Lessons in Food Processing Economics

Every food professional needs to know the basic elements of the business in which they practice even if their normal assignment would appear to have little directly to do with the business. In particular, researchers need this understanding because, as we will see, they are often perceived to be cost centers, and cost centers are vulnerable. It is far more secure to be perceived as a profit center.

Understanding Cash Flow
Every enterprise needs positive cash flow to survive. Cash flow, in business terms, is the difference between income and expenses, including taxes paid, called profit, plus depreciation. Depreciation, because it is not a cash expense, is added back to profit to get cash flow. Other money infusions and outflows, such as loans, repayment of debt, investments, and dividends are separate from cash flow. These are sources of the underlying assets with which money is earned.

Universities, government agencies, and not-for-profit institutions have the same fundamental financial structure though they may use different terminology. In all cases, there is some source of income—sales, tuition, grants, appropriations—and a number of expenses. If income does not exceed expenses, at least over the long term, the enterprise will not survive.

Most of this column is about how to evaluate food processing projects, but understanding the underlying purpose—to help generate positive cash flow—is critical. Typically, there are more opportunities than there are financial resources so an essential function of economic analysis is to help allocate resources to maximize the benefits to the enterprise.

Capital Cost Estimation
There are two separate components of a project cost estimate: the investment required and the ongoing or operating cost. In a food project, we typically separate the facility-related investment costs and the process- or equipment-related costs. The facilities for food production are usually more expensive than those for other industrial purposes because food plants need to be designed and constructed for easy sanitation and often are refrigerated, at least in part.

The components of a food facility include the following: raw material receiving and storage; packaging material receiving and storage; material handling; utilities; environmental controls; the building itself (floors, walls, ceiling); engineering and construction fees; and contingency.

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The processing component includes processing equipment; packaging equipment; engineering fees; installation (rigging, mechanical, and electrical connections); process control; and contingency.

Each of these elements may be estimated from firm quotes, past experience, or correlations, such as average costs per square foot. Costs are very sensitive to a specific site. There is no such thing as a perfect location anymore; all the good building sites have been taken in most places. Thus, any specific site is likely to have unique issues that affect costs. A common situation for a food project is to install a new line in an existing manufacturing facility. In that case, costs are incurred for protecting existing operations, providing special training to construction workers about personal and food safety, and providing separate access for construction equipment and people.

One technique that can be useful for estimating equipment costs is to get quotes for used equipment of the appropriate size or capacity. Used equipment is offered on the Internet and often is about 30–50% of the cost of new equipment. Such equipment might be adequate for a given case, or its price can be adjusted to approximate the cost of new equipment when it might be difficult to obtain reliable quotes on new equipment. (For reasons that are not clear, many new equipment suppliers are reluctant to respond quickly to requests for budgetary quotations. Perhaps their salespeople are spread too thin.)

Contingency is a controversial element of a cost estimate. It is a line item in the estimate that is meant to cover inevitable errors in the other elements, typically errors of omission, but also errors of estimates—forgetting to include taxes or shipping, for instance. Contingencies are not meant to cover acts of God or significant changes in scope or schedule. Some companies have policies that limit the amount of contingency allowed in published estimates or budgets, but these are often unrealistic. Contingency in a preliminary estimate often should be 30–50%. As more information is gathered, it is appropriate to reduce the contingency because uncertainty and risk is reduced with additional knowledge, but it should never be zero. One study of a number of large projects revealed that, on average, there was still a 5% uncertainty in final cost when the projects were nearly complete.

A good capital cost estimate requires a process flow diagram, a description in words of the process, and an equipment list. Engineering companies and in-house engineering departments develop their own procedures and sources of information, including their experience with other projects. Food professionals rarely need to prepare such estimates, but they need to understand how they are done and how to evaluate them, including how to question or challenge them.

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Operating Cost Estimates
Operating costs are dependent on the specific product, process, and corporate practices. Operating costs, of course, are one component of cash flow, the other being income from sales. Income is usually thought to be well known from projections of volume and selling price so the costs are the major unknown. In practice, unfortunately, income projections are often wildly optimistic, and so income should be, but rarely is, treated as significantly uncertain.

The components of operating costs are raw materials (including ingredients, sometimes considered separately), packaging materials, energy, labor, depreciation, and indirect costs.

For the food industry as a whole, raw materials and packaging materials average about 70% of the cost of goods, with energy, labor, and all other costs each about 10%. This emphasizes the importance of yield in the economics of food processing. Many cost reduction efforts focus on labor and energy, but these actually represent a relatively small element of cost.

Indirect costs, in this context, are mostly salaries not associated directly with manufacturing, such as quality, human resources, and management. Some other cost elements, over which the food professional may have little influence, include sales and distribution, marketing, general administrative (corporate as distinct from manufacturing), taxes, and insurance.

Depreciation is a cost element, which is intended to allow recovery of the capital investment. It is an accounting entry that serves to reduce taxes, so it is added back to net profit after taxes to comprise cash flow. Depreciation schedules are defined by tax law. Taxpayers like to depreciate investments as quickly as possible to minimize taxes paid while the government holds the exact opposite view. In practice, for most estimates, straight line depreciation is used because it is simple and well accepted. Buildings are depreciated over 20 or 30 years, and most equipment is depreciated over seven to 10 years. Small investments are commonly not depreciated but are deducted from income as expenses in one year. Exact treatment of a given investment is typically determined by a corporate finance department.

The important point is that depreciation contributes to cash flow, but it also reduces reported earnings so publically held companies are conflicted over investments: they need to invest in order to grow, but investments reduce reported earnings and thus their perceived value in the stock market. Privately held companies are less beholden to the perception of value and so may be more aggressive investing for growth.

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Comparison of Alternatives
Once a project’s investment cost and operating consequences are known, it can be compared to other opportunities. Corporations typically budget a certain amount annually for capital investment and then projects compete for the resources, much as academics compete for research grants. There are many ways in which projects are evaluated, but in light of the fact that cash is lifeblood, one easy and reliable technique is to compute the net present value of the cash flow of the project over its expected lifetime or for some predetermined time frame. The net present value (NPV) takes into account that a dollar in the future is worth less than one in hand today.

The time value of money arises from the fact that a dollar in hand can be invested and earn interest, becoming worth more in the future. The hypothetical interest rate, i, is also called the discount rate and is used in a simple calculation to bring future cash flows to a common point in time. The equation, for a single cash flow is this:
PV = FV/(1 + i)ⁿ . In this equation, PV = present value; FV = future value; i = interest or discount rate (fraction); and n = time period in future, consistent with i; that is if i is % per year, n is in years. For a series of future cash flows, each is computed appropriately and added together to give present value. The initial investment and any future investments are negative cash flows at the appropriate point in time. This approach allows for varying cash flows over time as when future investments are made and when sales are expected to grow.

J. Peter Clark,
Contributing Editor, Consultant to the Process Industries, Oak Park, Ill.
[email protected]