Basic economics of value adding for fish products

Gunnar Knapp

Institute of Social and Economic Research

University of Alaska Anchorage Anchorage,

United States of America

Abstract

Value adding may represent an opportunity for companies and regions to derive greater
economic benefits from the fish that they produce and process. Whether value adding is
profitable depends on whether the increase in value offsets the increase in costs. This paper
reviews important things to understand about the economics of value adding for fish products.
These include: (1) not all value adding which is technically possible is necessarily profitable; (2)
location affects the economics of value adding; (3) the most profitable location for value
adding is not necessarily where primary processing occurs; (4) how capture fisheries are
managed may affect the economics of value adding; (5) whether fish are produced in capture
fisheries or aquaculture may affect the economics of value adding; (6) tax and trade policies
may affect the economics of value adding; (7) the economics of value adding may change
significantly over time; (8) marketing is critical to successful value adding; (9) choices which
maximize the overall profitability of a fish processing operation do not necessarily maximize
the profitability of by-product processing; and (10) different groups within a region may be
affected in different ways by value adding.

Introduction

The purpose in this paper is to review, as simply and clearly as possible, some of the most
important things to understand about the economics of value adding for fish products. “Value
adding for fish products” may be broadly defined as “additional processing to produce higher
valued products.”1 An example would be processing Alaska salmon into fillets rather than the
traditional “frozen headed and gutted” product form. Other examples of “value adding”
include breading, smoking, flavouring, portioning, and combining fish with other ingredients to
produce consumer-ready meals. Another kind of value adding would be using fish parts which
might previously have been disposed of (such as fish heads and entrails) to produce “by-
products” such as fish meal, fish oil and pet food.

In theory, value adding represents an opportunity for regions to derive greater economic
benefits from the fish that they produce and process. But many companies do not engage in
value adding to the extent that would be possible given existing production technologies. For
example, Alaska salmon processors typically produce much more headed and gutted salmon
than salmon fillets—even though salmon fillets command significantly higher prices. In some
cases, companies produce non value-added products in the region where the fish are caught or
farmed, and “export” those products to other regions (in the same country or in foreign
countries) where further value-added processing occurs. For example, a significant share of
Alaska salmon production is exported as frozen headed and gutted salmon to China, where it is
processed into value-added products for sale to markets in the United States and Europe. In
some cases, companies do not fully utilize fish even though technologies exist to do so. For
example, many Alaska salmon processors do not utilize salmon heads or entrails, even though
they could be processed into fish meal, fish oil or pet food. The fact that seafood processing
companies engage in less value adding than would be possible given existing production
technologies can be both puzzling and frustrating for residents of fish producing regions, who
perceive that they are not receiving the full potential benefits of their fishery resources.
However, seafood processing companies which engage in less value adding than they might
are not necessarily lacking in knowledge or willingness to innovate. They may rather be making
fully rational business decisions. Not all value adding that is technically possible is necessarily
profitable or optimal for a company. In almost all cases, higher value products are also higher
cost products to produce. When and where value adding is profitable depends on the extent to
which the increase in value offsets the increase in costs. In this paper the basic economics of
secondary processing and by-product processing are briefly reviewed first and then ten
important things to understand about the economics of value adding for fish products are
discussed. For purposes of this paper, the term “primary product” refers to a non-value added
product, and “secondary product” refers to a value-added product that could be made by
further processing of the primary product. The term “by-product” is used to refer to products
that could be made from the fish in addition to whatever primary or secondary products are
produced, utilizing parts of the fish that would otherwise be discarded as waste.

Basic Economics of Secondary Processing

Under what conditions would secondary processing, following primary processing, increase a
fish processor’s profits? Suppose first that secondary processing could be done without any
additional cost. Secondary processing increases profits only if the increase in price is
sufficiently great to make up for any volume loss involved in secondary processing. Put
differently, the profitability of secondary processing depends not only on the relative prices of
the secondary and primary products, but also on the yield from the primary product volume to
secondary product volume. Mathematically, secondary processing increases value only if the
following condition is met:

Equation (1) may be rearranged to give:

Suppose next that secondary processing requires additional capital investment in plants and
machinery. Secondary processing will increase profits only if the increase in price is sufficiently
high to also cover additional unit capital costs. Unit capital costs depend on the efficiency of
utilization of capital. Secondary processing is less likely to be profitable if the scale of
production is too small to fully utilize the additional plants or machinery, or if they can only be
utilized some of the time. Secondary processing may affect transportation costs in several
ways. Secondary processing may reduce transportation costs by reducing the volume of
product to be shipped. This potential cost advantage may be offset by additional costs of
packaging or special handling requirements for secondary products.

Basic Economics of By-product Processing

By definition, “by-products” are produced using parts of the fish that would otherwise be
discarded as waste. By-product processing is profitable only if the additional revenue from the
by-products exceeds the additional processing costs. Processing for certain kinds of by-
products, such as fish meal and fish oil, is highly capital intensive. Processing these kinds of by-
products is more likely to be profitable with a larger scale of production. Put differently, it is
harder for plants that process small volumes of fish to cover the high capital costs of fish meal
or fish oil processing. Note that it is unlikely that any kind of by-product processing utilizing
traditional technologies to process fish parts that have traditionally been discarded as waste
would be highly profitable. This is simply because processors are unlikely to have ignored or
overlooked highly profitable ways of using fish resources. However, if by-product prices
increase or by-product processing costs decrease, formerly unprofitable types of by-product
processing may become profitable. In contrast, new technologies to produce new kinds of by-
products, or to produce traditional by-products in new ways, may potentially be highly
profitable.

Ten Important Things to Understand About the Economics of Value Adding

Below are ten important things to understand about the economics of value adding for fish
products.
1. Value adding isn’t necessarily profitable.

Whether value adding increases a fish processor’s profits depends on numerous factors,
including (but not limited to) relative product prices, secondary processing yields, wage rates,
secondary processing labour requirements, secondary processing unit costs and uses of other
inputs such as packaging and ingredients, transportation costs for secondary processing inputs,
and relative transportation costs for primary and secondary products. All of these factors
matter. You can’t conclude that secondary professing would necessarily increase a processor’s
profits simply because value added products may command a much higher price.

2. Location affects the economics of value adding.

Many of the factors that affect the economics of value adding may vary significantly between
different locations. These include, in particular, labour costs, energy costs, transportation costs
of secondary processing inputs such as packaging and ingredients, and relative transportation
costs for primary and secondary products. Value adding that is profitable in one location may
not be profitable in another location. For example, labour-intensive value adding is less likely
to be profitable in places where wage rates are high.

3. The most profitable location for value adding is not necessarily where primary processing
occurs.

Because primary processing must be done soon after harvesting in order to stabilize fish
quality, most primary processing has to occur relatively close to where fish are harvested by
capture fisheries or grown in aquaculture systems. Secondary processing does not necessarily
have to be done soon after harvesting or in the same location as primary processing. It might
seem that value adding at the same location as the primary processing would convey an
obvious economic advantage by saving on the cost of transporting primary product to another
location. But this potential transportation cost advantage may be outweighed by many other
factors which might be more favourable at a different location, such as labour costs, costs of
other processing inputs such as packaging and ingredients, and transportation costs to end
markets. Note in particular that if value adding occurs near end markets, there may be little or
no transportation cost advantage to value adding at the same location as primary processing.
Suppose, for example, that a “local” processor has a choice of value adding “locally” where
primary processing is done, or in a different “foreign” location. Assume that “foreign” wage
rates and other unit processing costs are lower than “local” wage rates and other unit
processing costs. “Local” value adding will be more profitable than “foreign” value adding only
if the foreign savings on labour and other costs are less than the increase in transportation
costs. This depends not only on relative wage rates and other unit costs, but also the labour
intensity of processing and the intensity of use of other inputs. “Local value adding” is more
profitable than “foreign value adding” only if the condition in Equation (6) is met:
This helps to explain why an increasing share of the fish captured or grown in American and
European fisheries and aquaculture are being shipped to China, Viet Nam and other countries
for secondary processing—and then shipped back to markets in America and Europe. The
savings on labour and other costs outweigh the additional transportation costs. In recent
years, increasing volumes of Alaska salmon have been exported to China for value-added
processing. In China, frozen headed and gutted Alaska salmon are thawed, filleted, portioned
and packaged for re-export to U.S. and European markets.

4. How capture fisheries are managed may affect the economics of value adding. Fisheries
management may affect the timing of fish deliveries to processors.

For example, in competitive “derby”3 fisheries, processors may receive large daily volumes of
fish during a short season, followed by long periods during which they don’t receive any fish. In
contrast, in fisheries with individual quota management, fishermen may deliver smaller daily
volumes over a longer season. The timing of fish deliveries affects how efficiently processors
can utilize the additional investments in plants and machinery needed for fish processing. The
unit cost of a packaging machine will be much lower if the machine is operated every day than
if it is only operated part of the year. Fisheries management may also affect the quality of fish
delivered to processors. For example, in competitive “derby” fisheries where fishermen are
trying to catch fish as fast as possible, they may not take the time to handle fish as carefully as
they would in fisheries with individual quotas. This may result in more bruising, reducing the
processing yield for value-added products such as fillets and portions.

5. Whether fish are produced in capture fisheries or aquaculture may affect the economics of
value adding.
Regardless of how capture fisheries are managed, they may face certain inherent competitive
disadvantages relative to aquaculture with respect to the potential for efficient secondary
processing. Capture fisheries tend to have greater inherent variability in fish size and other fish
characteristics, making it more difficult to design secondary processing machinery and
reducing processing yields. Capture fisheries are subject to greater seasonality and annual
harvest variability and uncertainty, increasing the difficulty of utilizing secondary processing
capacity efficiently. Wild fisheries may occur in remote locations with extremely high labour,
transportation and utility costs and where aquaculture facilities would not be situated.

6. Tax and trade policies may affect the economics of value adding.

If primary and secondary products are subject to different tax policies (by domestic
governments) or trade policies (by foreign governments in end-market countries) this may
affect the relative profitability of primary and secondary processing.

7. The economics of value adding may change significantly over time.

Seafood industry technology, prices, costs, taxes, consumer tastes, regulations and other
factors affecting the profitability of secondary processing are subject to significant and
sometimes rapid change. These can create new opportunities for profitable value adding – or
make formerly profitable value adding unprofitable. New labour saving technologies such as
salmon pinbone-pulling machines can make secondary processing profitable in areas with high
labour costs. Increasing labour costs in China could reduce the profitability of the large
secondary processing industry that has developed there in recent years.

8. Marketing is critical to successful value adding.

Secondary products may command significantly higher prices than primary products. This
creates an incentive for processors to increase production of these products. Unless increased
production is accompanied by effective marketing to expand demand, prices may fall as
production expands – particularly for niche market products. Successful value adding requires
more than producing value added products cost effectively. It also requires an understanding
of what kinds of products markets demand and communicating effectively about how products
meet those demands.

9. Choices which maximize the overall profitability of a fish processing operations do not
necessarily maximize the profitability of by-product processing.

Fish processors make choices such as the location and scale of plants based on how the
choices affect total revenues, costs and profits rather than the revenues, costs and profits from
by-products. In general, processors face trade-offs between having more smaller-scale
operations located closer to where fish are harvested or grown (which reduces costs of fish
transportation and improves product quality) or having fewer larger-scale operations (which
benefit from greater economies of scale). In general, because of the relatively greater intensity
of by-product processing than food product processing, the optimal fish plant scale for
maximizing total profits is lower than the optimal scale for maximizing the profitability of by-
product processing. In fisheries that are widely dispersed and/or highly seasonal, such as some
Alaska salmon fisheries, the scale of production may be insufficient to economically justify the
capital costs of utilizing the entire fish, resulting in the discarding of significant volumes of
“waste” products such as fish heads and entrails.

10. Different groups within a region may be affected in different ways by value adding.

Fish processors benefit most from whatever types of processing are most profitable. In some
cases, it may be most profitable for processors not to engage in value-added processing or to
“export” primary products for further value-added processing outside a region. In general,
fishermen and fish farmers also benefit most from whatever types of processing are most
profitable for processors – which maximize the prices processors might potentially be able to
pay for their fish. In contrast, other businesses within a region – those which sell to fish
processors or to their employees – may benefit most from whatever types of processing
maximize expenditures by processors within the region, or which maximize processing
employment. Similarly, local and regional governments may benefit most from whatever types
of processing maximize sales taxes or property taxes. Thus other businesses and local
governments may advocate for relatively more value adding than processors prefer. In some
cases, local governments may provide tax incentives or subsidies as incentives for processors
to undertake value adding – or they may mandate it. Mandating value-adding may be rational
from a local business development perspective but is not necessarily optimal for processors or
fishermen.