Answer all the questions. Case study: NIK-05 Ltd: Development of Managerial Infrastructure in the business model of a pellet producer Abstract: Nikola Zmeev the owner of the NIK-05 Ltd - is a producer of wood for heating and has a very good understanding of the possible use of biomass as a renewable energy source (RES). Because of his job he spends most of the day in the forest, breathing fresh air, analyzing the consequences of pollution and its impact people's health. His biggest dream is to give a better opportunity to his two little children to live and work in an environment with adequate respect for nature. He has the full support of his wife on this issue. But can these intentions be converted into business action? This case study presents the issues facing a very small firm in starting up the production of pellets from biomass. Key words: business model, pellet-production, vertical integration, financial sources, investments. Background of the firm Nikola has been working in the woodcutting sector for over 10 years, most of them as an employee of his father's firm. In 2005 he established his own firm (NIK-05 Ltd) with a main office in the village of Udelnik in the municipality of Slivo Pole. He also manages NIK-05 Ltd which is in the business of cutting and selling tree trunks and timbers in forms that are suitable for use as heating fuel. Nikola identified the advantages of supplying intelligent energy in the form of pellets and eco-briquettes made from biomass (plants) during the first year of his firm's activities. He came to realize that the concept of energy efficiency is based on a transition to renewable energy sources for heating, including pellets and Eco briquettes. The use of wood for direct heating is contrary to environmental protection and increases the share of RES. For these reasons, in 2007, Nikola took the first steps to develop a new activity for his firm -intelligent energy production in the form of solid fuel (pellets and eco- briquettes). He estimated that this initiative needed the implementation of an innovation, which was beyond his personal capacities. He therefore contacted scientists at Ruse University for support and expertise, especially those from departments of Business and Management and Agricultural Techniques. NIK-05 Ltd uses the Ruse University academics as knowledge suppliers for research and the implementation of research, related to: the legal environment which has a direct influence on pelletaneco-briquette production. the creation of a business model and a management structure for the production of pellets and Eco briquettes, using a specific technological approach. the resources (financial, human, informational and material), that are necessary in pellet and Eco briquette production. The task for Nikola is to give his knowledge suppliers full access to the documents and assets of NIK-05 Ltd. Elements of the business model according to Alexander Osterwalder approach Dr. Daniel Pavlov, the Head of Ruse University Entrepreneurship Centre, has given a variety of advice to Nikola This has focused on developing the new activity- pellet production, using Alexander Osterwalder's conceptual business model. This consists of 4 pillars, subdivided into 9 elements (Table 1) 1 Source: , ., , ., , ., . . ( ) / 20+10 : ( 3). ISBN 978-954-9972-90-0, 2008, ..82-93, 134,135. 3 CODE: MGT 5 0 4 Table 1. Business model elements, according to Alexander Osterwalder Pillar Description Building Block of Business Model Value Proposition Product Target Customer Customer Interface Distribution Channel Relationship Value Configuration Infrastructure Management A Value Proposition is an overall view of a company's bundle of products and services that are of value to the customer The Target Customer is a segment of customers a company wants to offer value to. A Distribution Channel is a means of getting in touch with the customer The Relationship describes the kind of link a company establishes between itself and the customer. The Value Configuration describes the arrangement of activities and resources that are necessary to create value for the customer A capability is the ability to execute a repeatable pattern of actions that is necessary in order to create value for the customer A Partnership is a voluntarily initiated cooperative agreement between two or more companies in order to create value for the customer The Cost Strueture is the representation in money of all the means employed in the business model. The Revenue Model describes the way a company makes money through a variety of revenue flows. Capability Partnership Cost Structure Financial Aspects Revenue Model Nikola Zmeev needs to develop the business model of a pellet-producer and he has received help from the Ruse University Entrepreneurship Centre. An important step is to identify the key partners, who may be useful not only in the production process, but also in helping the company to enter a market niche and get proper financing. Looking for an answer to this challenge Dr. Pavlov has developed some options, based on vertical integration. Biomass capacity of Bulgaria Renewable energy has three different applications: electricity generation, heating and cooling, and the production of biofuels for transport (Table 2). These three applications represent different technological processes and they take place in different industrial sectors. Of all the types of renewable energy, only biomass is used in all the applications described. Table 2. Types of renewable energy used Energy Electricity Heat Transport Fuel Table 2. Types of renewable energy used Energy Electricity Heat Transport Fuel RES Biomass YES YES YES Solar YES YES Geothermal YES YES Wind YES Ocean YES Small Hydro YES The basic source for the production of pellets and eco-briquettes is biomass, which is widely produced in rural areas. The Bulgarian crop fields cover over 3 million hectares, which is about 28% of the total territory of the country as is shown in Table 3. The areas that produce wheat, barley, corn and sunflower, amount to about 2.4 million hectares (Table 4) Table 3 Total cultivated agricultural area in Bulgaria (in hectares) Year 2007 2006 2005 Average per year Agricultural areas 3,057,740 3,089,531 3.128,210 3,091,827 4 CODE: M GT 5 0 4 Table 4 Area of land for Production of Agricultural Crops in Bulgaria, (in hectares) Year 2007 2006 2005 Average Wheat 1,120,510 979,925 1,134,354 1,078,263 Barley 193,840 192,539 276,472 220,950 Corn 408,880 386,772 340,847 378,833 Sunflower 686,692 785,064 653,371 708,376 Total: 2,409,922 2,344,300 2,405,044 2,386,422 The maximum biomass that the fields in Table 4 are able to supply for pellet production is almost 4.8 million tons, as the average production of biomass is around 2 tons per hectare. The energy equivalent of 1 ton of biomass is 18,000-19,500 MJ, or 5- 5.42 MWh. If all biomass could be harvested and processed, the annual energy equivalent would be at least 24 million GWh or some 3000 MWh per hour, which is almost equal to the capacity of the Bulgarian nuclear power plant at Kozlodui, which supplies 42% of the electricity in Bulgaria. These figures describe the most optimistic usage of biomass for energy, but even if a much smaller portion of this is used for energy production, it is still a crucially important source of renewable energy. This means that the rural areas have an important role as biomass suppliers. It is vital to develop the relationships between the key partners: biomass suppliers (mainly agro firms and wood/timber firms), pellet producers and traders (or large direct customers). Nikola's focus is on developing vertical integration among these partners, which will improve his business model, especially the partnership' element. Forward (up-stream) vertical integration of pellet production Depending on the source of initiative for the integration, it is possible to outline two main stages: (a) from the biomass supplier to the pellet producer and (b) from pellet producer to pellet trader/key customer. a) During the first stage of the forward vertical integration the source of initiative is in the agro firm. It produces crops, especially wheat, barley, corn, and sunflowers and there is a significant amount of waste biomass which is entirely suitable for pellet production. Instead of burning the secondary biomass in the field, the agro firm may supply it to a pellet producer. The agro manager has various options: to sell packaged biomass to a pellet producer, to allow the pellet producer to take the biomass from the field; or to produce its own pellets. We will take a closer look at each of these options: The agro firm sells packaged biomass to a pellet producer The agro firm packs the biomass and delivers it to the working premises of the pellet producer. The costs of gathering, packing, storing and transporting the biomass are paid by the agro firm. This variant is suitable for the agro firm in the case where the pellet producer has requested a quantity of biomass that covers its fixed and variable costs. An advantage for the suitable for pellet production. Instead of burning the secondary biomass in the field, the agro firm may supply it to a pellet producer. The agro manager has various options: to sell packaged biomass to a pellet producer, to allow the pellet producer to take the biomass from the field; or to produce its own pellets. We will take a closer look at each of these options: The agro firm sells packaged biomass to a pellet producer The agro firm packs the biomass and delivers it to the working premises of the pellet producer. The costs of gathering, packing, storing and transporting the biomass are paid by the agro firm. This variant is suitable for the agro firm in the case where the pellet producer has requested a quantity of biomass that covers its fixed and variable costs. An advantage for the agro firm is that it can store the biomass and then, according to the market price of the secondary biomass, offer it to the pellet producer. However, to establish a long-term relationship with the pellet producer the agro manager needs to sign a contract that has a price control mechanism. The two business entities may also exchange shares making each of them a shareholder of the other and thus confirming their long-term relationship. The price will also depend on the cost of storage and transport. Storing biomass brings risks, such as fire, which may cause enormous losses. These risk management issues require extra expenditure. According to a Ruse University study the distance between the fields and pellet working premises should be less than 50 km if the transaction is to be economically viable. Longer distances cause very high transport costs and lead to unattractive economic results. If the pellet producer takes care of the transportation of the packaged biomass from the agro firm store to the pellet producer's working premises, then the agro firm would receive a price offer for delivery at the storehouse. The pellet producer takes the biomass from the agro-firm's fields. If the agro firm is not able to make attractive profits from delivering the packaged secondary biomass to the producer, it is better to allow the pellet producer(s) to take the biomass directly from the crop fields. In this case, all expenses for gathering, packing, transporting and storing the biomass are paid by the pellet producer. Bulgarian legislation restricts the burning of biomass in the crop fields. The agro firm therefore has to find ways of disposing of the waste biomass. The pellet producer 'cleans' the fields making them suitable for the next cycle of agricultural activities. In some cases, it is possible for the pellet manager to pay only a limited amount of money. The opposite case is also possible, with the agro manager paying for the 'cleaning' of his fields. Finding a solution is a matter of negotiation. Even in the case where no party pays the other, both parties' benefit: the fields of the agro firm are cleaned without expense and the 5 pellet producer has free of charge access to secondary biomass. In searching for long-term collaboration, they may sign a contract or exchange shares and become shareholders. The agro manager could initiate such a partnership with a pellet producer if the latter has the necessary equipment for packing and transportation, as well as a storehouse with sufficient capacity. The agro firm establishes its own pellet production facilities. In this case, the agro firm develops a subdivision or a daughter company, which produces pellets using its own biomass. If it is a daughter company, then it could be a strategic unit that is expected to generate profit. The new unit of the agro firm is expected to sell the pellets to clients, but it is also rather attractive for the agro firm to use these pellets for heating its own premises and thus be more energy independent. The agro firm may take this decision if there is enough entrepreneurial capacity in the management body and access to capital, extra labour, expertise, infrastructural facilities, etc. The agro firm could get financial support from public funds. One of these is the Bulgarian National Programme for Development of Rural Areas (measure 311). This programme supports renewable energy production under 1 MWh, which is the equivalent of a production line capacity of 150-200 kg pellets per hour. The maximum of the eligible support is 1 million, and the programme covers up to 70% of the investment. b) In the second stage of the forward vertical integration the initiative is with the pellet producing company, to make contact with either wholesalers of pellets or direct large customers. In addition, it may also establish its own pellet shop for households and other small clients: The pellet producer develops business relations with whole traders of pellets. It is up to the pellet producer to offer either a long-term or a short-term relationship. The price of the pellets could be the key factor for taking this decision, but the terms of payment, the security of delivery, etc. may also be involved. If the trader pays on delivery, the price could be low. If the trader pays after selling the pellets, then the price may be expected to be higher. It is also possible for the trader to pay for the pellets even before their production, but would only apply when the market prices of pellets are very high and the pellet producer offers cheaper access to its products. The pellet producers may offer shares to the trader. If the trader buys them, it is a kind of confirmation for the pellet producer that the trader will sell itsr pellets instead of looking for other pellet producers. In this case, the pellet producer should be prepared to deal with shareholders and share its profits with them proportionally. The pellet producer develops business relations with direct large customers. A variety of buildings can be heated with pellets: storehouses, agricultural farms, working premises, schools, hospitals. The pellet producer develops business relations with direct large customers. A variety of buildings can be heated with pellets: storehouses, agricultural farms, working premises, schools, hospitals, transport stations, administrative halls, shopping centres, sport facilities, etc. Many of them are also in rural areas. The pellet producer may contact their managers and offer them a long-term contract delivering pellets at a negotiable price. If these buildings are without pellet ovens/stoves, then the pellet producer could suggest that the existing heating system is replaced with a system based on pellets, provided this is technically possible and economically effective and efficient. The pellet producer may offer its own shares to the large customer too and get a kind of security that this client will buy its pellets instead of looking for other producers. It is important for the pellet producer to know how to deal with shareholders. The large customer will have direct control, not only of the pellet price, but also of all levels of management of the firm according to the size of their shares. The pellet producer may loose its independence and become a daughter company of the large customer. The producer should carefully choose whom to offer shares, how many shares to sell, and the share price. The pellet producer establishes its own commercial shop The pellet producer may plan to develop its own commercial chain for pellet delivery to households and other small clients. The location of the shop, all logistic issues and profit forecasts must all be carefully considered. There could be an advantage if the shop offers pellets as well as ovens, stoves, and pellet-related accessories. In this case it would be a 'one- stop-shop'. The technology of the production of eco-briquettes is the same as pellet production; the stove is the same as for wood-heating. The pellet producer may use this advantage and both eco-briquettes and stoves, attracting the clients that have been using wood for heating. Many of these clients are in the rural areas. The pellet producer is expected to be aware that pellet ovens are relatively expensive in Bulgaria. In the autumn of 2008 they are available in Ruse city market at a price of 3000, which is about the annual average salary in Bulgaria. Another 6 challenge is the market price of the pellets, which is about 150 per tonne. The cost of buying the necessary amount of pellets for use during the cold months (about 4 tonnes) is in fact 20% of the average annual salary. Therefore, it will be some time before pellets become a viable heating product for most households. Backward (down-stream) vertical integration of pellet production Depending on the source of the initiative, it is possible to outline two main stages again: (a) from the pellet trader/large customer to the pellet producer and (b) from the pellet producer to the biomass supplier. a) During the first stage of the backward vertical integration the initiative is with the pellet trader/large customer, because of market reasons (for the trader) or willingness to replace the existing conventional heating system with a pellet system. They contract a pellet producer for the long term, giving the necessary agreements that they will buy its products as stated in the contract. If there is no pellet producer available, then the trader or the large customer may initiate the establishment of a company for pellet production. This could be established as a daughter company or a subdivision of their existing company. It is also important to contract biomass suppliers, and offer a joint venture with an agro firm sharing the following responsibilities: the agro firm supplies secondary biomass; the joint venture produces pellets; the trader (or large customer) buys and sells pellets This case is attractive for traders and direct customers, which operate in areas with scarce biomass but high prices for conventional energy. It is possible to import the pellets from other regions or states or to establish a daughter company. This is the case for one small pellet producer in the Ruse region, which is a daughter company of an Italian firm. The entire pellet production of this company is exported to Italy. Large customers have to develop a pellet heating systems in their buildings and in parallel, search for a pellet producer and develop long term collaboration. The Ruse Municipality administration intends to replace some of its existing conventional heating ovens with pellet ovens in selected kindergartens and schools. b) During the second stage of backward vertical integration (from the pellet producer to the biomass supplier) the initiative is with the pellet producer. The manager contracts an agro firm for long-term usage of the secondary biomass. There are three alternatives here: the pellet producer can buy the packaged biomass, pack and transport the biomass, or produce the biomass itself. Pellet producer buys the packed secondary biomass Pellet producer buys the packed secondary biomass In this case, the pellet produce initiates commercial relations with the agro firm. It is a matter of negotiation to fix the price and financial mechanism for its updating. The cost of transporting the biomass from the agro firm to the pellet producer could be borne by one of them. Depending on the place of delivery, the secondary biomass price will vary. The price will be lower if the pellet producer takes the packaged biomass from the agro firm stores, and higher if the agro firm delivers it to the pellet producer's factory. There could be some exchange of shares. The pellet producer may offer to buy some shares in the agro firm. This could be applied in the case where the agro firm faces financial problems. By allowing the pellet producer to buy some of its shares, the agro firm not only receives money, but also a market for its secondary biomass. The pellet producer may offer the opposite arrangement and invite the agro firm to buy some of its shares. In this case, the pellet producer allows the agro firm to have some control of its activity (according to the size of the shareholding) in order to be sure that the pellet producer will buy mainly its biomass, not that of competitors. In both cases described, the agro firm and pellet producer have to be prepared to deal with shareholders; otherwise, a long term contract could be an acceptable alternative. The pellet producer packs and transports the biomass. It is necessary for the pellet producer to own or to have adequate access not only to agricultural vehicles for packing the secondary biomass, but also facilities for storage of the packaged biomass. The pellet producer is able to optimise the costs related to packing and transporting. It is a matter of negotiation whether that will be free of charge or whether the pellet producer will pay a certain price for having access to the agro firm's fields. The pellet producer may offer to sell some shares to the agro firm or, alternatively, to buy some its shares. The one in greater need will allow the other one to buy some shares and become a shareholder. 7 CODE: M GT 5 0 4 An important factor in their business relations is the moisture of the biomass, which depends on the weather conditions and the length of time the secondary biomass has been in the fields. If the moisture is low, then the cost of drying it (in the pellet production process) is lower. This keeps down the total expense significantly as the drying costs make up about 40-50% of the total electricity costs of pellet production. Using biomass for heating instead of electricity can also help to keep drying costs down. Dry secondary biomass is a precondition for optimizing the cost of pellet production. Pellet producer produces the biomass In case all the other variants fail because of economic, technical or other reasons, the pellet producer has to develop its own production unit for biomass. This agro unit could be a subdivision of the pellet producer or a daughter company. The new unit has to have access to land by owning or renting it. In this case, the pellet producer is independent in its choice of biomass suppliers and is able to control the price of the biomass. From an organisational point of view, there are some new expenses that the parent company has to bear, in comparison with the other cases: Expenses related to the agro machines and agro stores - purchasing, maintenance, renting, etc; Higher transport costs if the fields are far from the working premises of the pellet producer, The threat of paying higher rent to the landowners, if other appropriate fields are not available and dealing with landowners; A variety of other issues concerning the management of a unit, which is new for the pellet producer; the manager needs time to learn the appropriate, economically effective solutions and these 'lessons' come at a price. Financial issues In 2009. Nikola Zmeev considered purchasing one of two possible pelletizing machines: the MGL-200, produced in the Czech Republic and the BM-130, produced by Andromeda Ltd, in Ruse, Bulgaria. The price of the MGL-200 pelletizer was half that of the BM-130, while there was no big difference in output capacity; 100 kg/hour for wood pellets and 150 kg/hour for pellets produced from straw or agricultural crops. According to the preinvestment analysis the total initial costs (for the MGL-200) are 63,000, (VAT included). This breaks down as follows: 30,500 for a production line which consists on a thin breaker, a dryer and a pelletizing press machine; 15,000 for construction (or purchase) of working premises with proper rooms and workshops in the village of Udelnik,; 15,500 for machines that gather and break down the biomass in the forest (a rough breaker, a tractor and one axis trailer); 2,000 for administrative and management activities, fees and taxes. 2,000 for administrative and management activities, fees and taxes. The minimum labour requirement is: one worker for the pellet production line and one or two workers for gathering and breaking the biomass in the forest. The sum of 63,000 exceeds the current annual turnover of NIK-05 Ltd and banks have refused to provide the firm with credit. There are two opportunities for Nikola to attract extra financial sources: partners (but some of them have refused to participate in this initiative due to the difficult circumstances of the financial crisis); public funds for small firms support. (a good example is the Bulgarian Rural Areas Development Program 2007- 2013, measure 312 "Support in creation and development of small firms".) NIK-05 Ltd is eligible for Measure 312 of the Bulgarian Rural Areas Development Program and is able to apply. According to the financial requirements the firm has to make all payments in advance and then receive a grant for up to 70% of the eligible costs. Nikola can do it only if he has access to a bank loan to cover the initial costs. He has a positive reputation at one of the banks and they agree to credit the firm, but the bank puts a cofinancing system as a requirement. This new issue forces Nikola into reconsidering the material assets which he planned to attract for pellet production. He develops an alternative (Variant 2) financial plan where the initial costs are reduced to 20 000 (VAT included): 18 000 for a rough breaker, a thin breaker and a pelletizing press machine - all of them new; 2 000 for administrative and management activities, fees and taxes; 8 CODE: MGT 5 4 He plans to use a second-hand tractor and trailer, both given for free by partners (mainly relatives); the working premises are to be rented; the biomass will be dried naturally (instead of with a dryer machine) in the fields during the summer harvest. Measure 312 requires the beneficiary to use the mobile assets within the territory of the rural municipality. Therefore NIK-05 is eligible to use the rough breaker only in forests within the territory of Slivo Pole Municipality. This obstacle predetermines the maximum transport expenses (up to 15 kilometers). There is no restriction in Measure 312 regarding the territorial origin of the biomass (straw and wood). . . Annual expenses forecast in pellets production for 'Variant 2 The variable costs are 75 per ton of pellets, and they include: labour and transport expenses for gathering, breaking and transporting the wood biomass from the forests to the plant in the village of Udelnik or buying and delivering of 1 ton of straw bales. electricity and labour in the pelletizing workshop. The annual fixed costs are expected to be 5,660 and they include: rent of work premises. machine service and maintenance. administrative and management costs; expenses related to bank interest and other annual bank fees (not including the credit capital itself) . O (1) X = TFC/(P-V), where: X is break-even point, TFC is total fixed costs, P is unit sale price, V is unit variable cost. (2) TFC = IC/PBP + FC, where: IC is initial costs, PBP is pay back period of the investments in our case it is equal to the period of return of the loan), FC is fixed costs. (2) TFC = IC/PBP + FC, where: IC is initial costs, PBP is pay back period of the investments in our case it is equal to the period of return of the loan), FC is fixed costs. A combination of formula (2) and formula (1) gives formula (3), which allows us to calculate the breakeven point (X) for one year within the period of return of the bank loan (60 months): (3) X = (IC/PBP + FC)/(P-V) We replace formula (3) with data about NIK-05 Ltd and calculate: X = 193,2 tonnes = (20000/5 +5660)/(125 - 75) If the annual sales of pellets are over 198.4 tons then NIK-05 Ltd is capable of covering all expenses and to return the bank loan within a period of 60 months. If NIK-05 Ltd successfully benefits from measure 312 to the amount of 10,500, then minimal annual sales of pellets are: X312 = 139,76 tonnes = (9500/5 + 5088) / (125-75). The output capacities of the I production line are determined by the pelletizing press (MGL-200) and they are 0.1 tonne/hour when using wood and 0.15 tonne/hour in the case of straw. If it works 24 hours per day and 356 days per year (8760 hours), then the annual maximum output is 876 tonnes of wood pellets or 1314 tonnes of straw pellets. In fact NIK-05 Ltd plans for the production line to work 80 hours per week for 52 weeks. In this case the annual production would be 416 tonnes of wood pellets or 624 tonnes of straw pellets. The technology has the capacity to produce pellets far beyond the break-even point (X=193.2 tonnes). The priority for NIK-05 Ltd should be searching for major clients for pellets and making contracts with them. The company should also explore the development of direct sales to households. 9 Conclusion The major issues and problems of NIK-05 are related to searching for appropriate partners in order to develop proper markets and attract proper financing. It has been easier for Nikola in the past, because the firm dealt directly with small clients, and he managed to develop a positive reputation while working in his father's firm. But now he faces an entirely different market with a different type of client. The major milestone for his pellet project is to sign a contract with strong partners (clients) which will enable him to buy the technology he needs to start producing this renewable energy fuel. Therefore his key areas of interests are; firstly, to show them his level of loyalty by integrating them into his activity and being transparent; secondly, to ensure that the pellets he is going to produce are high quality and to constantly monitor the production costs and improve the whole management of his firm with the help of Ruse University Entrepreneurship Center; third, once he has some clients, to enlarge his target group, searching for markets outside the Ruse region, or even outside Bulgaria. (Bucharest, the capital of Romania, is only 70 km from Ruse.) The specific problems faced by Nikola are related to changing the way his firm is organized. Until now he has been the sole owner of the firm and he has dealt with small clients, which is the pure market economics of Adam Smith. But he has become aware that the future belongs to business networks and clusters. He has to make a decision on how to develop such a network and his optimism is based on the variety of collaborations he has established with scientists at Ruse University. Answer the following questions: a) Discuss the level of cooperation that Nikola Zmeev has been able to establish with Ruse University. b) In accordance with Alexander Osterwalder's business model, explain the parts of the business model. c) In your own words, describe the advantages of vertical integration? d) Develop a business model of the pellet-production activity of NIK-05 giving a short description for each of the 9 elements