When
a specialty-chemical business gets commoditized
Contrary
to conventional wisdom, a commoditized chemical business can be as profitable
as a specialty one. The key is to change to a different operating model.
Commoditization of the specialty-chemical industry is
accelerating. While the history of the chemical sector is one of relentless
commoditization as one generation’s innovations become standard products of the
next, the pace is increasing. There are a number of
causes behind the shift.
In some segments, specialty players are struggling to
create the innovative products that offer significant additional value to
customers and differentiate themselves from competitors. Meanwhile, the
combination of new, low-cost market entrants—especially from China—and too much
capacity means that the prices of increasing numbers of products are determined
not by the value they deliver to customers but by their production costs and
freight to market.
Commoditization of specialty-chemical businesses poses a
structural challenge for the industry. How should these enterprises respond?
Chemical companies must recognize that commoditized businesses can earn
attractive returns if they are run in an entirely different way from specialty
businesses. The key is to tailor the new operating model to the business’s true
needs and the costs it can bear.
Our analysis of chemical-industry shareholder-returns
performance shows that commodity-chemical players have captured just as much
value as specialty players since 2000. While this performance may be
contrary to widely held assumptions and conventional wisdom in the chemical
industry, our data have consistently shown that over the long term, this
pattern holds. Chemical companies facing these challenges can also take
encouragement from the example of other industries successfully supplying
commoditized offerings. In the airline sector, for example, low-cost carriers
have outperformed their full-service rivals in profitability.
To turn commoditization from a threat into an
opportunity, companies should take three steps. First, they need to spot
commoditization coming, so that they can start to act before they are outpaced
by others. Second, they should design an appropriately tailored operating model
for their commoditized businesses. Third, they must embark on a comprehensive
change effort to put that new model to work. Companies that get this right can
capture significant rewards, with a return-on-sales uplift of as much as five
percentage points.
Recognizing
commoditization
Companies that have built their reputations on
innovative, differentiated products and responsive customer service can be
understandably reluctant to admit that the market has moved on. That’s risky.
If the tide of commoditization has already turned, they can find themselves
isolated while more focused competitors snatch their customers.
Every specialty-chemical player should keep a watchful
eye for encroaching commoditization and systematically look out for the warning
signs. Here are some questions that executives should ask themselves: Does
capacity significantly exceed demand? Have prices been declining steadily
despite attempts to raise them? Have prices been squeezed to maintain market
share? Have new competitors from countries with lower production costs entered
the market, and are their offerings similar to those of the incumbents but at
lower prices? Have we created any innovative products in the last five years?
Are we no longer dealing with our customer’s product-development unit but just
with its purchasing department? Have customers stopped asking and paying for
additional services? Central to the analysis should be a clear understanding of
the price-setting mechanisms in the market. If the price of a product is close
to the costs of a marginal producer, then it is, or soon will be, a commodity.
By analyzing these indicators across its product
portfolio, a company can understand how it should shape its operations: as a
specialty player, as a commodity manufacturer, or in a mixed model with pockets
of specialty production alongside a core of commodity products.
Designing the right
operating model
Once it identifies what products are becoming
commodities, a company can set about designing an operating model that will
allow it to manufacture and sell those products profitably. There is no
one-size-fits-all approach here, but there are certain requirements that must
be met. The right combination of changes will depend on the company’s portfolio
mix, on the nature of the products involved, and on the needs of its commodity
customers and markets. For some organizations, the breadth of this operating
model will extend to the whole company; for others, it will include specific
business units, or lines of business within those units.
Whatever the scope, there are a few guiding principles
that will greatly increase an organization’s chance of designing and
implementing a successful operating model. First, it should start from scratch,
and make a priority of minimizing costs. Merely tinkering with approaches more
suitable for specialty products will rarely achieve the impact necessary to
compete in a commodity market—or create an organization that is agile enough to
deal with the cyclicality of a commodity business. Second, the change should
encompass the whole organization, including sales, manufacturing, supply chain,
and administrative and support functions. Third, the design should begin with a
clear perspective on customers, bearing in mind that commodity buyers will have
needs and expectations different from those that purchase specialty products.
Understanding
customer needs
Commodity customers expect simplicity and
standardization. They typically do not need technical support and are
comfortable with standard delivery sizes and schedules, in contrast to
specialties customers, who often expect extensive sales and technical support
and different lot sizes. A good commodity operating model is designed
specifically to meet those needs. That usually means a reduction in the number
of products offered. It always calls for a standardized sales and marketing and
service offering—tailored to a limited number of customer segments—and taking
steps to minimize the
cost of serving those customers. This should be
backed up by the right kind of lower-cost sales and distribution channels.
Such transitions must be done with care, with clear and
consistent customer communication. And companies must accept that not all their
current customers will be willing to accept the change. Losing a certain
percentage of high-cost, low-profit customers is an inevitable, and planned,
part of the switch to a commodity approach.
For many commodity players, digitization is
proving to be a powerful way to reduce cost to serve.
Switching customers to self-service models using online platforms makes sales,
support, and order management cheaper, especially if most of the business is
reordering. Done well, it can also result in a more satisfactory customer
experience.
Manufacturing and
supply chain
Commodity businesses need streamlined manufacturing and
supply-chain processes that align with their new customer-service requirements.
That means a shift from make-to-order to make-to-stock strategies, with
automated forecasting and clearly defined and rigorously enforced “frozen
zones”—where no changes can be made—in manufacturing planning. Manufacturing operations
aim to achieve high levels of equipment utilization and apply lean principles
in an effort to continually improve quality and productivity. A different
approach to capital investments is also needed in a cyclical, commodity
business: it’s hard to do, but adding capacity at the bottom of the cycle
rather than when profits are peaking can contribute substantially to value
creation.
Commoditization often requires a fundamental mind-set
change in manufacturing operations, as staff learn to prioritize standardization,
compliance with agreed service levels, and progress in efficiency improvement,
and to move away from costly individual orders and exceptions to meet specific
customer needs. Transparent pricing helps here: when customers understand that
they will have to pay for late specification changes or shorter delivery times,
they are less likely to make such demands.
Innovation
Commodity operating strategies make fundamentally
different demands on the organization’s innovation department. Its focus will
switch from research to development—especially the development of recipe and
process improvements that reduce costs and increase throughput. Efforts to
reduce the number of raw materials used and standardize the specifications
required can pay off through higher equipment utilization and reduced costs
elsewhere in the supply chain.
The function may still support customers in application
development, but as with supply-chain exceptions, these activities should be
limited and clearly priced, with customers understanding they will pay a
premium for special products and services.
Administrative
functions
Across the business, all other support functions will
need to modify their way of working to support the new focus on costs and
standardization. Procurement,
for example, will shift its strategy from sourcing innovative new technologies
to securing inputs at the lowest overall cost. Often this change requires
purchasing staff to adopt new tools, find new suppliers, and modify their
negotiation and contracting strategies.
Efforts to streamline the finance and controlling
functions will also benefit from the adoption of new digital approaches. Activities
such as report creation and accounts-payable processes can become automated,
for example.
To support their ongoing efforts to squeeze costs and
waste from their processes, many companies find it valuable to establish a
dedicated continuous-improvement team with a
remit to help the organization to achieve performance excellence in all the
business’s functional areas—including production and related operations, as
well as marketing and sales. We call this functional excellence.
Governance
Many commoditized businesses find they also need to
alter their management and governance approaches. Changes can include a reduction
in the number of management layers and increasing spans of control for
individual managers. Many organizations make greater use of “working managers”
who share functional and management responsibilities. Strong centralization and
the greater use of shared-service functions can also help to promote
standardization and reduce overhead.
Many companies implementing a commodity operating model
find that it’s helpful to follow a zero-based
budgeting (ZBB) approach, which can help
focus on minimizing costs now and in the future. This cost-budgeting technique
helps to ensure a repeatable process is in place to challenge every dollar in
the annual budget, and to manage financial performance throughout the year. To
get the most efficient return on spending, the ZBB approach includes rigorous
annual target setting and a stringent monthly budget-monitoring process—and
provides deep visibility into underlying cost drivers. It also drives
accountability and broadens ownership of the cost-management focus, which helps
to ensure an overall alignment between top management and the line organization
for every dollar spent in the company. In this way, ZBB can be an important
component in a commodity operating model, alongside the operating-model
initiatives within each functional area described previously.
Companies also need to change the way they steer their
activities. Commodity businesses are inherently cyclical. Companies should
recognize and respond to this cyclicality, for example, by measuring their
capital returns on a through-cycle basis. They also need to focus on cash flow
and price adjustments so that they have the resources to invest during
downturns to be better prepared for the subsequent peaks.
Making the shift
Once a company knows what its commodity operating model
should look like, the challenge is getting there. Like any large-scale change
effort, this process is not to be taken lightly. Even with decisive action, the
transformation process can take around two years to achieve—and the process can
be painful. Focusing on
mind-sets, behaviors, and culture is as
important as the more outwardly obvious changes in organizational structures,
systems, and processes.
There are two requirements for the management team to
make this a success. First, the leaders must embrace the idea that there is
nothing bad about a commodity business—it is just as valuable as a specialties
one, but it simply needs to be managed in a different way. Second, the
management team must fully understand all of the changes that will have to be made,
and it must be able to act as a role model for the organization. Successful
companies often appoint a chief transformation officer and bring in new
managers who have experience running commodity operations.
Many people may need to take on new roles, or they may
need to adjust to significant changes in long-established ways of working.
Salespeople, for example, have to learn to offer their customers only
standardized order sizes from a more limited catalog of products, instead of
the customized orders, backed up with technical advice, offered in the past—and
many individuals find this is a difficult adjustment to make.
To help the workforce navigate the change, executives
must establish clear guidelines and redesign work processes—and they must
actively ensure that employees are not slipping back into their old ways of
working. It is also essential to deploy classic change-management techniques
that emphasize extensive communication with the workforce, including frequent
meetings with staff, newsletters, and speeches from company leadership.
Commoditization can’t be stopped, but it will reward
those companies that can adapt better, and faster, than their competitors.
Those benefits can be significant: as noted before, return-on-sales increases
of up to five percentage points can be achieved by companies that get their
commodity operating models right.
Take the example of one global chemical company with
operations in China, Europe, and the United States. Recognizing the inexorable
commoditization of its core-product portfolio, the company embarked on a
comprehensive change program. Abandoning its former governance model, in which
its operations had been managed on a regional basis with little central
coordination, it adopted a new global structure and performance-management
system designed to meet the needs of commodity customers. The company
streamlined and centralized several functions, including procurement, and set
up a global manufacturing-improvement program. An intensive change effort also
identified annual savings opportunities worth more than €100 million in the
company’s purchasing, manufacturing, sales and marketing, and administrative
functions—savings that could represent a possible five to eight percentage
point increase in earnings before interest, taxes, depreciation, and
amortization. Together, those changes helped the company to lift its
profitability from close to zero to more than 5 percent of sales, although this
took place against a background of strong volume pressure from emerging-market
competitors.
By
Michael Glaschke, Marco Moder, and Christoph Schmitz
http://www.mckinsey.com/industries/chemicals/our-insights/what-to-do-when-a-specialty-chemical-business-gets-commoditized?cid=other-eml-alt-mip-mck-oth-1706&hlkid=137d59adf2b74fb0a2d292250cbe1510&hctky=1627601&hdpid=767a177c-6dde-4cfe-b556-4d594aec32da
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