Case 007Sector economicsHard

Regional cement capacity rises 15% while demand grows 7%, and utilisation falls from 78% to about 73%. Rajvela Cement earns EBITDA of Rs 1,000 a tonne. What happens to price and EBITDA a tonne if producers cut price to hold share?

The situation

Rajvela Cement sells 10 million tonnes a year in one region at Rs 5,500 a tonne. Variable cost, mostly fuel, power, freight and raw material, is Rs 3,600 a tonne, and fixed costs are Rs 900 crore a year, Rs 900 a tonne at today's volume. EBITDA is Rs 1,000 a tonne, Rs 1,000 crore in all.

Next year, new plants raise regional capacity 15% and demand grows 7%, so utilisation falls from 78% to about 73%. Over the last eight years the region's price has moved with utilisation, and a line through those years rises about Rs 59 a tonne for each point of utilisation. Producers, including Rajvela, cut price to hold their share, so Rajvela's volume grows with demand.

Your task

What happens to the regional price, Rajvela's EBITDA a tonne and its total EBITDA, and why do analysts watch capacity more closely than demand?

Quick check

Rajvela sells 7% more tonnes. What happens to its total EBITDA?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Price falls about Rs 319 a tonne and Rajvela's EBITDA a tonne drops from Rs 1,000 to about Rs 740, so total EBITDA falls about 21% even on 7% more volume. Utilisation falls to 72.6% because supply grew faster than demand, and in a regional market with high fixed costs that sets the price. Demand growth was healthy; the damage came from capacity.

Step 1Why does utilisation, not demand, set the price?

Think of autorickshaws outside a railway station. If passengers grow 7% but rickshaws grow 15%, fares fall even though business is up, because each driver would rather take a lower fare than sit idle. Cement plants have high fixed costs and a product that is expensive to move far, so when a region's plants run below capacity, each producer cuts price to keep its kilns full. The ratio of supply to demand, utilisationProduction or sales as a share of installed capacity. A plant making 78 tonnes a year from capacity of 100 is at 78% utilisation., is the variable that moves price.

First the utilisation. Demand grows 7% and capacity 15%, so utilisation becomes 78% x 1.07 / 1.15, which is 72.6%, a fall of 5.4 points. At about Rs 59 a tonne per point, the regional price falls about Rs 319, to roughly Rs 5,181. The line is fitted to the region's own history, so say that it is a pattern, not a law: a price war can overshoot it, and discipline among a few large producers can hold price above it.

In a regional cement market, utilisation sets the price5,0005,2005,4005,6005,800Today: 78%, Rs 5,500After: 72.6%, about Rs 5,181Fitted: about Rs 59 a tonne per point70%74%78%82%86%Regional capacity utilisation; hollow dots are past years
Across eight past years, the region's cement price rose about Rs 59 a tonne for each point of utilisation; a fall from 78% to 72.6% utilisation moves the price from Rs 5,500 to about Rs 5,181 a tonne.
Step 2What happens to Rajvela's EBITDA a tonne and in total?

Two effects pull in opposite directions. The price cut takes about Rs 319 off every tonne. Selling 10.7 million tonnes instead of 10 spreads Rs 900 crore of fixed cost more thinly, from Rs 900 to Rs 841 a tonne, adding back about Rs 59. EBITDA a tonne falls from Rs 1,000 to about Rs 740, and total EBITDA from Rs 1,000 crore to about Rs 792 crore, a 21% fall.

EBITDA per tonne: the price cut is not offset by volume, Rs a tonne1,000Today-319Price cut+59Fixed cost spreadover 7% more tonnes740AfterEBITDA per tonne-26%
Rajvela's EBITDA per tonne falls from Rs 1,000 to about Rs 740: the price cut removes Rs 319 a tonne and spreading fixed costs over 7% more tonnes wins back only Rs 59.
Per tonne, RsTodayNext year
Price5,5005,181
Variable cost(3,600)(3,600)
Fixed cost per tonne(900)(841)
EBITDA a tonne1,000740
Volume, million tonnes10.010.7
EBITDA, Rs crore1,000792
Rajvela sells 7% more cement next year but earns about Rs 740 a tonne instead of Rs 1,000, so total EBITDA falls from Rs 1,000 crore to about Rs 792 crore.
Step 3Why do cement analysts track capacity more closely than demand?

Because demand moves a few points a year and capacity arrives in lumps. A 7% demand year is a good year, and it still produced a profit fall because 15% of capacity arrived at once. The recovery depends on the pipeline: with no new plants, 7% demand growth would take utilisation back to 78% in about 1.1 years; if another round of plants is under construction, the low-price period stretches. The research job is to list every announced plant in the region, with its start date, before forecasting a single price.

Where candidates lose it

The common mistake is to see 7% demand growth, multiply volume, and forecast higher EBITDA. That ignores the capacity side, which is the half of the question that moves price.

The second is to apply the price cut but forget the fixed cost benefit of higher volume, or the reverse. The interviewer wants both effects named and netted, with the price effect shown to dominate.

What the interviewer asks next

  • If Rajvela held its price and lost share instead, would its EBITDA be better or worse?
  • How many years of 7% demand growth does it take to return to 78% if capacity grows another 5% next year?
  • Why might a new entrant cut price harder than the incumbents?
  • How would you value Rajvela at the bottom of this cycle?

Company names and figures are illustrative.