Long-term view: the chemicals industry is thriving.
In the last decade the value of chemical exports has doubled. The American Chemistry Council expects the industry to see additional growth of 3.9% in 2016, despite the headwind of failing global economies.
Even the oil industry, which suffered a steep decline in price per barrel, has recovered closer to what some have called “the Goldilocks Zone” where prices are just right for producers and consumers.
And yet, right now, chemical manufacturers are feeling downward price pressure.
A number of factors are creating a ripple effect that leads to poor decisions negatively impacting an organization’s profitability.
Domestic chemical investments are reaching new highs, buoyed by strategic decisions to take advantage of low cost input costs like shale development. As companies increase capacity, they often assume simplistic pricing strategies as a shortcut when projecting acquisition of new business to fill that capacity.
It’s a perpetual cycle of overbuilding and underutilizing, overbuilding and underloading. Everyone wants to wait for market demand to increase, justifying added capacity, but no one wants to be anything but first to market with new (low cost) capacity.
Is it working?
The short answer is no.
There is a mad rush. An unbelievable number of projects are announced, yet a smaller, still unreasonable number of projects start. Even after continued apprehension, a surprisingly large number of projects begin production. Although the capacity of these producing plants is far lower than what was announced, it is far more than what the market needs.
We know what happens when boards ask about the return on new assets. The command comes: sell out the capacity! These decisions are made on the false assumption that low cost investments will yield higher margins to replenish the investment funds. Sometimes this works, but more often than not, the decisions are made with too narrow of a focus, especially with respect to timing.
Sometimes, the best thing to do in the long term is plan to not get ahead of demand. Lowering your price is not going to have a measurable impact on total market demand. But if you plan to build excess capacity, you need to consider that excess as an investment in the future. Don’t destroy the value of your utilized capacity by not having a strategy that looks long term. To make that strategy work, you’ve got to be able to control and measure the execution of your tactics.
Previously, I outlined an alternative pricing strategy—“Down and Out” pricing—to cope with volatility. By taking a similar approach that incorporates wide and narrow views of your business, downward price pressure and commoditization can be positive drivers of profit.
The Market is Not in Control
The market is turbulent. The status quo today will be completely different in the next few years—or even months in some cases. Your costs will change. The demand in your market will change. Your competitors will make decisions about their capacity. An enterprise must be able to adapt.
The investments discussed above take time and significant planning to execute upon. By the time the new assets come up, the only certainty is that all the forecasts were wrong. In this process of determining investments to act upon, the marketplace environment is taken into account, but companies frequently look inwardly to determine if the upcoming changes make sense from a financial performance viewpoint, ignoring the effect on profitability.
For a successful – profitable - pricing strategy, the race to build and load should make sense to your business situation. Is demand rising to the point of needing more? Have new customers been found to justify the increase? If you are building excess capacity, how are you going to manage it?
The picture becomes much clearer as to whether or not an increase in capacity is warranted when market intelligence is married with internal data. This needs to be understood both in the “now” and in the “future” that will happen if you take those actions now.
Segment your internal transaction history to better understand the behavior of customers and products. Is a particular product selling well in a certain region, regardless of price changes? Maybe it makes sense to increase capacity—or, increase price to capture the value those customers see in your products.
This process opens up the possibilities and insights into what is making your company profitable now, so future decisions—about pricing and capacity—can grow from this knowledge.
This is very important in the area where manufacturers believe that they have “commoditized” products. It is commonly believed that the market makes the price for commodities, and if you follow that thinking to its conclusion, it infers a race to the bottom. The thinking is that you must have costs lower than that incremental producer. That is certainly a reasonable, and very conservative, position.
Before investing in increased production, it is key to establish the uniqueness of the commodity to identify its true value, especially early on. There are always distinguishing, even innovative features. If not on your product itself, perhaps it’s your tech support, for example.
The financial objective must include the magic of the “and.” How to have the new asset earn its living now, and preserve the value of that asset in the future.
Understanding how the product impacts your organization and those of your customers can preserve profitability. Does your company use it in a different way that influences its value to business performance? Do customers rely on this product?
Your pricing strategies and tactics should be aligned with the added value your business provides to customers—now and in the future.
No matter what, the process must begin with the foundation to better understand what is needed to make the business more profitable. The volatility of the market is telling you something that often requires a tactical response – and a successful strategy knows that up front. Proper considerations of these factors, supported by an agile, enterprise-capable solution, can provide your organization fact-based information for decisions that protect and enhance your profitability.
Mitchell Lee is a Business Consultant at Vendavo with 25+ years of experience in the technical, operational, marketing, and commercial arenas of the chemical industry.