MARKETS

Mining costs demystified

<b>ALLAN Trench</b> laments the misrepresentation of production costs across the minerals sector – and tries to keep definitions simple in suggesting that costs are best recognised with reference to mineral production value-chain.

Staff Reporter
Mining costs demystified

Strictly Boardroom is a student of mining costs – and a long suffering one at that. Multiple cost definitions abound in the minerals sector, most of which don’t help investors or managers a great deal at all.

C1, C2 and C3 productions costs are quite popular with some miners – but as an experienced mining colleague recently suggested, “the C system of costs should really be called ‘see-nothing’ as the derived costs are of little use in decision-making”.

All in sustaining costs (AISC) have gained traction in gold – but are less useful in base metals and bulk commodities. Why? Gold has no substantial logistical costs – but most other commodities do – so cost systems beyond gold need to fully describe the value chain.

The question of by-product credits reveals an even worse situation. Current normal practice (termed “normal” costing) is to offset the full revenue of by-products against the main product revenue in order to report (artificially) lower main product costs.

This works for small fractions of by-product production in revenue-terms – but is also widely used (and largely abused) in reporting costs from co-product mines. Copper-gold mines are the worst culprits – with the AISC system not designed to address such cost complexity. Few managers that report such “normal” costs realise that the underlying assumption is that the co-product production cost equals the full co-product revenue. Implicit in normal cost reporting is the fact that no margin exists for the co-product.

Few realise this: Try asking an executive who reports an artificially low gold cost at a porphyry operation what their copper production costs are as a brief experiment. The mathematically correct answer is that the copper production cost must, by definition, be actually the price that has been assumed for copper revenue – but few will answer that way.

It is time for a back-to-basics approach. Managers need cost information in order to manage – and investors need it to assess where the true margins lie (or the lack thereof).

The approach that CRU Group takes to mining costs, termed value based costing (VBC) is based on a production system from mine through to customer. For any given production operation, VBC identifies four basic levels of cost along the value chain:

  • Site costs, primarily of relevance to the operating management team of a specific facility or group of related facilities;
  • Business costs, primarily of relevance to managers taking key marketing, business development, and investment appraisal activities;
  • Corporate costs, primarily of relevance to the financial management team; and
  • Full economic costs, primarily relevant to the CEO, board and stakeholders

Why this approach? Simple really: It allows the different managers along the chain the ability to actually manage their costs.

Staff at a mine or plant site are primarily responsible for production volumes and cost control; staff at a business unit or divisional level take the medium short-term planning, purchasing and marketing decisions and are responsible for the free cash flow and return on investment of a group of mines or plants producing a specific range of commodities; and a central corporate staff are responsible for longer-term strategy and the interface with the shareholders and the broader financial community.

Naturally, in smaller companies the business and corporate levels may be merged, and a company with a single operation will have all of these levels consolidated. However, even in these cases there will normally be identifiable individuals, whose responsibilities can be classified.

Site costs, as the name implies, site costs are all the costs incurred at the specific production site. This is the relevant concept for such activities as benchmarking, Six Sigma programs, and other forms of technically focused performance improvement. For downstream plants, site costs can be usually be subdivided into raw material costs and conversion costs.

Business costs include the additional costs associated with the transportation, sales and marketing of the commodity. It is here that VBC introduces the important concept of “realisation cost” so that business costs can be directly compared with the commodity’s benchmark price, thus yielding an estimate of the free cash flow associated with the production unit. This is the relevant concept for asset valuations and also for most cyclical price forecasting applications.

Corporate costs include the additional costs associated with corporate activities and responsibilities, including where appropriate recognition of the changes in the value of various corporate assets and liabilities. Unfunded mine closures and other environmental liabilities are also a potential cost at this level. This is the relevant concept for corporate finance and equity investment analysis applications.

Finally, economic costs include a capital charge that reflects the market value of the asset, amortised over its remaining production life at the weighted average cost of capital. This is the relevant concept for value based management applications and strategic investment decisions.

Cost clarity still has a long way to go in mining and metals: Watch that space.

Allan Trench is professor (value and risk) at the Centre for Exploration Targeting, University of Western Australia, professor of energy and mineral economics at Curtin University Graduate School of Business, a non-executive director to several resources sector companies – and the Perth representative for CRU Strategies, a division of independent metals and mining advisory CRU Group (allan.trench@crugroup.com).

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