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Celulosa Arauco is a Chile-based producer of pulp sold on open market and wood products. As one of the largest producers of pulp market, it is looking into heightening its capacity. It has undergone the first phase of the project which includes a sawmill, plywood mill, and energy complex. Presently, Arauco's president and CEO Alejandro Perez is looking forward to the second phase of the project, which would include the company's sixth market pulp plant. The company has plunged into a variety of wood products like panels, medium-density fiberboard, and other remanufactured wood products contributing to about 50% of Arauco's income. Now, Perez is considering forward integration into the paper business or increasing the company's capacity in market pulp.
Ramon Casadesus-Masanell; Jorge Tarzijan; Jordan Mitchell
Harvard Business Review (705474-PDF-ENG)
February 15, 2005
Case questions answered:
- Compute the quasi-rents, that is the additional profit for both parties of the relationship between the pulp mill and its closely located plantations (50% of pulp mill capacity) for the Alto Paraná operations over what the pulp mill and the closely located plantations could achieve in terms of profits if they did not trade with each other and instead each party had to trade with its respective second-best option. You may ignore loading costs and assume that there are no quality differences from using different suppliers.
- How is each party’s profit in the relationship affected by their outside options? Should Arauco own both forests and pulp production facilities? How would you graphically communicate the result to an audience?
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Case answers for Arauco (A): Forward Integration or Horizontal Expansion?
Arauco acquired Alto Parana in 1996 as an entry into Argentina with the biggest pulp mill in the country and plantations.
Currently, Alto Parana has a maximum capacity in its pulp mill of 350,000 tons and its current production is 323,000 tons, equalling 92.3% of capacity – a value nearly equal to the minimum efficient scale (MES, achieved around 95% utilization). The Alto Parana site also has a plantation spanning 173,000 hectares, yet only half of the available land is planted (86,500 hectares). This plantation is able to meet 50% of the raw material required for the pulp manufacturing mill and assuming a 1:1 ratio between raw material and pulp, the in-house plantation capacity is 161,500.
The other 50% of the required input material used to meet the current capacity/demand is sourced externally from third-party vendors, with the closest in Corrientes (one of the main forestry zones of Argentina), located 300 kilometers from Alto Parana. In the pulp manufacturing industry in Argentina where proximity to suppliers plays a key role, this relatively close proximity of supply creates a huge competitive advantage for Alto Parana.
An alternative supply chain option for Alto Parana is to source all the raw material required for its pulp production from external vendors and sell off the raw material produced through the company-owned plantation to other external manufacturers. Considering 86,500 hectares of in-house plantation provides 161,500 tons of raw material, the Corrientes plantation – which includes 188,000 hectares of land – would be able to handle Alto Parana’s raw material demand of 323,000 tons. The possible alternative supply options are diagrammed in Exhibit 1.
Because this is a commodity market, it can be assumed that the purchasing power and selling power for the raw material is roughly the same; in this case, $300/ton for both suppliers and buyers. Currently, the costs incurred by Arauco include a raw material cost of $300/ton from its own plantation as well as a cost of $300/ton plus transportation costs from the importation of material from Corrientes. Therefore, as calculated in Exhibit 2.2, the total cost for the current setup comes to…
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