Ferric Processing*

Richard Hansen, who is working as the Assistant to the General Manager of Ferric
Processing was preparing his presentation for the upcoming Executive Committee meeting.
He intended to present the results of a cost study that he recently conducted, and propose a
new way of predicting costs for prospective plant sites. In addition, he wanted to suggest
several possible extensions of his study, which he felt would help the company better
understand their long-run costs, and the way these costs were influenced by several key
factors.

Company Background
Ferric Processing was a relatively new subsidiary of the Metzger Machinery Company. It
was organised in 1995 to capitalise upon a newly patented process for recovering iron from
the waste slag of steel mills. In the past eight years, Ferric had built ten new slag-processing
plants, and compiled an enviable record of both sales and earnings growth.

As a largely unwanted by-product of steelmaking, either in the rather old-fashioned open-

hearth furnace, or in the modern basic-oxygen process, quantities of slag are produced. This
slag contains small amounts of iron and iron oxides, which could be potentially valuable if
they could be economically recovered from the slag. Several steel companies had
experimented with recovery processes, which re-cycled the recovered iron back into the
steelmaking process, but these processes seemed to be of doubtful quality.

In the late 1980’s, an executive of the Metzger Machinery Company who was familiar with
the steel industry developed and patented a new process for this recovery, which promised
great potential. Basically, the slag was carried along conveyor belts through a continuous

*
The original version of this case was created at the London Business School. It is based on an existing problem situation
and is used as the basis for class discussion rather than to illustrate either effective or ineffective handling of an
administrative situation.
cycle of alternating crushers, magnets, and screens. The crushers broke the slag into
smaller and smaller pieces, the magnets recovered the iron, and the screens sorted the
remaining slag with a very low iron content into various particle sizes, which could be used
for other industrial purposes.

Once the patents for the process seemed secure, the Metzger Machinery Company formed
a new subsidiary named Ferric Processing Inc., and negotiated contracts for two of these
slag-processing plants. Although there were many unexpected problems in the initial break-
in period of about two years, these plants were eventually very successful. They were
followed in succeeding years by eight other plants, all of a similar design, but modified
slightly because of Ferric’s experience with earlier plants.

In every instance, Ferric’s plants processed the slag from a particular steel mill, and each of
the plants was located as close as possible (usually within five or ten miles) to the steel mill
that it served. Ferric’s men and equipment would be used to dig the slag from the deposits,
and load it into large heavy duty trucks. These trucks would deliver it to the in-take conveyor
at Ferric’s plant, where it would be fed into the recovery process. After processing, the
recovered iron would be returned to the steel mill to be re-used, and the remaining slag
would be returned to the steel mill. Ferric Processing was paid a flat processing charge per
ton of slag it handled, and this fee was always negotiated at the time the original contract
with the steel company was signed. Generally, a rather lengthy series of negotiations
preceded the decisions to build any new plant. As the final outcome of these negotiations,
the steel company and Ferric would agree upon a contract covering at least three to five
years, which stipulated both the processing charge per ton and several minimum guarantees
to Ferric in terms of total tonnage processed. After the contract, Ferric would begin
constructing the new plant, whose capacity was matched to the size of the particular steel
mill.

Over the years, Ferric had attempted to make sure that the negotiated rate per ton was high
enough to cover all their expenses, including labour, transportation, depreciation of the
capital equipment, etc. They found however, that on several of their plants they had
seriously underestimated the total processing cost per ton, and in several instances they had
renegotiated a second contract at higher rates after the first contract expired. On the other
hand, they also had overestimated these costs in several plant locations that were not
producing efficiently at cost/ton rates significantly below the negotiated processing charge.
The Cost Study
Currently, Ferric was considering three additional plant sites, and in one case negotiations
were proceeding rapidly to a final agreement. Because the difference between the
negotiated charge per ton and the average processing costs per ton was the critical variable
for Ferric’s profitability, it was important to estimate future processing costs early in the
stages of negotiation for each prospective plant site.

Ferric’s management had, on several earlier occasions, asked its industrial engineer to
provide detailed cost estimates for various parts of their overall process. Based upon the
auditing of an individual plant’s cost records and time-and-motion studies of various
functions within the plant, these studies had provided what was considered to be a very
detailed and accurate breakdown of all costs within a plant, as well as some suggestions for
cost reduction. On the whole, however, they did not provide an adequate comparison of
costs across different plants; and it was very difficult to extrapolate cost estimates for a new
plant from them.

In a recent discussion with the General Manager, his Assistant, Richard Hansen, had
volunteered to make a new kind of cost study. Mr. Hansen believed that some of the key
factors influencing Ferric’s costs were the economics of scale inherent in the different plant
sizes, and he believed that the effect of these economics of scale were acknowledged but
not well understood by top management.

Indeed, it seemed that there could be a substantial disagreement about the way plant size
affected total costs per ton, particularly among several of Ferric’s management group
responsible for making cost projections. This disagreement could be inferred from the
different cost estimates the executives had submitted for the smallest of three prospective
plant sites, although none of them had ever directly addressed the problem of economies of
scale as such. With the concurrence of the General Manager, Mr. Hansen set aside his other
duties for a day and concentrated upon this new study of average costs per ton across
different plants.

As the basic data for his study of costs, Mr. Hansen compiled a list of all of Ferric’s plants,
their processing capacity, and an estimate of their individual average costs/ton for the last
year. These data are shown in Table 1. The cost estimates were furnished by the
Controller’s office. The total yearly costs attributable to each plant, including all direct and
indirect labour, materials, transportation, depreciation of capital equipment, supervisors’
salaries, etc.., were already compiled as an important part of Ferric’s management control
system. These costs for last year, divided by the number of tons actually processed past
year by the plant, provided the average costs/ton figure which the Controller’s office
furnished.

Plant First Began Capacity Average Costs/Ton 1999

Operations (tons/month) ($)
1 1995 450 21.95
2 1995 250 27.18
3 1997 875 16.90
4 1998 1,000 15.37
5 1999 700 16.03
6 1999 750 18.15
7 2000 1,500 14.22
8 2001 550 18.72
9 2001 1,300 15.40
10 2002 950 14.69

Table 1. Plant Capacity and Cost Data

Looking at the list, Mr. Hansen became convinced that economies of scale were indeed
important, and he decided to study them in more detail. Intrigued with the progress of the
cost study, Mr. Hansen discussed the results in general terms with several managers in the
company. They were all quite interested, but many of them objected to drawing any
conclusions from studies across different plants. There were so many other important
differences from plant to plant, they argued, that it was very risky to draw conclusions using
only plant capacity as a discriminating factor. In particular, several of these managers
pointed out that the costs of hauling the slag between the steel mill and processing plant was
a major factor in Ferric’s overall costs. Because some of the plants were built adjacent to the
steel mills and others were up to ten miles away, the differences in transportation mileage
could cause major differences in total costs, which would be reflected in the average
costs/ton figures. Several plant managers argued that these differences could be seriously
distorting the results of Hansen’s cost study.

In addition, the manager of one of the older plants argued that the age of the plants could be
one of the principal determinants of costs. More recent plants included several modifications
made in light of previous plants’ experiences, and thus they tended to be larger, the
increased efficiency of the later plants could be distorting the results of the cost study.
Furthermore, the older plants might well have higher maintenance costs, although the newer
plants might have initially higher costs before management could get the “bugs” shaken out
of the processing unit. The manager of one of the older plants was concerned that Hansen’s
study was overlooking these possible effects.

Richard Hansen sat down to prepare brief presentation of his results for the forthcoming
Executive Committee. He wanted to briefly summarise and interpret the results, and discuss
possible problems with the interpretation. He also wanted to suggest several extensions of
the study, which he felt would help management better understand their average costs, and
the way these costs were related to various key factors.