What to Do When a Specialty- Chemical Business Gets Commoditized

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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.

Michael Glaschke, Marco Moder, and Christoph Schmitz

Commoditization of the specialty-chemical much capacity means that the prices of increasing industry is accelerating. While the history of the numbers of products are determined not by chemical sector is one of relentless commoditization the value they deliver to customers but by their as one generation’s innovations become standard production costs and freight to market. products of the next, the pace is increasing. There are a number of causes behind the shift. Commoditization of specialty-chemical businesses poses a structural challenge for the industry. How In some segments, specialty players are struggling should these enterprises respond? Chemical to create the innovative products that offer companies must recognize that commoditized significant additional value to customers and businesses can earn attractive returns if they are run differentiate themselves from competitors. in an entirely different way from specialty businesses. Meanwhile, the combination of new, low-cost The key is to tailor the new operating model to the market entrants—especially from China—and too business’s true needs and the costs it can bear.

1 McKinsey on Chemicals May 2017 MoChemicals 2017 What do when a chem bus commoditized Exhibit 1 of 2

Exhibit 1 Over the long run, commodity chemicals and specialty chemicals show similar performance.

otal returns to shareholders RS1 RS1 indeed, 100 Dec 31, 2000, compound annual growth rate,

Commodity chemicals All chemicals

Specialty chemicals Diversified chemicals Dec 2000 Dec 200 00 Mar 2016 Mar 2016

Specialty chemicals 11 17 600

Commodity chemicals2 11 16

400 All chemicals 14

200 Diversified chemicals 6 13

0 2002 2004 2006 200 2010 2012 2014 2016

1Figures have been calculated using . Data set used is based on 212 chemical companies worldwide and excludes fertilizer companies and SABIC. Data have been indexed to Dec 31, 2000. 2Excluding fertilizers. Source: Datastream; Corporate Performance Analytics by Mcinsey

Our analysis of chemical-industry shareholder- steps. First, they need to spot commoditization returns performance shows that commodity- coming, so that they can start to act before they are chemical players have captured just as much value outpaced by others. Second, they should design an as specialty players since 20001 (Exhibit 1). While appropriately tailored operating model for their this performance may be contrary to widely held commoditized businesses. Third, they must embark assumptions and conventional wisdom in the on a comprehensive change effort to put that new chemical industry, our data have consistently shown model to work. Companies that get this right can that over the long term, this pattern holds. Chemical capture significant rewards, with a return-on-sales companies facing these challenges can also take uplift of as much as five percentage points. encouragement from the example of other industries successfully supplying commoditized offerings. In Recognizing commoditization the airline sector, for example, low-cost carriers have Companies that have built their reputations on outperformed their full-service rivals in profitability. innovative, differentiated products and responsive customer service can be understandably reluctant To turn commoditization from a threat into to admit that the market has moved on. That’s risky. an opportunity, companies should take three If the tide of commoditization has already turned,

What to do when a specialty chemical business gets commoditized 2 they can find themselves isolated while more organizations, the breadth of this operating model focused competitors snatch their customers. will extend to the whole company; for others, it will include specific business units, or lines of business Every specialty-chemical player should keep a within those units (Exhibit 2). watchful eye for encroaching commoditization and systematically look out for the warning signs. Whatever the scope, there are a few guiding Here are some questions that executives should principles that will greatly increase an ask themselves: Does capacity significantly exceed organization’s chance of designing and demand? Have prices been declining steadily implementing a successful operating model. First, despite attempts to raise them? Have prices been it should start from scratch, and make a priority squeezed to maintain market share? Have new of minimizing costs. Merely tinkering with competitors from countries with lower production approaches more suitable for specialty products costs entered the market, and are their offerings will rarely achieve the impact necessary to compete similar to those of the incumbents but at lower in a commodity market—or create an organization prices? Have we created any innovative products that is agile enough to deal with the cyclicality of in the last five years? Are we no longer dealing a commodity business. Second, the change should with our customer’s product-development unit encompass the whole organization, including sales, but just with its purchasing department? Have manufacturing, supply chain, and administrative customers stopped asking and paying for additional and support functions. Third, the design should services? Central to the analysis should be a clear begin with a clear perspective on customers, understanding of the price-setting mechanisms in bearing in mind that commodity buyers will have the market. If the price of a product is close to the needs and expectations different from those that costs of a marginal producer, then it is, or soon will purchase specialty products. be, a commodity. Understanding customer needs By analyzing these indicators across its product Commodity customers expect simplicity and portfolio, a company can understand how it should standardization. They typically do not need shape its operations: as a specialty player, as a technical support and are comfortable with commodity manufacturer, or in a mixed model with standard delivery sizes and schedules, in contrast pockets of specialty production alongside a core of to specialties customers, who often expect commodity products. extensive sales and technical support and different lot sizes. A good commodity operating model is Designing the right operating model designed specifically to meet those needs. That Once it identifies what products are becoming usually means a reduction in the number of commodities, a company can set about designing an products offered. It always calls for a standardized operating model that will allow it to manufacture sales and marketing and service offering—tailored and sell those products profitably. There is no to a limited number of customer segments—and one-size-fits-all approach here, but there are taking steps to minimize the cost of serving those certain requirements that must be met. The customers.2 This should be backed up by the right right combination of changes will depend on kind of lower-cost sales and distribution channels. the company’s portfolio mix, on the nature of the products involved, and on the needs of its Such transitions must be done with care, with clear commodity customers and markets. For some and consistent customer communication. And

3 McKinsey on Chemicals May 2017 MoChemicals 2017 What do when a chem bus commoditized Exhibit 1 of 2

Exhibit 2 Before and after: Key changes in the operating model made at a chemical company moving to a commodity setup.

rom o Specialty-chemical management Commodity-chemical management

usiness serices Manage growth and differentiate ean setup to manage costs and general and vs competitors administratie

Marketing alue pricing mind-set ow cost-to-serve model (eg, web based) and sales Differentiated segment approach Standard offering with 1 service model with differentiated service levels Rigid product-portfolio management

perations No OEE1 focus High utilization, targeting 26 OEE As many product grades as demanded 1020 product grades, as demanded Shorter run times, many changeovers Cost leadership Fleibility High degree of right first time

Supply-chain redominantly made to order redominantly made to stock management and “Frozen zone” 12 weeks Frozen zone weeks procurement Securing supply Standard service level and model Reduction of raw materials and standardization of recipes

nnoation Tuned and tailored to market and No tailoring and RD customer reuirements Focus on recipe improvements for cost Strong innovation engine optimization and maimizing throughput

1Overall equipment effectiveness, a metric for manufacturing productivity. Source: Mcinsey analysis

companies must accept that not all their current manufacturing and supply-chain processes customers will be willing to accept the change. that align with their new customer-service Losing a certain percentage of high-cost, low-profit requirements. That means a shift from make-to- customers is an inevitable, and planned, part of the order to make-to-stock strategies, with automated switch to a commodity approach. forecasting and clearly defined and rigorously enforced “frozen zones”—where no changes For many commodity players, digitization is can be made—in manufacturing planning. proving to be a powerful way to reduce cost to Manufacturing operations aim to achieve high serve.3 Switching customers to self-service models levels of equipment utilization and apply lean using online platforms makes sales, support, and principles in an effort to continually improve order management cheaper, especially if most of quality and productivity. A different approach to the business is reordering. Done well, it can also capital investments is also needed in a cyclical, result in a more satisfactory customer experience. commodity business: it’s hard to do, but adding capacity at the bottom of the cycle rather than when Manufacturing and supply chain profits are peaking can contribute substantially to Commodity businesses need streamlined value creation.

What to do when a specialty chemical business gets commoditized 4 Commoditization often requires a fundamental new digital approaches. Activities such as report mind-set change in manufacturing operations, as creation and accounts-payable processes can staff learn to prioritize standardization, compliance become automated, for example. with agreed service levels, and progress in efficiency improvement, and to move away from costly To support their ongoing efforts to squeeze individual orders and exceptions to meet specific costs and waste from their processes, many customer needs. Transparent pricing helps here: companies find it valuable to establish a dedicated when customers understand that they will have to continuous-improvement team with a remit to pay for late specification changes or shorter delivery help the organization to achieve performance times, they are less likely to make such demands. excellence in all the business’s functional areas— including production and related operations, Innovation as well as marketing and sales. We call this Commodity operating strategies make functional excellence. fundamentally different demands on the organization’s innovation department. Its focus Governance will switch from research to development— Many commoditized businesses find they also especially the development of recipe and process need to alter their management and governance improvements that reduce costs and increase approaches. Changes can include a reduction in throughput. Efforts to reduce the number of raw the number of management layers and increasing materials used and standardize the specifications spans of control for individual managers. Many required can pay off through higher equipment organizations make greater use of “working utilization and reduced costs elsewhere in the managers” who share functional and management supply chain. responsibilities. Strong centralization and the greater use of shared-service functions can also help The function may still support customers in to promote standardization and reduce overhead. application development, but as with supply-chain exceptions, these activities should be limited and Many companies implementing a commodity clearly priced, with customers understanding they operating model find that it’s helpful to follow a will pay a premium for special products and services. zero-based budgeting (ZBB)4 approach, which can help focus on minimizing costs now and in Administrative functions the future. This cost-budgeting technique helps Across the business, all other support functions to ensure a repeatable process is in place to will need to modify their way of working to support challenge every dollar in the annual budget, and the new focus on costs and standardization. to manage financial performance throughout Procurement, for example, will shift its strategy the year. To get the most efficient return on from sourcing innovative new technologies to spending, the ZBB approach includes rigorous securing inputs at the lowest overall cost. Often annual target setting and a stringent monthly this change requires purchasing staff to adopt budget-monitoring process—and provides deep new tools, find new suppliers, and modify their visibility into underlying cost drivers. It also drives negotiation and contracting strategies. accountability and broadens ownership of the cost-management focus, which helps to ensure an Efforts to streamline the finance and controlling overall alignment between top management and functions will also benefit from the adoption of the line organization for every dollar spent in the

5 McKinsey on Chemicals May 2017 company. In this way, ZBB can be an important long-established ways of working. Salespeople, for component in a commodity operating model, example, have to learn to offer their customers alongside the operating-model initiatives within only standardized order sizes from a more limited each functional area described previously. catalog of products, instead of the customized orders, backed up with technical advice, offered Companies also need to change the way they in the past—and many individuals find this is a steer their activities. Commodity businesses are difficult adjustment to make. inherently cyclical. Companies should recognize and respond to this cyclicality, for example, by To help the workforce navigate the change, measuring their capital returns on a through-cycle executives must establish clear guidelines and basis. They also need to focus on cash flow and redesign work processes—and they must actively price adjustments so that they have the resources to ensure that employees are not slipping back into invest during downturns to be better prepared for their old ways of working. It is also essential to the subsequent peaks. deploy classic change-management techniques that emphasize extensive communication with the Making the shift workforce, including frequent meetings with staff, Once a company knows what its commodity newsletters, and speeches from company leadership. 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 Commoditization can’t be stopped, but it will take around two years to achieve—and the process reward those companies that can adapt better, and can be painful. Focusing on mind-sets, behaviors, faster, than their competitors. Those benefits can and culture is as important as the more outwardly be significant: as noted before, return-on-sales obvious changes in organizational structures, increases of up to five percentage points can be systems, and processes. achieved by companies that get their commodity operating models right. There are two requirements for the management team to make this a success. First, the leaders must Take the example of one global chemical company embrace the idea that there is nothing bad about with operations in China, Europe, and the United a commodity business—it is just as valuable as a States. Recognizing the inexorable commoditization specialties one, but it simply needs to be managed of its core-product portfolio, the company embarked in a different way. Second, the management team on a comprehensive change program. Abandoning must fully understand all of the changes that will its former governance model, in which its operations have to be made, and it must be able to act as a role had been managed on a regional basis with little model for the organization. Successful companies central coordination, it adopted a new global often appoint a chief transformation officer and structure and performance-management system bring in new managers who have experience designed to meet the needs of commodity customers. running commodity operations. The company streamlined and centralized several functions, including procurement, and set up a Many people may need to take on new roles, or global manufacturing-improvement program. An they may need to adjust to significant changes in intensive change effort also identified annual

What to do when a specialty chemical business gets commoditized 6 savings opportunities worth more than €100 million 1 See Bing Cao, Obi Ezekoye, and Michael Glaschke, “Chemicals in the company’s purchasing, manufacturing, sales and capital markets: Still a strong performer,” McKinsey on and marketing, and administrative functions— Chemicals, July 2016. 2 savings that could represent a possible five to For further discussion of adapting commercial operating models to commoditization, see Jochen Böringer and Theo Jan eight percentage point increase in earnings before Simons, “Commoditization in chemicals: Time for a marketing interest, taxes, depreciation, and amortization. and sales response,” McKinsey on Chemicals, December 2016, Together, those changes helped the company to McKinsey.com. 3 For further discussion of digital approaches to marketing and lift its profitability from close to zero to more than sales in chemicals, see Søren Jakobsen, Kedar Naik, Nikolaus 5 percent of sales, although this took place against Raberger, and Georg Winkler, “Demystifying digital marketing a background of strong volume pressure from and sales in the chemical industry,” McKinsey on Chemicals, emerging-market competitors. February 2017, McKinsey.com. 4 For a more detailed discussion of zero-based budgeting, see Matt Fitzpatrick and Kyle Hawke, “The return of zero-based budgeting,” August 2015, McKinsey.com; and Shaun Callaghan, Kyle Hawke, and Carey Mignerey, “Five myths (and realities) about zero-based budgeting,” October 2014, McKinsey.com.

Michael Glaschke is a partner in McKinsey’s Munich office;Marco Moder is a partner in the Frankfurt office, where Christoph Schmitz is a senior partner.

7 McKinsey on Chemicals May 2017