Chapter 2 Industrial Growth Trends

8/13/2019 Chapter 2 Industrial Growth Trends

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The Industri al Sector :and Inves

Growtment

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Chapter 2

Trends,ehavi or


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The Industrial Sector . . . . . . . . . . . . . . ., . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Size and Growth of the lndustrial Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Industrial Productivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Industrial Investment Decisionmaking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Uses of Capital ....*** .....,. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Strategic Planning. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Factors That Influence lnvestment Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Levels of Decisionmaking. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Elements of a Strategic Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TABLES

212122242426273031

Table No.

d. Major Manufacturing lndustry Groups as Listed in the Standard IndustrialClassification Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5, Sensitivity Analysis of lnternal Rate of Return(lRR) Under Different Scenarios forComputer Process Control System . . . . . . . . . . . . . . . . . . . 4 . . . . . . . . . . . . . . . . . . . . .

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FIGURES

Figure No. . . . .5. Output in the Industrial Sector ............. . . . . . . . . . . . . . . . . . . . . . . . . . .6. . . . . . . . . . . . . . .

. . . . , ,23


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Chapter 2The Industrial Sector: Growth, Trends,

and Investment Behavior

THE INDUSTRIAL SECTORAs defined by the Department of Energy (DOE),

the industrial sector is essentially the goods-producing part of the economy, It is largely con-cerned with obtaining raw materialsthrough ex-traction or through animal and plant husbandryand with the mechanical and chemical transfor-mation of these materials and their derivatives.

The industrial sec tor contains agriculture (in-cluding forestry and fisheries), mining (includingoil and gas extraction), construction, and manu-facturing. Manufacturing is the largest of the fourin dollar value of output and energy use.

These four components of the industrial sec -tor correspond to the first four of eleven divisionsin the Standa rd Industrial C lassification (SIC)system. The SIC system defines industries andgroups of industries in accordance with the com-position and structure of the economy. It coversall economic activity. The Federal Governmentand many other organizations use the SIC frame-work for collecting statistical data; many busi-nesses use it to c lassify customers and suppliers.

Table 4 lists the SIC major manufac turing industrygroups.

Size and Growth of the Industrial Sector

The industrial sec tor ac counts for nearly one-third of the gross national product (GNP). Asrevealed in figure S, output (discounted for in-flation) by the industrial sector has grown at arespectable rate since the end of World War II.Real industrial gross produc t increased 167 per-cent, or an a verage of 3 percent per year, be-tween 1947 and 1980 (latest data available).

The industrial sec tors proportion of overallU.S. economic activity has been decreasing, how-ever, owing to two factors. First, service-type ac-tivities have grown more rapidly than goods-pro-ducing activities, a situation typical of highlyindustrialized economies. Gross product originat-

Table 4.Major Manufacturing Industry Groups asListed in the Standard Industrial Classification Manual

(1972 edition)

SIC code Major group20. . . . . .21 . . . . . .22. . . . . .23. . . . . .24. . . . . .25. . . . . .26 a . . . . .27. . . . . .28 a . . . . .29 a . . . . .30. . . . . .

31 . . . . . .32. . . . . .33 a . . . . .34. . . . . .35. . . . . .36. . . . . .

37. . . . . .38. . . . . .39 . . . . . .

Food and kindred productsTobacco manufacturesTextile mill productsApparel and other textile products b

Lumber and wood productsFurniture and fixturesPaper and allied productsPrinting, publishing, and allied industriesChemicals and allied productsPetroleum refiningRubber and miscellaneous plastics productsLeather and leather productsStone, clay, glass, and concrete productsPrimary metal industriesFabricated metal productsMachinery, except electricalElectrical and electronic machinery,

equipment, and suppliesTransportation equipmentInstruments and related products b

Miscellaneous manufacturing industriesalndustries groups examined in detail by OTA studybShortened title.SOURCE: Standard Industrial Classification Manual, 1977 (Washington, D C

Office of Management and Budget, 1977).

ing* in nonindustrial divisions increased 243 per-cent between 1947 and 1980, or 3.8 percent peryear on average, compared with 3 percent onaverage for the industrial sec tor. In 1980, grossproduct originating in the industrial sector rep-resented 31.6 percent of the real GNP, a dropfrom 37.2 percent in 1947.

Second, among goods-producing activities,there has been a historical shift toward higherdegrees of fabrication and more technologicallyadvanced products. For example, gross productoriginating in the nonelectrical machinery, elec-

*Gross product originating in a division or Industry is that partof the GNP attributable to the output of establishments in that divi-sion or Industry. It is the sum of the factor costs of production(wages, salaries, profits, net Interest, and so forth) and nonfactorcosts, such as depreciation and Indirect business taxes,

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99-199 IO - 83 - 3


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22 . Industrial Energy Use

Figure 5.Output in the Industrial Sector(billions of 1972 dollars)

Other$295

sect

Mining$115

$11

1947(Total economy $470)

tric and electronic equipment, and instrumentand related products industry groups, combined,ac counted for more than 6 percent of the G NPin 1981, compared to about 3.5 percent in themid-l950s. in contrast, the combined share of the GNP accounted for by the primary metals andfabricated metal products industry groups fellfrom over 4.5 percent to less than 3 percent forthe same period. *

Both the faster output growth of nonindustrialdivisions and the shift to higher degrees of fabrica-tion and more technologically advanced productshave an important bearing on the level of energyuse in relation to output in the industrial sec tor.

Others$533

ConstructD $50

on

Mining$15

1983(Total economy $833)

Agriculture$43Construction

I $53

Ot$1

Mining$23

1981(Total economy $1,482)

SOURCE: U.S. Department of Commerce, Bureau of Economic Analyses

The industrial sec tor employs about 30 millionpeople, or about 30 percent of the total employ-ment in the U.S. ec onomy (see fig. 6). This per-centage is slightly higher (31 percent) when em-

ployment is figured according to the full-timeequivalent of workers rather than by the numberof full- and part-time workers. There are relativelymore pa rt-time workers in the nonindustrial divi-sions, pa rticularly in trade and services. (Unpa idfamily workers, mostly in farming, are not in-cluded in this analysis. ) Employment in the in-dustrial sector has increased about 15 percentsince 1947, while employment in the rest of theeconomy has more than doubled. Despite rela-tively low nominal wages in agriculture, employ-ee wages in the industrial sec tor as a whole areabout 1s percent higher than those in the econ-omy as a whole.

Industrial Productivity

Industrial labor productivity, as measured bythe amount of output produced per hour of laborused, has dramatically increased since WorldWar II. Production per person-hour in manufac-turing (which accounts for three-fourths of in-dustrial sector output) grew at an average rate of 2.6 percent per year between 1947 and 1981, In

*Data on gross product originating by detailed industry groupmay contain considerable errors and are not published by the es-timating agencythe Bureau of Economic Analysis (BEA) of the De-partment of Commerce. BEA strongly recommends that the figuresbe used with caution.


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Ch. 2 The Industrial Sector Growth, Trends, and Investment Behavior 23

Ot31

Figure 6.Distribution of Employment in the

Industrial Sector

her.2

sec

1.0 Manufacturing15,4

1947(Total employment 57.3 million)

Other41.3

Mining0.6


Agr4.1

Con

3.6

fact

ture

ction

icultu

s t ruc

uring

Mining1.1


re

t ion

ture

struction

ing

comparison, labor productivity in the private non-farm economy as a whole increased 2.1 percentper year on average during the same period. Thiscontrast reflects the more rapid gains in labor pro-ductivity in goods production than in the produc-tion of services. Part of the substantial rise in labor

productivity in the industrial sector has comeabout through the use of more energy. Yet, atthe same time, the other factors contributing tohigher labor produc tivityimprovements and/ orincreases in technology, physical capital, and theskills and education of the labor forcehave alsocombined to actually decrease the amount of energy used per unit of output.

SOURCE U S Department of Commerce, Bureau of Economic Analysts


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INDUSTRIAL INVESTMENT DECISIONMAKING The significanc e of industrial energy demand

in overall U.S. energy use has foc used con-siderable attention on means of encouragingmore rapid improvements in industrial energy

productivity. A business decision to invest in newplant and equipment or in retrofits of old equip-ment for the purpose of cutting energy use (andthereby reducing costs) is made, however, in thecontext of many other competing criteria. An un-derstanding of this decision making process is animportant goal of this study.

The fiduc iary duties and responsibilities of management are well known. In a modern socie-ty these responsibilities can be said to range fromprotec ting shareholders interests to assuringemployee welfare and safeguarding the environ-ment. These fiduciary obligations play a majorrole in the companys decision making process,ensuring that investments are prudent and thatthey protect the c ompanys assets.

A well-managed company that wishes to ex-pand its operations has many avenues open toit for raising capital and does not have to rely en-tirely on the current profits generated. Theseavenues range from selling company stock, to is-suing interest-bearing paperi e., debentures, toborrowing the required amount of money andpaying interest to a lending institution.

Management responsibilities in these areas aredirected at ensuring that debts arising from bor-rowing or the issuance of stock do not overdiluteor undermine the asset value of the company.It is this fiduc iary responsibility, with its inherentemphasis on prudent management, that gives riseto financial planning and investment policies thatare incorporated into a strategic plan. Decisionsregarding all investments, inc luding those relatedto energy, are made within this area of strategicplanning.

Uses of Capital

Corporate funds can be used to pay the debtand debt service on existing loans; to pay divi-dends to stockholders, for such payments oftenserve to keep up the price of the stoc k so more

stock ca n be issued; and to pa y for the workingcapitaIi. e., everything from the companys in-ventory to the cost of raw materials. For manycompanies, working capital is the largest dollar

expenditure but is allocated only after the firstthree items have been satisfied.

Once a company knows the size of its capitalpool, it must decide how to allocate it. Certainprojects are considered mandatorye.g., pollu-tion c ontrol equipment, equipment required forhealth and safety, and projects agreed to in col-lective bargaining. Also, some capital projects,especially those in the capacity expansion cate-gory, obligate a company to spend in certainways to support a major project. Once a deci-sion has been made to build a new pulpmill ora new blast furnace, completing a number of projects related to that decision becomes man-datory. Such things as purchasing additionaltransportation equipment for the new productwould be in this category.

plants in the primary manufacturing industriesare often very large. To take advantage of criticaleconomies of scale, major expansion of industrialcapac ity in these plants involves large bloc ks of financial resources and delayed returns on invest-ment during lengthy construc tion p eriods. To jus-tify such investments, projec t lifetimes must bepredictably long term. Such long-term forecastsare exceedingly difficult to make, especially dur-ing periods of economic instability. Consequent-ly, at present, primary manufacturers requiringlong-term investment commitments involve great-er apparent risks than do industries that offershorter term investment opportunities.

After all mandatory allocations are made, acompany is left with its discretionary capital poolthat is subjected to the corporations strategicplanning proc ess for ranking investments. Insome c orporations, investment dec ision makingis a very formal process. The company invests inonly its most productive product lines and plants.In other firms, decisionma king seems less for-malized, but still subject to the perceptions of managers on growth po tential of a product, mar-ket and technological competition, and use of


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Ch. 2The Industrial Sector: Growth, Trends, and Investment Behavior 2 5

capital, labor, and materials. I n no case has OTAidentified companies that accord energy projectsspecial status. All firms regard energy efficiencyas one more item in which they could invest andnot as a series of projec ts that differ from otherpotential investments. The ec onomic incentiveto save energy because of its high cost is counter-balanced by high capital and labor costs and in-creasingly costly raw materials.

To be effec tive in the marketplac e, manage-ment must have a strategic plan. The approvalprocess in developing the plan and its projectstends to be complex and the project analysis, ex-haustive. Technical decisions tend to be separatefrom and subservient to financial decisions. Thecorporate engineering staff performs detailedtechnical analysis, estimating such factors as con-struc tion costs, potential energy, labor or materialsavings, and project lifetime. A return on invest-ment is then calculated. I n multi plant firms, pro-posals for capital projects are then submitted tothe plant manager, who may approve certainareas and not others. This package is then senton to the corporate staff for consideration withproposals from other plants. This capital fund re-quest summary would be reviewed by senior cor-porate management, and only at this time wouldfunding source, tax credits, and the like be dis-cussed.

As shown previously in table 1 energy efficien-cy improvements are generally classified into four

categories: housekeeping, equipment retrofit,new plant construction or capacity replacement,and product shift.

Housekeeping

Housekeeping refers to the substitution of laborand management inputs for energy. It includes:1 ) closer monitoring of p roc ess strea ms andgreater coordination of products in process inorder to minimize delays and reject rates, 2) morefrequent equipment repairs to increase averageenergy efficiencies, and 3) improved job skill

training and motivation to minimize human er-rors. Because many of these alternatives are notexpensive and involve a very large return for lit-tle effort, they are often the first actions taken bya company. The consensus of energy managers

and corporate investment analysts i n the four in-dustries studied by OTA is that most firms havedone their housekeepingthat those things thatcan be readily adjusted, insulated, turned down,or turned off, have been.

Equipment Retrofit

Most existing equipment was installed whenenergy costs were expec ted to be much lowerthan they are today. Replacement with newequipment would offer the greatest improvementin energy efficiency and the greatest reductionin fuel costs (via fuel switching). However, sincereplacement is most expensive and a great dealof capital in place may not have been amortized,replacement would be tantamount to acceptinglarge, lump-sum losses. The alternative is toretrofit existing equipmente. g., by adding pipeinsulation, combustion controls, more efficientmotors, and heat exchangers to heaters andboilers in order to achieve their maximum designefficiencies; by adding computer controls to proc-ess streams in order to minimize deviations fromoptimum temperatures and pressures; and byadding or replacing a muItitude of other processcomponents whenever such installations do notsignificantly increase downtime.

Most important energy-saving retrofit alterna-tives involve well-proven technology. Severalfirms contacted used a lower hurdle rate forenergy conservation projects because they were

considered to be of low technical risk. On theother hand, while there are a multitude of retrofitproject alternatives at any major industrial facili-ty, the actual energy savings for a particular proj-ec t may be severely constrained, or the invest-ment outlays may be excessively large, becauseof the existing plant configuration.

New Plant Construction orCapacity Replacement

The most costly investment strategy (at least ininitial capital outlay) is to build entirely new

facilities that embody the latest energy-efficienttechnology or any technology that lowers c ostand improves product quality. This alternative isfrequently the most attrac tive to growing indus-tries. However, in the four subjec t industries, this


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26 Industrial Energy Use

choice is less attractive because a new plant mustreplace an old plant, with all the attendant lossesof jobs, established ways of doing things, andeven capital writeoffs if the old plant has not beenfully deprec iated. Curiously, new construction isattractive in the steel industry, which is experi-

encing the greatest overall decline in total domes-tic output. It occurs there at the initiative of rel-atively new minim ill firms that reprocess scrapmetal. These new firms are growing at the ex-pense of older, established steelmaker.

Product Shift

Product shifts are unique to a given corpora-tion and quite idiosyncratic. Whether the man-agers of a company choose to invest in maintain-ing their existing capital stock, add new capaci-ty, or invest in entirely new product lines dependson how those managers view their industry. Partsof an industry may be more susceptible to com-

petition than others, or have higher costs or lowerreturns compared to other product lines in whicha firm could choose to invest.

Of all the factors that enter into a firms dec i-sion to invest, those that influenc e the twocategories of new capacity or product switching

are the most difficult about which to generalize. The managers of one firm may dec ide to stay witha product line or with an industry, while anothergroup of managers may decide to expand to an-other product line or industry. Once a firm makesthis type of evaluation, it locks itself into a par-ticular kind of capital spending pattern. For in-stance, a paper firm that decides to build a newpulpmill commits itself to 3 to 5 years of capitalexpenditures before a single dollar in increasedsales or increased net profits attributable to thatinvestment is realized . This situation dramatical-ly affects the size of the capital pool available forother projects.

STRATEGIC PLANNING There are as many strategic plans as there are

corporations because each c orporation has itsown proc edures for strategic planning. For thepurpose of this report, simple generalizations aregiven to illustrate commonalities.

Strategic plans tend to have a framework of 5to 10 years, but are revised annually. Often, thechief executive officer devotes most of his atten-tion to strategic planning. Such plans invariablyidentify the markets and the products that aremost important to the company and direct man-agements attention to strengthening the mostpromising of these.

In a simplified strategic plan, business sec torsare ranked, and often individual factories withina corporation are ranked. Most of managementsinterest, and most of the money for new invest-ment, goes into highly ranked fac tories in highlyranked business sectors. A facility ranked low onboth scales has little hope of acquiring new in-vestment capital.

Strategic plans are based primarily on the as-sumption that a firm is operating in a normalbusiness environment and is not prone to drastic

fluctuations in commodity and raw materialprices, labor, interest rates, or other precipitouschanges that cannot be anticipated. Therefore,in order for the strategic plan to work, the en-vironment must be relatively stable. Althoughmanagements go to great pains to attempt toforecast disturbances in a worldwide environ-

ment, where factors ranging from political unrestto large changes in government policies takeplace, sometimes firms are surprised by unfore-seen events and strategic plans break down. Forexample, overnight, the U.S. car industry becameextremely vulnerable to the J ap anese small-carimport, a situation almost entirely due to eventsthat took place in Iran in 1979 and to the subse-quent 300- to 40()-percent increase in world oilprices. The American car industry obviouslycould not have planned in the mid-l 970s for therevolution in Iran.

Similarly, the whole infrastructure of the hous-ing industry, from the basic forest products in-dustry to the savings and loan bank mechanismsthat finance it, has matured and grown on thebasis of relatively low interest rates. The dramaticrise in interest rates in the late 1970s caused va st


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Ch. 2 The Industrial Sector: Growth, Trends, and Investment Behavior 27

dislocations to the market that could not possiblyhave been foreseen by the strategic planner of a forest products company planting trees 20 yearsago, or by a mortgage broker planning his loanstrategies in the 1960s.

Factors That InfluenceInvestment Decisions

Fiduc iary responsibilities strongly influenc emanagement thinking. The first and possibly themost overriding factor when dealing with invest-ments is management confidence. In this context,the word confidence does not describe man-agements own view of its abilities, but describesinstead managements perspective of all the rele-vant factors that make up and influence itsenterprise.

Management must be confident, for example,that its investments are going to bear fruit. it ismore likely to invest when it is confident that themarket for its companys products is growing, orthat the company can capture a larger share of the market, or that the general economic climateis improving. This confidence has a major impacton how management views the risks associatedwith an investment. As the confidence factorgrows, the impact of a risk factor is minimized.

Furthermore, management must demonstrateto the financ ial marketplace that the companyis financially sound and that its investmentstrategies and policies are well thought out. [t isnot uncommon for the chief executive officerand/or his designated appointees to expend timeand effort explaining these plans and strategies,not only to their immediate bankers, but also toWall Street analysts, brokerage houses, andothers in order to assure the dec ision ma kers incapital markets that money raised and invest-ments made are prudently managed.

The four industries examined for this reportidentified five fac tors that affec t their strategicdecisionmaking: product demand, competition,cost of capital and size of capital pool, cost of materials and labor, and general economic en-vironment and Government policy.

Product Demand

Demand for primary industrial commodities de-pends on the general level of economic activityi.e., the GNP. When the economy is growingsteadily and existing capacity is fully operating,profits that depend critically on capacity factorsare generally high, investment capital is generatedinternally, and new energy technologies can beadopted as soon as they become profitable. Onthe other hand, when the economy is stagnantor depressed, low-capacity utilization leads to lowprofits and curtailed investment. So even if en-ergy-related profits have calculated a return oninvestment well in excess of normal corporatehurdle rates, they may not be implemented.

The generally accepted opinion seems to bethat market opportunities for U.S. suppliers of basic industrial commodities are below average.

Despite many uncertainties, analysis suggests thatthe advanced industrial economy is gradually sat-urating markets for durable manufactures andconstruction and moving into higher and softerareas of technology, such as semiconductor-based computation and communication. For ex-ample, in the steel and petroleum refining in-dustries, more production capacity is now inplace than is required for the next 5 years. In1982, the steel industry used less than half itscapacity. As long as the economy is sluggish fromhigh interest rates, unemployment, and inflation,the steel industry will not use muc h of that ex-cess produc tion c apability. In add ition, with therecent U.S. recession, fewer durable goods, suchas refrigerators and washing mac hines, are be-ing sold, and some goods that are sold tend tobe made of less steel.

The overcapac ity (a lmost 30 percent) of pe tro-leum refining in the United States, is due in partto the high market price of the fuels produc edwhich has in turn led to fuel conservation, theuse of more fuel-efficient autos, and the switchfrom fuel oil to natural gas in residential heating.In both the steel and petroleum refining indus-

tries, then, it is clear that major new capacity ex-pansions will not be undertaken. The existing ca-pacity, although not as efficient as it could be,


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28 Industrial Energy u s e

will provide sufficient steel, petroleum, andassociated products to meet anticipated growth.

In the paper industry, demand is forecasted togrow at 2.5 percent per year, given a GNP growthrate of about the same percentage. This an-ticipated growth is sufficient to encouragemanagers to plan for new capacity, although itwould not be the only factor they would con-sider.

The chemicals industry expec ts product de-mand growth that exceeds that of paper and acontinued ability to export products outside theUnited States. Because the chemicals industry hasmore product flexibility than do the other in-dustries discussed so far, it can be expected toadd new capacity on the basis of anticipated mar-ket growth, although, again, this would not bethe only factor considered.

Competition

Perception of competition also exerts an in-fluence on investment decisions. There are twotypes of competition: a technological one withinan industry and market competition, both localand foreign. Although it is beyond the scope of this report to examine the competitive quality of products made by the four subject industries, thereport does identify within each of the industry-specific chapters, new technologies in whichthese industries will most likely invest in the next

two decades to help maintain or improve theircompetitive positions.

Two of the subject industries face severe marketcompetition from foreign c ompanies. The steelindustry has initiated suits with the International

Trade Commission, alleging that foreign produc-ers make steel that is subsidized by their respec-tive state governments. The subsidized steelis then sold in the United States at prices lowerthan that of domestic steel. The U.S. producersfeel that an unfair advantage is ac corded EastAsian and Western European manufac turers bytheir governments in order to sell steel in the U.S.market. The reasons for the alleged subsidizationseem clear: the desire for high employment andthe need to develop or maintain a heavy indus-trial base by each country. Such subsidization

raises major questions about U.S. dependenceon foreign sources for ba sic industrial materials.

In the chemicals industry, the United Statesfaces external competition, but of a different type.C hemica l manufac turers in the United States al-ready have a large share of the overseas chem-icals market. Foreign producers claim that theUnited States subsidizes chemicals production byartificially keeping feedstock (specifically, naturalgas) prices low through controlled prices. Asnatural gas prices are decontrolled in the UnitedStates, the $12 billion balance-of-payments sur-plus generated by the chemicals industry in 1981will be reduced as foreign producers take awayforeign markets formerly dominated by theUnited States.

The paper industry does not ap pear to face im-minent foreign market competition, except per-

haps from Canada. Petroleum refining should alsobe free of c ompetition. In both c ases, transpor-tation c osts should limit intrusion by foreignproducers.

In generaI, exports of primary industrial c om-modities are unlikely to sustain U.S. industrygrowth because developing nations typically em-phasize relatively low-tec hnology industries first,making such commodities highly competitive ininternational trade.

Cost of Capital and Size of Capital Pool

Money to be used for capital expenditures canarise from several different sources. The majorsources are debt, equity, and retained earnings.Corporation managers view their money as a re-source that could be invested in any of the fourproject categories (e.g., equipment retrofits) orin some type of revenue-earning ac count. Anyreturns from capital investment, in theory, mustexceed the interest return of possible bank de-posits. The more funds a corporation must bor-row from commercial sources to finance its cap-ital projec ts, the more profitable a project must

be .Corporations derive their funds for capital from

a number of internal and external sources. Inter-nal sources include: retained earnings or money


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Ch. 2The Industrial Sector: Growth, Trends, and Investment Behavior 2 9

remaining after the costs of production are paid,the delay in paying corporate taxes, and theclaiming of tax credits. External sources includeborrowing money and paying interest, or equi-ty, and selling ownership (stock) in the company.

Many firms try to mantain a specific debt-equity

ratio in order to avail themselves of particuIarfinancial sources. If a firm is already at or nearits desired debt-equity limit (usually about 35 per-cent), borrowing ability can be severely con-strained. The only way to alleviate this problemwould be to issue more stock. However, if thecompany cannot purchase the stock at an ade-quate price, because of poor returns, the size of the company capital pool cannot be expanded.

In the steel industry, with its low c apital returnand its need to finance from debt sources, highinterest costs of capital restrict the ability to in-

vest in energy saving or any other kinds of proj-ec ts. The other three industries also find them-selves constrained by the cost of capital, but forthem it is but one of the capital allocation deci-sion factors.

interest rates also impact these industries inother ways. When interest rates are high, con-sumer sales are restricted; then, consumer goodsthat use products from the chemicals, steel, andwood products industries do not sell rapidly.

Thus, firms may not invest in many tec hnologiesthat would save energy, either because they donot expect sales volumes large enough to returna profit on the new outlays or because they sim-ply cannot raise the money, no matter how prof-itable an investment might be. High interest ratesalso give firms that have traditionally producedprimary commod ities at least a strong positive in-centive to diversify. Diversification can occur byvertical integration downstream into more fin-ished products that generally offer larger profitmargins. Also, a firm might engage in an entirelydifferent industry by acquiring another company.

Cost of Materials and Labor

Individual firms in particular industries competewith one another to purchase raw materials andenergy at the lowest levels of cost possible, a goalthat affects both day-to-day operations and stra-tegic planning. Management can compete by in-

vesting in projec ts that minimize the c ost of pro-duc tion by minimizing labor or by substitutingone material for another (or using it more effi-ciently). process controls and automation can of-fer a company significant cost savings through im-proved quality controli,e., more efficient useof materialand labor savings. Such changesplace more demand on corporation managers touse their employees more productively and oftenrequire employee retraining.

From a raw materials standpoint, apart from theprice of the raw materials, large and mature com-panies in the industries discussed also see securityof supply as a major problem that couId affectboth their fiduc iary respo nsibilities and their com-petitiveness in the marketplace. If, for example,during the time of a fuel embargo, a companyhas to tell its customers that it cannot supply thembecause its plants are shut down from lack of energy, it might very well lose those customersforever to a company that can supply them.

Therefore, it is not unusual for firms to couplethese two factors, price and security of supply,into one strategic decision. For instanc e, a steelcompany may choose to own iron ore and coalresources or a paper products company maychoose to own forests and timberland.

General Economic Environment andGovernment Policy

Obviously, management is concerned not onlywith the immediate environment within its owncompany a nd industry, but also within the gen-eral economic environment. In the large, multina-tional firms, this concern has both national andinternational ramifications. The factors that affecteconomic outlook are therefore very importantto management and vitally affect investment deci-sions, inc luding the obvious c riteria i. e., interestrates, inflation rates, GNP, and the like.

In the larger corporations, such factors couldinclude international trade agreements, Euro-dollar and J apanese interest rates, and interna-tional labor rates. It must also be considered thatthe international competitor could, in fact, begovernment owned and subsidized in terms of interest rates, research and developing backing,subsidized pricing of the product, and so forth.


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Such backing may be carried out in the nationalinterest to the extent that the fiduciary respon-sibility to operate the company at a profit is great-ly diminished.

Government regulations or taxes that unnatu-rally tip the balance of the marketplace are con-

sidered extremely detrimental by industry. For ex-ample, if a Btu tax were applied to oil, the non-integrated papermill would be at a severe disad-vantage with an integrated papermill because theintegrated papermill can use wood waste, blackliquor, and other materials to meet its fuel re-quirements. These resources are unavailable tothe nonintegrated mill.

Conversely, pollution legislation that appliesequally to all companies can be viewed by in-dustry as a pass-through that does not alter thecompanys competitive position. However, in to-

days marketplace, pollution legislation that is ap-plied in the United States, but not equally appliedin other industrialized countries, could be con-sidered detrimental to U.S. manufacturers be-cause it upsets the competition balance of theworldwide marketplace.

Finally, the perception of Government policyaffects strategic planning. Changing policies, in-definite polic ies, and polic ies whose provisionstake a long time to effect can play havoc withan industrys strategic planning. For instance, oneproblem with energy investment tax credits is thatit often takes 6 months to 1 year to determineif a project will qualify for the credit. The sug-gestion heard time and again in case study visitsand workshops was to avoid changing policy.With respect to natural gas deregulation, mana-gers said that, by far, the best policy for theGovernment to pursue was to fix a definite datefor deregulation (as has been done) and then toallow sufficient time for the corporation to reactto the anticipated price increase.

Levels of Decisionmaking

The responsibility for assessing and minimiz-ing risks falls on all levels throughout the corpora-tion. In most major corporations, those respon-sibilities are clearly defined. Examples of the prov-inces of risk decision making are given below.However, it must be emphasized that each in-

dividua l corporation would have its own criteriaand decision making levels that may be differentfrom those given.

Senior Management

Ensuring the security of energy, material, and

labor supplies in a strategic plan is a pivotal aspectof risk reduction for senior management. For ex-ample, often the site of a new plant is chosenbecause of the perception that it will ensure asecure labor or materials supply. In addition, ef-forts invested in better employee/management re-lations make a major contribution to risk min-imization by avoiding potential strikes in whichlosses of bo th profits and wages would be high.

Upper/Middle Management

Upper and middle management play an ex-tremely detailed and comprehensive role in riskmanagement. At this level proposed investmentsthat are compatible with the corporations stra-tegic plan are reviewed and selected for approvalbefore the commitment of funds is made.

Innovations in new energy-saving processesface a series of hurdles pertaining to risk. Oneof the greatest of these is skepticism aboutwhether they will actually work as well as theyare supposed to. Most companies are reluctantto be the first to try out a new idea. * The managerwho accepts an unproven innovation and com-mits his production line to it reaches for a possi-ble incremental gain on the upside, but may facea total shutdown on the downside. The managerof another mill, who waits to see how his com-petitor fares, suffers none of the costs of debug-ging a new idea and generally loses less than ayear in catching up if the new idea works. In fast-moving fields like genetics, pharmaceuticals, andcomputers, a year can be devastating; but inpa per, steel, or energy-intensive chemicals, itmakes little difference.

*This reluctance on the part of business leaders was recognizedby the Energy Research and Development Administration (prede-cessor to DOE) in 1976. Subsequently, the Office of Industrial Pro-grams within DOE focused its industrial energy conservation pro-gram on full-scale demonstrations of new technologies.


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may never be c losed. It is, instead, insuranc eundertaken purely to meet fiduciary responsibilityand reduce risk. Of course, if an interruption doestake place, the investment becomes very worth-while indeed.

Finally, an example of a long-term considera-tion would be a forest products company buy-ing woodlands or planting trees, or a steel com-pany purchasing iron ore mines and ore-bearingrights. Again, there is a fiduc iary responsibilityassociated with this type of investment, togetherwith the minimization of risk that comes fromprotecting raw material supplies into the future.However, such long-term investments would takesecond place to short-term considerations asso-ciated with cash flow.

Investment Levels Within the Strategic Plan

Investments can be considered as falling intotwo broad levels of priorities. In the first level areshort-term demands that enable the company tomeet its fiduciary responsibilities on a day-to-daybasis, for example, meeting payroll. Althoughthese investments can be categorized as man-datory, decisions assoc iated with them a re stillvery much part of the strategic plan and involvediscrete management judgments. For example,a decision to reduce a skilled labor force or ac -cept a small market share by shedding marginaloperations in order to protect cash flow in theshort term could seriously jeopardize the com-pa nys growth in the future if its market positionimproved. The company may not be able to re-capture easily the skilled labor force or the marketshare it lost.

The sec ond level of investments, categorizedas discretionary, are made after mandatory in-vestments. They a re chosen from a list of alter-natives and are subjected to various criteria of evaluation, from technical scrutiny to rigorousfinancial analysis. Investments in energy conser-vation fall into this category when they a re partof the overall strategic plan, most often under the

disc retiona ry investments assoc iated with costcutting.

The importance of cost cutting within a plandepends on the overall ec onomic c limate andhealth of the company. In general, cost cutting

that does not involve capital outlay is alwayswelcome. Energy conservation that often falls inthe subcategory of cost cutting is housekeeping.

Cost cutting is usually a very low, if not thelowest, level of priority within the overall plan,particularly when capital outlays are involved.

Therefore, Government tax policiese.g., di-rected energy investment tax credits that attemptto influence the outcome of industrial investmentanalysisonly come into play at the lowest levelof corporate strategy. The major decisions asso-ciated with an investment are based on other as-pects which, from managements point of view,are infinitely more important.

Financial Analysis

All corporations have extremely sophisticatedmethods for carrying out financ ial ana lyses, usingcertain accepted financial and accounting prac-tices. Each c orporation has its own criteria thatreflect its basic mana gement style and philoso-phy. Once a dec ision to proceed on an invest-ment has been made, a detailed investment anal-ysis, including returns on investment, discountedcash flow, and tax and depreciation implicationsis undertaken. Although these implications wereconsidered in the formative stages of planning,their specific importance was not quantified indetail until the decision to proceed was made.However, and most important, these implications

are not expected to make any material differenceto the decision. For example, an energy tax crediton a very small percentage of a multimillion dollarinvestment would have negligible impact on thedec ision to undertake the project. A c hange indepreciation rates that alters cash flow would playa larger role, but again would be unlikely toreverse the decision. However, a large increasein interest rates or a perceived downturn in themarket could abort the project immediately.

Any c ap ital investment requires money to bespent at the front and before any revenue streamcan be generated from the investment. Becausethese investments generate returns over longperiods of time, methodologies have been devel-oped to c alculate ac curately the returns on in-vestment, from a projects conception to the endof its useful life. These methodologies consider


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Ch. 2The Industrial Sector: Growth, Trends, and Investment Behavior 33

inflation rates, depreciation rates, cost of money,and so forth, and produce calculations that a t-tempt to predict cash flow and the returns on in-vestment over the lifetime of the projec t.

Methodologies of varying complexity are oftenused within a corporation when evaluating in-

vestments. These methodologies calculate suchparameters as simple payback period, net pres-ent value, internal rate of return, equivalent rateof return, and profitability index. In choosingwhich parameter to calculate, corporations reflectboth the management style and accounting prac-tices that are compatible with the operation of their business. Each parameter is described brieflybelow.

SIMPLE PAYBACK PERIOD

The simplest estimate of profitab ility is obtained

by taking the initial capital cost and dividing itby the positive c ash flow in the first full year of operation. For typical projects, this gives a num-ber between 1 and 10, which is called the sim-ple payback period. For example, a $1.2 millioninvestment which returns $400,000 per yea rpays back the original investment in 3 years.

NET PRESENT VALUE

When the sophistication of the analysis is in-creased, two steps are taken. First, the impact of depreciation and taxes are included becauseafter-tax dollars are important factors in determin-ing corporate cash flow. Second, future streamsof income are discounted to recognize the greatervalue of a present over a future dollar.

The effect of the resultant net present valuecalculation is to produce a number that reflectsthe dollar value of the specific project to a com-pany, compared to the value of the money usedto undertake that same project if that money wereinvested.

INTERNAL RATE OF RETURN

For most projects where the cash flow is nega-tive at first and positive later, there exists a dis-count or interest rate such that net present valueis zeroe.g., such that the initial capital outlaysexactly balance the later profits, The interest rateat that point, called the internal rate of return

(lRR), can be looked on as the interest rate atwhich money is returned to the company for thedollars invested in the capital project.

PROFITABILITY INDEX

One indication of the profitability of a project

is made by comparing the capital outlay of moneyto a project and the revenue stream of moneyfrom a project, discounted back to the present.

The ratio of the two dollar va lues is the profitabili-ty index.

Comparison of Methods

These sophisticated analysis techniques and thewide variety of capital formation opportunitiesopen to industry are designed both to assess ac-curately the profitability of the investments andto facilitate their financing. By varying the dif-ferent parameters, some of the risk involved canbe assessed, that is, various interest rates or in-flation rates could be examined in order to ascer-tain the potential vulnerability of the investmentsto c hanges in external fac tors.

The choice of methods used to ca lculate thevalue of a capital investment reflects the manage-ment style of and within a corporation. It is notunusual for the energy engineering departmentto assess a project in simple payback terms whilethe finance department takes the engineering cal-culations and applies the more sophisticated tech-niques used by the corporation.

For the purposes of this study, OTA has se-lected the IRR method for most of its calculations.IRR has the advantage that it lets each projectstand alone, unencumbered by the choice of cor-porate discount rate within any firm. The indus-try-specific and general investment opportunitiesdiscussed in later chapters are evaluated quan-titatively using the IRR. The impact of the legis-lative options on investment decisions concern-ing specific projects can be seen quite well usingthe IRR.

The financ ial assessment is not the final assess-ment undertaken, however, particularly wheremajor projects are concerned. Sensitivity analysis,which takes into account all other factorsfromR&D to final market potentialcan also havemajor impac ts on the success of investments,


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Sensitivity Analysis and Its Effects

A number of hypothetical investments werecarried out by OTA and shown to industrial man-agers at case study firms in each of the four in-dustries. Upon seeing the results, they cautionedOTA not to take return on investment calcula-

tions too seriously. The fa c t that an initial10-percent tax credit changed the after-tax IRRby 6 percentage points was not considered per-suasive enough to induce investment in a project.

In order to understand this position more fully,further calculations were carried out, incorporat-ing parameters that couId be considered uncon-trollable by a c orporation. This simple sensitivi-ty analysis was applied to a process control sys-tem

ing:

1.

2.

3.

4.

5.

project using five simple variations, includ-

negotiating a small change in the vendorscentract,incurring unexpected repair costs equivalentto 10 percent of the investment,experiencing a recession during the lifetimeof the project,achieving a performance rate of only 90 per-cent of what was expected, andhaving prices held down by competition, asshown in table 5.

The results of these ana lyses, compared to theeffect of a 10-percent energy investment tax cred-

Table 5.Sensitivity Analysis of Internal Rate ofReturn (IRR) Under Different Scenarios a

for Computer Process Control System

Condition After-tax IRR1. Base Case. . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.42. Vendor escalates service contract . . . . . . . 15.33. Unexpected repair cost in year 4 . . . . . . . . 14.8

4. Recession in midlife of project . . . . . . . . . 13.15. Profits only 900/0 of expectations. . . . . . . . 12.36. Prices held down by competition . . . . . . . . 10.47. Addition of a IO% EITC . . . . . . . . . . . . . . . . 21.5alnvariant conditions:

Project: Installation of Computer Process Control SystemProject lifetime = 7 yearsInflation rate = 6 percent10 percent Investment tax creditACRS depreciation schedule

SOURCE Office of Technology Assessment

it (EITC), indicate that external factors such as

those listed above can have as dramatic an ef-fec t on the potential profit derived from a cap italproject as that of a 10-percent EITC. OTA calcula-tions show that a mild recession can cause a cap-ital project IRR to shift 3 percentage pointsi. e.,to fall from 16.4 to 13.1 percent. On the otherhand, a 10-percent EITC would cause the IRR toshift upward by only 5 points; for example, from16.4 to 21.5 percent, which may in part explainwhy aversion of risk and anticipated energy pricesdrive project decisionmaking more than do taxcredits and other Government policies.

Documents

Chapter 2 Industrial Growth Trends