production cost calculation methodology
In order to calculate roundwood production costs, it is necessary to identify all the activities required to produce roundwood, collect information about the productivity and cost of each activity and then convert these into a production cost per unit of output (i.e. cubic metre of roundwood). The following section describes the main activities in the roundwood production process, then presents a simplified accounting system that can be used to categorise or classify each type of production cost. It then describes a simple model for adding together all of these costs and calculating the production cost per unit of output. It finishes by discussing the main variables that are likely to affect total production costs.
Production cost accounting framework
In order to calculate roundwood production costs, it is first useful to have an accounting framework into which the data can be classified for analysis. This study has used a simple two-dimensional framework based on forestry activity and type of cost.
Forest harvesting and management activities
The forestry activities included in the roundwood production cost accounting framework are defined as follows:
Forest harvesting activities:
Felling - including: cutting; cross-cutting; tagging or marking; and de-limbing felled trees, plus rest periods and time spent refuelling the chainsaw and performing on-site maintenance. In the case of minor forest products (e.g. hewn squares, utility poles, stakes and split poles), the cost of further processing (which will usually take place at the roadside) should be included in this category.
Skidding with bulldozer - including: skid-trail construction; travelling to and from the log landing (roadside) to the felled tree; attaching the cable to the tree and detaching the cable at the log landing; and winching to the skid trail, plus rest periods and time spent refuelling the bulldozer and performing on-site maintenance.
Skidding with wheeled skidder3 - including: skid-trail construction; travelling to and from the log landing (roadside) to the felled tree; attaching the cable to the tree and detaching the cable at the log landing; and winching to the skid trail, plus rest periods and time spent refuelling the skidder and performing on-site maintenance.
In forest loading - including: collecting the roundwood from the log landing; travelling to and from the lorry; and loading on to the lorry, plus rest periods and time spent refuelling the loader and performing on-site maintenance.
Road transport - including: travelling to and from the log landing to the quayside (in the case of further transportation by barge) or final destination, plus loading time, rest periods and time spent refuelling the lorry and performing on-site maintenance. For roadside sales, this activity would normally be the responsibility of roundwood buyer and, thus, not a cost incurred by the forest manager.
Unloading and reloading - including: unloading the lorry; and travelling to and from the lorry to the logyard, plus rest periods and time spent refuelling the loader and performing on-site maintenance. If roundwood is delivered by lorry to a final destination (i.e. sawmill or quayside for export), this activity would normally be the responsibility of roundwood buyer and, thus, not a cost incurred by the forest manger. In the case of roundwood transported by barge to the final destination, this activity may occur twice (i.e. unloading at one time then subsequent re-loading on to a barge) unless the barge is present during unloading. Unloading and reloading may also occur one or more times if logs are temporarily stored or sorted between the forest and final destination or have to be transferred between a barge and a lorry more than once. The number of times roundwood is loaded and reloaded will depend on the transport infrastructure available to the forest manager.
Water transport - including: travelling to and from the quayside to the final destination, plus loading time, rest periods and time spent refuelling the barge and performing on-site maintenance. This activity is only relevant for a proportion of forestry operations in Suriname.
Road building - including: uprooting and removing trees and other vegetation; all necessary earthworks; and simple grading/blading, plus rest periods and time spent refuelling the loader and performing on-site maintenance. Currently, road building is not a very common activity in Suriname. Most forestry operators prefer to use existing roads (often built by LBB or Bruynzeel, up to 25 years ago) and skid for long distances rather than incur the costs of road building.
Forest management activities:
Exploration inventory - including: inventory planning and design (including purchase of base maps and aerial photographs, if necessary); travel to inventory plots; cutting trails; plot demarcation; tree identification, measurement and recording; measurement of other plot variables (if necessary); data entry and analysis; mapping; consultation with local communities; and report production, plus rest periods and construction of temporary camps (if necessary).
Outline management plan production - including: preliminary road and felling coupe design; outline production and infrastructure planning; mapping and report production.
Annual stock survey - including: travel to annual felling coupes; cutting trails; tree identification, measurement, marking and recording; stock mapping, measurement and recording of other variables (if necessary); data entry and analysis; final map production; and report production, plus rest periods and construction of temporary camps (if necessary).
Annual cutting plan production - including: final road, skid trail and felling coupe design; estimation of gross and net commercial production volume; mapping and report production.
Production control - including: monitoring and recording of roundwood production and transport; reporting to the Foundation for Forest Management and Production Control (Stichting voor Bosbeheer en Bostoezicht or SBB).
In addition to the above direct costs, there are other miscellaneous costs, which apply to all activities. These include: transport of workers to and from the forest (where local workers are not used); medical and other social costs; insurance payments (for both workers and machinery); and management and administrative overheads. In a few cases (the largest forest concessions) there are also the costs of permanent forest camp construction and/or maintenance.
Depending on the available transport infrastructure and the point at which roundwood is sold, many forest managers may only undertake some of the activities described above. For example, most local communities sell the roundwood from their community forests (Houtkapvergunning or HKVs) standing (thus, incurring no costs) or felled at stump (incurring only the felling cost). Other local communities and small logging companies fell and extract the roundwood (often using contractors for the extraction and loading) and sell it at roadside. Larger logging companies buy the roundwood felled and extract and transport it themselves (road and water transport is often contracted to separate companies). Only sawmillers and the largest logging companies tend to engage in all the harvesting activities from felling to delivery to the mill or harbour (for export). Thus, in order to examine where the economic rent is currently being captured, it is important to examine production costs for a range of situations for and compare them with prices (and contracting costs) collected elsewhere as part of this study.
Currently, most forest managers only perform harvesting activities and, of these, some activities are uncommon (e.g. road building). Only a few companies (e.g. Bruynzeel) carry-out any forest management activities. Thus, there is likely to be a discrepancy between current production costs and the costs that are likely to be paid in the future when the sector is more closely monitored and has to undertake forest management activities.
Types of production cost
For each stage of the production process, the cost of production has been split into the following three broad categories:
Labour costs - including: wages or salaries, calculated on the basis of time (e.g. monthly wage rate) or production (e.g. payment per cubic metre produced); social costs (including medical, insurance and other social costs), calculated as a percentage of the wage; and overhead (e.g. transport to and from the forest and accommodation expenses), calculated as a percentage of the wage. Payment of social costs and overhead vary considerably depending on the scale and location of forest operations.
Consumable (i.e. raw material) costs - including: fuel and lubricant costs, calculated from unit prices (e.g. cost per litre) and rates of consumption; the cost of minor parts (such as filters, tracks and types), calculated as a cost per working hour (derived from unit costs and the average life of each part); and the cost of other consumable items (e.g. clothing and tools), calculated as an annual replacement cost.
Capital costs - including the cost of depreciation of machinery used in each activity plus the cost of repaying any money borrowed to finance the purchase of the machinery. Depreciation has implicitly been calculated as a fixed percentage loss of value for every year each machine is used, spread over the estimated remaining lifetime of the machinery (i.e. the depreciation period). Loan repayments have been calculated using standard repayment formulae, assuming monthly repayment of principle and interest. The cost of major repairs (i.e. repairs beyond simple on-site maintenance) and insuring machinery has also been included under this heading. Repair cost has been calculated as an average annual cost based on the age of each machine and the annual insurance cost has been calculated as a percentage of the current value of the machine (which is, itself, based on the machine's current age and the depreciation rate - i.e. its depreciated replacement value).
In addition to the three types of cost presented above, the forest manager will also expect to earn a level of profit (which should be restricted to normal profit) in return for invested money in the activity. The expected level of profit has been included in the calculation of total production cost in two ways: as an expected rate of return or level of profit on the total amount of capital invested in each activity; or as a profit margin or mark-up on all other (i.e. non-capital) expenditure. The first approach is the standard approach that would normally be used in investment appraisal. However, after discussions with LBB, SBB and forest managers, it was discovered that, in view of the age of much of the capital currently used in the forestry sector in Suriname, many forest managers use the simpler second approach in their financial calculations.
For the purposes of updating the economic rent analysis, the results presented later also show the contribution to total production costs of the each of the main types of cost. This should make it easier to update these figures quickly, without having to go back and collect revised information for every individual cost item.
Calculation of roundwood production cost
There are two main ways in which roundwood production costs can be calculated. The first is the discounted cash-flow approach and the second is the delivered wood price approach.
The discounted cash-flow approach
The discounted cash-flow (DCF) approach involves constructing a cash-flow for the forestry operation and calculating economic performance measures such as the Net Present Value (NPV) or Internal Rate of Return (IRR) of the operation, using standard investment appraisal techniques.
A cash-flow is a table showing, for each year of the investment period, the expected costs and revenues from the operation. In an NPV calculation, all of the costs of the operation are discounted (see Box 1) and added together to give a total discounted cost. Total discounted revenue is calculated in a similar way and total discounted revenue subtracted from total discounted cost gives NPV.
The NPV of an investment can be thought of as the surplus of revenues over costs (expressed as though all financial flows occur at the start of the investment period) after the required rate of return on all expenditure during the lifetime of the project has been covered. If NPV were negative, this would indicate that the expected revenues during the investment period would not be sufficient to cover the required rate of return or normal profits.
Total discounted costs and revenues and NPV can be turned into an amount that is equivalent to an annual payment during the whole of the investment period (the annual equivalent or annuity). Alternatively, they can be converted into lump-sum payments that are equivalent to the total discounted costs, revenues or NPVs of a series of repeated investments carrying-on for ever (the capitalised or expectation value of these items). These alternative ways of expressing total discounted costs, revenues and NPV are sometimes also used in economic analysis under certain circumstances (see below).
IRR is an alternative economic performance measure to NPV and is calculated by varying the discount rate (or expected rate of return) used in the NPV calculation until NPV equals zero. The discount rate at which NPV equals zero is the rate of return on all expenditure during the lifetime of the investment. The IRR can thus, be compared directly to the normal or expected level of profits to see how well an investment performs.
Box 1 Discounting future costs and revenues
In order to take into account the timing of future costs and revenues, it is usual to reduce the value of future monetary payments by an amount which depends upon how far into the future they occur. This is based on the principle that an amount of money collected as revenue today is preferred to the same amount at some future time (time preference). The process of doing this is usually referred to as discounting. Cash-flows that have been modified in this way are referred to as discounted cash-flows (comprising discounted costs and discounted revenues) and the amount by which values are reduced for each year into the future in which they occur is called the discount rate. A discounted value is calculated using the following formula:
Discounted value = Future value
where r is the discount rate (expressed as a decimal fraction) and y is the number of years into the future in which the payment occurs. When all cost items are discounted and added together, the resulting total discounted cost is the total cost of the investment expressed as though all costs had to be paid at the start of the investment (ie. after they have been adjusted for their timing). Total discounted revenue and NPV can be thought of in the same way.
The major challenge in the process of calculating discounted cash-flows is usually choosing the appropriate discount rate for this calculation (the discount rate can be thought of as the level of profit or return on expenditure which companies operating in the sector would aim to achieve - ie. the level of normal profit). Most of the international development banks use a rate of 10% in their project appraisals. Discussions in Suriname revealed that a rate of return or discount rate of 20% would be considered appropriate for operators in the forestry sector.
The DCF approach can be used to identify the roundwood production cost (per m3) of a forest operation by dividing the total discounted cost of the operation by total discounted roundwood production. Furthermore, the NPV/m3 of the operation (calculated in the same way) is a direct measure of the economic rent (per m3) from roundwood production.
IRR analysis can be used in a similar way to estimate the roundwood production cost and economic rent, by adding a hypothetical rent payment to the roundwood production cost in the IRR calculation. By varying this amount in the calculation, the level of economic rent at which IRR equals the normal level of profit can be discovered.
The delivered wood price approach
Many of the costs of roundwood production are labour and consumable items, which are purchased in proportion to roundwood production each year (i.e. they are variable costs). The only cost items which are purchased occasionally, are used for several years and do not vary exactly in proportion to production, are machinery, equipment and infrastructure such as forest camps (i.e. fixed or capital costs). Thus, the DCF approach can be a complicated way of handling what are mostly simple cost and revenue flows. The delivered wood price approach is a simpler variation of the DCF approach described above, which treats most costs as annual expenditures and only discounts the costs of capital items in the calculation of roundwood production cost.
The easiest way to calculate delivered wood price is to calculate the average annual depreciation of all equipment used in the production process, add annual expenditure on labour and consumable items to this and divide the total by annual production. However, this would give a delivered wood pric e that does not take into account the profit that the forest operator would expect to earn. To include a level of profit in the calculation, a profit margin or mark-up must be added to the production cost.
As noted above, there are two ways in which normal profit might be considered: firstly, as a mark-up on current expenditure (the common approach in Suriname); or as a return on the capital invested in the operation (the standard financial approach). The first approach is relatively easy: a percentage mark-up can be simply added to all labour and consumable expenditures. However, the calculation of delivered wood cost including an allowance for return on capital is slightly more complicated.
Firstly, as noted above, any discounted cost can be converted into an annual equivalent or annuity. Therefore, the total discounted cost of a piece of equipment used in the production process can also be converted into an annuity. This annuity can then be divided by annual production for that piece of equipment to give a discounted cost per unit of production. The difference between this and the capital depreciation cost per unit of output, is the allowance for return on capital. This can be added to the costs of depreciation, labour and consumable items, to give a total delivered wood cost that includes an allowance for normal profit (expressed as an expected return on capital).
Choice of technique
The main strengths and weaknesses of each of the above approaches are described in Table 1. To summarise, the complete DCF approach is better for calculating total roundwood production cost in situations where forest harvesting and management is likely to be complicated and involve a lot of capital equipment, while the simpler delivered wood price approach is more useful where forestry activities are considerably simpler. Thus, the DCF approach might be appropriate for large operations working for a planned period of time (say, a 100,000 ha concession over 20 years) in a variable forest area. It is probably less appropriate for the scale of most forest operations currently working in Suriname.
Given the generally small scale of forest operations in Suriname therefore, the delivered wood price approach has been used to examine roundwood production costs in this analysis. It may be appropriate to consider using the DCF approach to calculate the roundwood production cost of the largest forest operators (e.g. Bruynzeel and MUSA) and explore the roundwood production cost under the more complex planning and monitoring requirements which will be required when the 1992 Forest Management Act is completely implemented. However, this would probably require a greater amount of information about cost and price structures in such operations than is currently available.
Table 1 Relative strengths and weaknesses of the discounted cash flow and delivered wood price approaches to calculating total roundwood production cost
Discounted cash flow approach
Delivered wood price approach
This approach can handle large initial investments on items such as forest camps, inventories and training. It can handle expected variations in annual costs and revenues due to factors such as moving into areas with different terrain conditions, roading requirements and stocking levels each year. It can also be used to incorporate more complicated forest management activities such as silvicultural treatments in various years after harvesting.
The approach is relatively simple and does not require a great amount of calculation. It is also generally easier to interpret, explain and understand the results of the delivered wood price approach. The amount of information required to calculate delivered wood price is also generally not very great.
To achieve the above benefits, the approach generally requires more information and is more complicated to calculate. It can also be more difficult to explain the calculation and results to others.
The approach implicitly assumes that most costs are roughly the same each year and that they generally fall into a few simple categories. Thus, it would not be very useful for very variable or complicated forest areas. It might also end-up being more complicated to use this approach if there are a many large capital investments at irregular times throughout the investment period.
The model used to calculate roundwood production cost
A simple spreadsheet model, which calculates the harvesting component of roundwood production cost using the delivered wood price approach, has been constructed for this study. The model includes all of the various activities currently undertaken to harvest roundwood in Suriname (a general overview of the model can be found in Appendix 1 and a detailed explanation of all the calculations in the model can be found in: Section 3.2 Data used in the harvesting cost model for a typical forest operation; and as comments within the spreadsheet itself). The model does not include the cost of management operations, because many roundwood producers do not currently undertake such activities. They will, however, be required to do so when the 1992 Forest Management Act is fully implemented. Therefore, these additional costs will have to be calculated by hand and added into any analysis of managed forest production.
With the model described above, it should be possible to examine the effects of changes in variables (such as productivity, machinery costs and transport distances) on the roundwood production cost. Such an analysis is called a sensitivity analysis. It is important in any analysis of economic rent, to carry-out a sensitivity analysis of the results, to examine which factors will have the most effect on production costs and, hence, economic rent.
Variability of the forest resource
Some variables are largely outside the control of forest managers. For example, they may face different production costs due to factors such as the location and stocking level of their forest concessions. These variables, over which the forest manager has no control, often arise as a result of the variability of the forest resource. The most important factors in this category are likely to include:
Transport distances. The distance between a concession and the sawmill or harbour can have a significant effect on transport costs and, thus, the cost of roundwood production. The further that roundwood has to be transported and the greater the number of times it has to be loaded and re-loaded onto different types of transport, the more expensive it will be to produce roundwood.
Forest management requirements. With the implementation of the 1992 Forest Management Act, forest managers will have to undertake a range of activities such as forest inventory, consultation and planning which most of them currently do not perform. Once a felling code of practice is implemented, they will also be required to provide proper safety equipment and may have to train workers in better harvesting practices. These are other factors that will be largely outside their control, but will affect the cost of roundwood production.
Concession area and stocking level. Roundwood production costs will vary with the size of forest concessions and the level of stocking of commercial species. Fixed costs, such as planning and forest inventory, will be spread over larger production volumes in larger forest concessions and concessions with higher levels of stocking of commercial species. In such cases, production costs are, therefore, likely to be lower. Larger forest concessions will also generally allow managers to achieve better rates of machinery utilisation, which will reduce production costs.
In cases where production costs are higher or lower than average because of factors over which the forest manager has no control (such as those described above), the economic rent from production is likely to vary and the chosen level of forest levies should take this into consideration. In some cases economic rent may be so low that it is questionable whether any roundwood should be produced at all. Greater benefits may be derived from conserving these areas or using them for some other activity (e.g. ecotourism of the production of non-wood forest products).
In addition to the above factors, there are other variables that can affect production costs, over which forest managers do have some control. Generally, these variables are associated with how efficiently the forest operation is managed and include:
Roading density. For any level of forest stocking, there is an optimal level of roading density at which roundwood production costs are minimised. Road building is currently uncommon in Suriname, leading to very long skid trails and high extraction costs. It is likely that a certain amount of road building in forest concessions would have the overall effect of reducing the total costs of extraction.
Skid trail length and layout. The length of skid trails required to extract roundwood is determined, in part, by the roading density. If more roads are built, the length of skid trail needed is reduced. However, a second factor which must be considered in determining the average length of skid trails and, hence the costs of skidding, is the design of skid-trails. A certain amount of deviation from the shortest possible route to felled trees is often necessary to accommodate site factors such as streams, steep terrain and trees that have not been felled. However, there is a big difference between the average skidding distance over well designed skid trails and the distance if skid trails aren't planned properly. Thus, careful planning and layout of skid trails can reduce skidding costs dramatically.
Replacement of capital equipment. As machinery gets older it becomes more expensive to maintain and can significantly reduce production capacity. There will be a point at which increases in repair costs and loss of productivity justify the replacement of equipment. This should also be examined in any analysis of production costs.
Types of equipment used in forest operations. A common feature of forest operations in Suriname is the use of old and outdated equipment. In particular, the use of skidders to construct skid trails and the use of light trucks to haul timber may have a significant effect on the roundwood production cost. Therefore, any analysis of production costs should also examine the benefits of using proper equipment such a logging trucks and bulldozers for skid trail construction.
In the case of these factors, the economic rent analysis should examine the scope for reducing production costs (and, hence, increasing economic rent and forest levies), by improving efficiency. In most cases, it is unlikely that forest managers are deliberately inefficient in the production of roundwood. Therefore, the analysis should examine why they may not be producing wood in the most efficient manner. There are often financial, institutional and technical reasons why forest managers might be discouraged from increasing efficiency and these should be identified along with possible solutions to these problems.
Comparison with contract cost information collected during the study
The above section has described how the different components of roundwood production cost can be calculated using standard investment appraisal techniques. However, many producers of roundwood in Suriname use contractors to perform some of their forest harvesting activities. This is particularly true in the case of small loggers and local communities producing roundwood. In these cases, the contract cost of these operations can be used in stead of the production costs (calculated from the raw data) in the economic rent analysis.
It may be more efficient for a forest manager to use contractors rather than invest in their own machinery, particularly in the case of small producers who might not be able to use large pieces of machinery for long periods of time. However, if the government is not capturing all of the economic rent from timber production with their forest levies, it is possible that these contractors are taking some of this rent. Therefore, in order to get some idea of the distribution of rent capture within the sector, the calculated cost of operations (such as extraction and haulage) should be compared with the contract costs of such activities collected during the study. This will start to give some insight into the impact of levy changes on the different stakeholders operating in the sector.
Production of minor forest products
All of the above discussion has centred on the production of roundwood for export or processing in the sawmill or plymill. However, a small amount of roundwood produced in Suriname is converted in the forest into simple value-added products such as utility poles and hewn squares. These products are sold for generally much higher prices in domestic and international markets, but cost only a little more to produce. Therefore, the economic rent from these activities will be different to the economic rent from roundwood production.
Where information exists about the additional cost of producing these minor forest products, this should be examined by varying the production cost and price data in the economic rent analysis. Where economic rent from these activities is significantly higher than that from roundwood production, this should be reflected in the levies set by LBB or SBB.