investments (i.e., ROE or RONCE at the company level or Return on Allocated Assets for the business segment level analysis) and pre-tax return on sales (i.e., operating profits divided by sales for a company and operating margin, or allocated operating profits divided by segment sales, for a business segment) to the quartile rankings in Benchmarks/Quartile Ranking Reports in StrategyStreet. See Analysis 53
Step 4:
Calculate the inflation adjusted price increases in the Standard Leader product over each of the last five years. Use government data for the consumer price index for consumer products and for the producer price index for business and industrial products in order to adjust for inflation.
Step 5:
Calculate the amount by which the pricing over the last five years has exceeded, or fallen short of, the price expected with simple inflation. To make this calculation, begin with the price for the Standard Leader product five years ago. In each of the subsequent years, increase the price by the inflation figure gathered from the government. Subtract the cumulative price adjusted for inflation during the last five years from the industry Standard Leader price today to complete this calculation.
Step 6:
In view of the announced new entrants, of the industry's current returns and of the real price increase or decrease over the last five years, estimate the likelihood that competitive expansion will exceed future demand over the next three to five years. If capacity expansion is highly likely to exceed demand growth, the Company should anticipate price declines and margin pressures to develop.
For Both Types of Industry
Step 1:
Determine how your expectations for future price pressures change when you change assumptions on demand growth, as well as capacity additions or withdrawals, within the range of potential forecast errors.