How chemical companies can manage commoditization and make it a competitive advantage

Commoditization challenge

24 July 2008 00:00  [Source: ICB]

Commoditization has always been a dirty word in the specialty chemical industry. How can companies identify this trend and turn it into a competitive advantage?

Debate commoditization at ICIS connect

Consultant's corner: Jonathan Goldhill/Kline

SPECIALTY CHEMICAL companies that base their strategy for success on selling differentiated products, services, and solutions are finding that many customers are only too ready to squeeze profit margins and drive value to the lowest common denominator - price.

Combined with rising energy and feedstock prices, commoditization is one of the biggest challenges facing the specialty chemical industry today.

With some foresight and planning, however, commoditization can be turned into an opportunity to gain competitive advantage.

COMMODITIZATION IN CONTEXT

Prior to the globalization of the chemical industry, "specialty" and "commodity" described distinct sectors that had different products and competitive landscapes.

Today, however, those distinctions have blurred. Far greater access to information and less expensive "generic" chemicals from low-cost countries like India and China give customers the tools to make more finely tuned purchasing decisions.

To compete under these circumstances, most companies now have a mixture of specialty and commodity products.

As a result, the terms "specialty" and "commodity" often represent a false dichotomy. Commoditization should not be viewed as a change in state from a specialty business to a commodity business, but as a counterforce that resists attempts at differentiation across a specialty/commodity continuum.

At the extremes of this continuum are the pure commodity business and the pure specialty business. What it takes to be successful in a commodity business (spending the least amount one can get away with) is the exact opposite of the requirements for success in a specialty business (spending the most one can justify).

Commodity businesses compete on the basis of delivered cost, and cost curves are typically used to assess competitors' relative position to each other and to the market.

Commodity players' margins depend on the extent of their cost advantage. Unviable players have costs that are higher than the market price, and marginal players have margins that do not return the cost of capital invested.

At the other end of the continuum, specialty businesses compete on the basis of differentiation. Specialty players' margins increase the more they invest, whether in manufacturing high-value/low-volume differentiated products and services, in research and development of new offerings, or in marketing and sales to convince customers that their premium pricing is justified.

Unviable and marginal players do not spend enough - or wisely enough - to justify the premium prices they seek.

However, most specialty chemical businesses today operate somewhere between the two extremes, competing in what we call the transition zone, where commoditization resists players trying to maintain a specialty focus and encourages commodity-oriented players to capture additional value.

Such businesses are in a no-man's-land, where price and performance-based competition uneasily coexist.

Many specialty chemical companies have seen their businesses shift to the transition zone since the mid-1990s (in hindsight, this was perhaps the glory days for specialty chemicals) with an associated decline in profitability.

Competing in the transition zone is problematic because the natural reaction of specialty-focused players is to cut costs in the face of margin erosion.

Meanwhile, commodity players seeking to differentiate themselves on criteria other than price tend to undersell. As a result, price supports disappear, making every player potentially a marginal competitor.

The result is converging performance. In recent years, the financial performance of companies with specialty, commodity, or diversified chemical portfolios has converged to the extent that both top-line and bottom-line results are virtually the same.

In this business environment, how is it possible to see commoditization as an opportunity rather than a threat? What does it take to turn commoditization pressures into a competitive advantage?

PREDICT COMMODITIZATION TRENDS AND IMPACTS

The key to success lies in how well companies manage the impact of commoditization on their businesses.

The ability to spot, track, and anticipate changes in commoditization trends, and then shift the portfolio mix and the allocation of resources, is critical. Companies that do this better and faster than the competition will gain a competitive advantage.

However, identifying and tracking commoditization trends across businesses and markets is not easy. There is no single "off-the-shelf" measure that distinguishes between more or less commoditized businesses. Also, commoditization does not occur at a steady rate, and it is reversible.

What's needed is a combination of approaches - tracking both quantifiable metrics and qualitative, event-driven indicators.

Metrics need to be measurable on a consistent basis over time and exclude, as much as possible, "noise" from factors unrelated to commoditization pressures. Examples include energy and feedstock pricing, unit prices and price differentials, market value along the value chain, and customer value added.

In parallel, monitoring relevant industry events can help identify potential triggers for further commoditization.

A useful framework here is Porter's Five Forces, but applied dynamically rather than at a fixed point in time. For example, you might track indications of growing rivalry between competitors, price-based competition from new entrants, and changes in purchasing patterns among key customers.

The best insights on commoditization trends come from comparing these "hard" and "soft" indicators, separating out extraneous influences such as industry cycles, and identifying likely causes and effects between the remaining factors.

ALIGN BUSINESSES WITH THE COMPETITIVE ENVIRONMENT

Businesses that fall into the transition zone between commodities and specialties generally are composed of multiple segments that focus on a diverse set of products, technologies, customer types, and geographic regions.

To manage the pressures of commoditization, such businesses must understand where their various business segments fit along the specialty/commodity continuum, and how segments stack up against their competitors.

This type of analysis is more granular than a conventional business assessment, and requires both internal and external data and insights. However, we do not necessarily advocate detailed assessments of cost curves and price/performance trade-offs by segment. Smarter, more finely tuned approaches are often more appropriate.

The key is to avoid "analysis paralysis" by focusing on those segments that are in the front line of the battle to capture value, concentrating on benchmarking representative stronger and weaker players within these segments, and using the results to assess the implications for the business and its room to maneuver.

Commodity-focused firms stand out in the way they leverage these approaches. One example is the merger between Netherlands-based Basell and US-based Lyondell that resulted in an improved cost position in upstream raw materials. Another is Saudi Arabia-based SABIC's acquisition of US-based GE Plastics, adding more value-added polymers to the firm's portfolio and balancing out its global presence.

CAPTURE VALUE THROUGH CHANGE

Business managers in the transition zone have two broad choices in how they create value. One approach is to adopt a radical business model in order to reverse or accelerate the impact of commoditization.

To date, we have not seen any specialty chemical firm adopting a radically new business model. But going forward, increasing energy and feedstock pricing, economic downturns, and the potential for increased availability of nonpetrochemical, renewable feedstocks will be key motivators for change.

Interestingly, we have seen commodity firms shifting models to become more specialty-oriented in nature. A prime example is US-based Dow Chemical's introduction of a slew of solutions-based businesses - making a transition from a product-focused approach to a "product-agnostic" model.

The alternative approach is to gain greater precision in several areas of the company's current business processes, such as pricing, marketing, customer management, and product development. This approach typically involves less risk and is designed to slow the impact of commoditization, but it can still result in a significant competitive advantage for companies that do it well.

WIN THE CHALLENGE

Staying ahead of the trends, aligning business segments with the competitive environment, fine-tuning ways to capture value, creating the right structure - these are the measures needed to turn the challenge of commoditization into an opportunity.

Our observation is that commodity chemical firms are taking the lead in turning the reality of commoditization into a competitive advantage, both on their home turf and in their moves toward the specialty end of the continuum.

In this environment, they may have greater opportunities because they have more control of energy and feedstock costs than specialties. Nevertheless, we believe that specialties can do much more to escape the transition zone and win the commoditization game.

CHARACTERISTICS OF THE SPECIALTY INDUSTRY

• Companies that produce functional, formulated and compounded chemical and/or "chemical process enabled" materials, with a focus on performance
• Many small and increasingly larger (diversified) companies
• Participation in relatively fragmented markets such as paints and coatings, personal care, adhesives or construction
• Declining profitability - average return on sales has been declining since the mid-1990s
• Technical and customer service continues to be an important customer-facing activity, but also more costly
• Management increasingly focusing on tactics: resource allocation (cost reduction), innovation-driven acquisitions and partnering, "virtual" business practices

Source: Kline

Jonathan Goldhill is a senior vice president with Kline where he directs the management consulting group worldwide and leads the corporate and business unit strategy practice. He is based in Philadelphia, Pennsylvania, US.

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