Dealing With Customer Contracts in a Period of Declining Prices
By Mitch Klingher
May 18, 2023
More and more customers are compelling converters to enter into contractual commitments. The contracts can contain clauses about inventory levels, delivery commitments, volume rebates, and various other terms. However, all contain some sort of mechanism to adjust prices when the published price of containerboard moves. The more sophisticated buyers want to have some certainty about what will happen to their packaging prices when the price of the basic raw material—paper—changes. Our larger integrated brothers, which tend to deal with larger companies, have had a large part of their output under contract for many years, and this trend has been accelerating rapidly in the realm of the independent converter for the past 10 years or so. Let’s spend a little time analyzing the financial aspects of the pricing mechanisms of these contracts.
First, we need to understand that paper in general is purchased by the ton and packaging sold by the square foot. So, to understand how to convert paper price changes to packaging, we need to understand the concept of basis weight. Basis weight is simply how many pounds per thousand square feet the paper weighs. For example, containerboard with a basis weight of 42 means that 1,000 square feet of this paper weighs 42 pounds. Pretty simple, right? Where it gets a little more complicated is that corrugated board is a combination of two layers of flat linerboard paper and one layer of fluted medium paper, and the size of the flute varies with each grade of board and each machine used to combine the board. This is called the take-up factor. So, B flute uses more medium than E flute, and older machines use slightly more paper in the process than more modern machines.
Without trying to make this too complicated, in order to craft reasonable pricing mechanisms in a customer contract, we need to have a sense of how heavy the packaging we are selling is. The most common grade of combined board is ECT 32, which is often made using 33-pound liner board and 23-pound medium board. C-fluted board on a modern machine will generally have a take-up factor of 1.45/1, so the calculation for the weight of ECT 32 board made this way would be:
(33 lbs. + 33 lbs. + (23 lbs. x 1.45)) = 99 lbs./msf (thousand square feet)
In order to make the following calculations easier, we will round this off to 100 and make the assumption that ECT 32 board has a basis weight of 100 (lbs./msf).
The next part of the puzzle involves converting dollars per ton to dollars per msf, and the formula for this conversion is as follows:
($/ton x lbs./msf)/2000 (lbs./ton) = $/msf
Therefore, if the price of paper drops $50/ton, and you are selling your customer packaging that has a basis weight of 100, then the change in the raw cost of paper is (($50/ton x 100 lbs./msf)/2000 lbs./ton) $2.50 per msf. If you are running your own corrugator, then these calculations are real and second nature to you. If you are a sheet plant purchasing sheets, the pass-through of the paper decrease may vary from these calculations, but you need to understand them in order to negotiate a reasonable deal with your supplier.
Your customer probably doesn’t fully understand these concepts and is trying to somehow extrapolate between the percent change in the price of containerboard to their packaging. The waters are muddied even further by how you approached prior increases or decreases with them and your need to recoup nonpaper costs in these inflationary times. Notwithstanding any of this, you need to have the following information before you begin to negotiate these kinds of terms with a customer:
- What is the average basis weight of the packaging you are selling that customer?
- What will your cost of sheets be before and after the published change in the price of paper?
- What is the current sales price per msf of the packaging you are selling this customer?
If you know these three things, then you can compute what percentage price change to this customer would be “neutral” to your existing material margins. Let’s look at a hypothetical example.
You have a customer whose average sales price per msf is $100, and you are selling them board that has an average basis weight of 120 lbs. If the price of paper goes down $50/ton, then to break even, the sales price of their packaging needs to go down by 3%. The calculation would be as follows:
($50/ton x 120 lbs./msf)/2000 lbs./ton = $3/msf
So, if your material cost is going down by $3/msf, and the current sales price is $100/msf, then you need to reduce your price by $3, which is 3% of the current sales price to maintain your existing material margin. As you can see, both the concepts and the math are fairly simple.
From November 2020 to March 2022, the published price of linerboard went from $765/ton to $935/ton—a 22% increase. From November 2022 to February 2023, the price has come down $70/ton to $865/ton—a 7.5% decrease. As I stated earlier, larger integrated companies have a longer history of using customer contracts, and a larger portion of their business in general is tied to customer contracts. The other thing we know about the integrated companies is that they ship more footage than independent converters do and generally sell it for a lower price per msf. Mill-based companies are more concerned with selling their mill output because it is enormously profitable and trying to set up extremely high yield plants that maximize throughput. Independent converters generally do more of the business that requires multiple machines, handwork, inventorying of goods, and tighter delivery times, and consequently, they charge more for their output. So, a pricing factor in an integrated customer’s contract probably needs to be higher than the same factor in an independent customer’s contract.
This is precisely where the problem arises. Customer A is doing business with a large integrated company for most of its packaging needs but also buys some packaging regionally from some independent converters. Their contracts with the integrated company call for 1.5% change in price for every $20/ton change in the price of paper. That may be an entirely appropriate percentage for the contract with the integrated producer, but when applied to the independent producer’s pricing, it will yield way too much gain when prices rise and way too much loss when prices drop. Let’s stay with our hypothetical customer and his $100/msf sales price and 120-pound basis weight. And let’s say that the same customer is doing a bunch of high-volume business with an integrated producer at $60/msf. Both integrated and independent producers have the same $3/msf change in the cost of paper. For the independent to create a neutral contract, the change in sales price needs to be 3% as we have already calculated. For the integrated company to craft a fair contract, the change for that $50/ton needs to be 5% ($60/msf x 5% = $3/msf).
What I have seen in my travels is that many independent companies have been using pricing adjustments based on contracts their customers had with larger integrated producers. To the customers, it seemed fair to have the same price adjustment mechanism in all of their packaging contracts. For the independent producers, this was a real moneymaker when the prices were going up and contributed to the stellar performance we have all noted in the past two years. Now that prices are going down, it could have a severely negative effect on many companies.
I strongly urge anyone who is entertaining doing a contract with a customer to think these pricing mechanism clauses through and do the basic math on basis weight, material costs, and overall sales price per msf. Unless you have a crystal ball and know which way paper prices will be moving over the contract term, try to craft a price that is neutral on margins and thus fair to both parties.
Mitch Klingher is owner of Klingher Nadler LLP. He can be reached at 201-731-3025 or email@example.com.