Future of chemicals, part X: Enabling profitable growth through natural supply chains

In an increasingly complex market, some chemical companies are winning by developing "natural supply chains," a market-back approach that optimizes the supply chain for each customer segment. As a result, these companies improve customer service and profit margins, and reduce their inventory.

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Future of chemicals, part X Enabling profitable growth through natural supply chains


Berlin Matthias Baeumler Partner +49-30-88705-852 matthias.baeumler @strategyand.pwc.com Chicago Eduardo Alvarez Senior Partner +1-312-578-4774 eduardo.alvarez @strategyand.pwc.com Dallas John Corrigan Partner +1-214-746-6558 john.corrigan @strategyand.pwc.com DC Peter Bertone Senior Partner +1-703-682-5719 peter.bertone @strategyand.pwc.com Dubai Andrew Horncastle Partner +971-4-390-0260 andrew.horncastle @strategyand.pwc.com

Dubai Asheesh Sastry Partner +971-4-390-0260 asheesh.sastry @strategyand.pwc.com Düsseldorf Dr. Joachim Rotering Senior Partner +49-211-3890-250 joachim.rotering @strategyand.pwc.com Florham Park Al Kent Partner +1-973-410-7660 albert.kent @strategyand.pwc.com Frankfurt Marcus Morawietz Partner +49-69-97167-467 marcus.morawietz @strategyand.pwc.com

Hong Kong Krishnan Narayanan Senior Executive Advisor +852-3182-7192 krishnan@narayanan @strategyand.pwc.com Houston Jayant Gotpagar Partner +1-713-650-4107 jayant.gotpagar @strategyand.pwc.com Juan Trebino Partner +1-713-650-4151 juan.trebino @strategyand.pwc.com Varun Ratta Principal +1-713-650-6162 varun.rotta @strategyand.pwc.com Rohit Singh Principal +1-713-650-4139 rohit.singh @strategyand.pwc.com

London Andrew Clark Partner +44-20-7393-3418 andrew.clark @strategyand.pwc.com New York Richard Kauffeld Partner +1-212-551-6582 richard.kauffeld @strategyand.pwc.com São Paulo Arthur Ramos Partner +55-11-5501-6229 arthur.ramos @strategyand.pwc.com



About the authors

Richard Kauffeld is a partner with Strategy& based in New York, where he leads the firm’s development of Fit for Growth* supply chain capabilities. He specializes in helping Strategy&’s clients refine business strategies and tailor supply chain capabilities to pursue customer and channel growth opportunities, manage complexity, and enable profitable growth. Jayant Gotpagar is a partner with Strategy& based in Houston, where he leads the North American chemicals practice and is one of the firm’s leading experts on the chemicals and materials industry. He specializes in strategy, R&D, and operations improvement, with a particular focus on strategy-based transformations. Rohit Singh is a principal with Strategy& based in Houston. He specializes in operations improvement programs, focusing on sourcing, global manufacturing, asset productivity improvements, and operations excellence for the chemicals industry. Subbu Palaniappan is a senior associate with Strategy& based in Chicago, where he focuses on operations and supply chain strategies to help companies grow profitably. He specializes in developing natural supply chain capabilities for chemical companies.

* Fit for Growth is a registered service mark of PwC Strategy& Inc. in the United States.



Executive summary

The chemicals industry is facing a challenging global business environment. Complexity — a combination of heightened competition in developed and developing regions, greater volatility in the price of raw materials, and the need to innovate and serve an extremely heterogeneous customer base — has constrained profitability for many chemical companies. Perhaps most worrisome, this complexity has made future growth uncertain. When companies face new conditions in their market that are altering the nature of their business and their relationships with customers, the usual (and wrong) response is to double down and make a bigger bet on a strategy that isn’t working. That is precisely what many chemical companies are doing. Instead of managing the complexity to their advantage, they are desperately trying to grow out of the problem by increasing sales no matter the expense, or severely cutting costs, often with a one-size-fits-all mind-set. Both approaches only exacerbate operating challenges and limit performance. Instead of single-mindedly focusing on growth or costs, some chemical companies are managing the complexity — and winning — by developing “natural supply chains.” This is a market-back approach that assesses customer value and service needs, and aligns these elements with the chemical company’s service and manufacturing capabilities. In so doing, the company can optimize its supply chain for each customer segment, to improve efficiency and service. More specifically, the business can enjoy significant improvements in customer experience as measured by on-time product availability, sales, and margins, along with reductions in costs, inventory, and operational complexity — resulting in profitable growth on a sustainable basis. In all, companies that adopt natural supply chains can achieve customer service improvements in the range of 15 to 25 percentage points, EBITDA (earnings before interest, tax, depreciation, and amortization) gains of 5 to 10 percent, and inventory reductions as large as 30 to 40 percent.
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Chasing growth or cutting costs will not work
Chemical companies are being buffeted by intense and shifting market forces. Globally, customers have become increasingly heterogeneous, with unique specifications and different expectations for service from their chemical and material suppliers. Some customers need low price points but require additional service and tech support; in the past, these additional needs warranted higher prices or add-on fees, but the current supply-and-demand equation makes demanding higher prices more difficult. Other companies, such as automotive manufacturers, have mature supply chain planning processes and capabilities in-house. They can routinely provide predictable orders for specialty materials with a lead time of three weeks or more. Still other customers depend on their suppliers to be nimble and flexible enough to deliver chemical supplies in varied quantities with short lead times. And virtually all customers want chemical and material suppliers to help them constantly innovate and meet consumer demand for new features and new products. Without a creative, tailored approach to this heterogeneous market, chemical companies are at a loss to meet each of their customers’ unique requirements in a cost-effective way. Moreover, demand is markedly shifting east to emerging Asian markets, even though the production footprints of established chemical companies are still predominantly in the West. The result is long supply chains that are less responsive and more expensive. Compounding the geographic challenge is that local manufacturers in these faster-growing emerging markets are offering competitively low prices, with short lead times and improving quality. Their local presence helps these new rivals react to customer needs in a more agile fashion, while also keeping production expenses down. Cost competition has become especially pronounced as prices fluctuate for critical raw materials made from oil derivatives. In all, the consequences of increased complexity and competition are reduced growth, earnings, and profit margins for chemical companies. Many of these companies have responded by digging a deeper hole for themselves, rather than addressing the new complexity with a strategy to manage and mitigate it. Indeed, established manufacturers tend to take one of two paths in the face of this disruption.
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Without a tailored approach to serve the heterogeneous customer base, companies experience reduced growth.

The first path is to try to grow their way out of the problem, with a desperate push to increase sales. In some cases, companies strive for growth by providing customized offerings, often for individual customers, which may or may not justify added costs. This can involve chasing all sales, even small orders with unique requirements that are expensive to fulfill. By stretching the product portfolio and supply chain to serve everyone with high levels of attention, these companies effectively add complexity and cost to product lines, and draw resources away from their most valuable customers — those that drive profitability. Chemical companies that choose the second path — reducing expenses — typically cut costs uniformly across all markets and functions, weakening customer relationships and limiting variation and innovation in the product pipeline. In attacking the problem this way, these manufacturers leave themselves vulnerable to large and wasteful production runs, with no connection to order forecasts, or they reduce inventory well below targets in order to meet financial reporting goals, further eroding customer service levels. It doesn’t take a profound analysis to realize that neither of these two approaches — driving sales or cutting costs — creates capabilities needed over the long run to manage the increasing complexities of the marketplace. Instead, they create a vicious cycle that leaves manufacturers less able to serve the chaotic marketplace, and less able to achieve profitable growth (see Exhibit 1).

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Exhibit 1 The vicious cycle faced by many chemical companies in a more complex market

Poor service levels

Lack of growth

Primary color gro

Inventory imbalance

Vicious cycle of deteriorating performance

Increased portfolio complexity

Production instability Forecast overrides to meet short-term goals

Reduced forecast accuracy

Source: Stategy&



Addressing complexity with natural supply chains
The solution to delivering profitable growth in the current chemicals market involves a set of capabilities that we call a “natural supply chain.” Simply put, the natural supply chain approach entails matching customers and their needs with supply chain capabilities that result in the greatest value generated. We have designed and implemented natural supply chain capabilities across industries to better manage complexity and enhance growth and service while controlling costs and asset productivity. This is a market-back approach in which the company assesses customer value and service requirements and compares them with its service and manufacturing capabilities, factory footprint, and product profitability. From this analysis, the company establishes a natural supply chain, with differentiated policies that best serve the needs of both the chemical manufacturer and the customer — a customized approach that benefits both sides of the transaction. The chemical company achieves the best profit margins and the most cost-efficient operations; the customer receives the products and services that it needs to ultimately satisfy its own customers and business imperatives (see Exhibit 2, page 8). With this approach, preference is given to the most valuable customers — determined not only by profit but also by qualitative factors, such as how well they fit with the manufacturer’s strategic objectives and whether they are willing to collaborate. Customers offering less value are still served, but with a more cost-effective supply chain approach that maximizes the profits available from the relationship. Meanwhile, customers that are not as profitable may be reevaluated and supplied through different channels, such as third-party distributors that can potentially wring small profits out of the arrangement. Using natural supply chains, a chemical company can serve any number of differentiated market requirements with tailored supply chains that align best with each of them, improving customer satisfaction, manufacturer cost levels, inventory productivity — and, of course, profits.

Differentiated policies serve the needs of both the chemical manufacturer and the customer.



Exhibit 2 Segmenting supply capabilities and go-to-market capabilities leads to the natural supply chain, with different policies to meet different customer needs
Segmented supply capabilities Differentiated supply chains Segmented go-to-market capabilities


Product importance

Differentiated supply chain #1 Supply policies Supply/asset response efficiency Segment by: • Product • Make-versus-buy analysis • Asset footprint/ capabilities • Service capability and cost structure Differentiate based on: • Lead times • Order quantities • Inventory targets • Postponement and pooling Inventory/ distribution Customer offers Customer service needs Segment by: • Market service needs

Customer value

Differentiated supply chain #2


• Customer value • Customer relationships • Demand variability

Source: Stategy&

Frequently, companies will find that there is systemic alignment between their supply chain capabilities and specific customer needs, but that these relationships could be much more profitable if the company can make structural changes. For example, they could consider adding warehouse space to hold forward-deployed inventory closer to key customers, offering local packaging services, or serving smaller customers through third-party distributors. The goal is to segment customer needs and supply chain capabilities in order to create a more profitable customer relationship.



In our experience across various industries, implementing these capabilities has generated remarkable and tangible gains at companies that had previously struggled in the face of shifting customer demands. Here are two examples: • A fashion retailer with a broad portfolio, ranging from basic design to trendy merchandise, was struggling with in-store availability, resulting in lost sales to more nimble competitors. In response, it established three natural supply chains: “basic,” “seasonal,” and “trendy.” Basic products were forecast statistically, sourced from low-cost suppliers, delivered via “cross-dock” shipments (with no storage at distribution centers), and replenished frequently to ensure they were always available. On the other hand, trendy products were forecast using demand sensing, sourced from suppliers that offered speed and flexibility, air-freighted, and not replenished after the initial delivery. With this approach, the retailer’s product availability increased by 12 percent and its cost of goods sold fell by 7 percent. • A global beverage manufacturer offered new products that did not have the same economies of scale as its older offerings, leading to significant increases in product costs. The company established two natural supply chains — “efficient” and “agile” — based on product life cycle, profitability, and demand characteristics. The efficient supply chain took advantage of inherently stable demand to get better pricing from suppliers, make products in economically favorable batch sizes, and ship products directly from the manufacturing facility to distributors. Conversely, the agile supply chain used end-to-end scenario planning, suppliers with flexible capacity, and production lines that could handle small batches. As a result, the beverage manufacturer was able to reduce costs by 5 percent and improve product availability and time-to-market for new product launches by 10 percent. As these examples illustrate, natural supply chains are a creative solution based on the unique characteristics of each manufacturer/customer relationship. Across the broad spectrum of potential solutions that companies may implement, one way to simplify the discussion is to describe a two-part approach — one supply chain that is designed for efficiency and a second that is designed for agility (see Exhibit 3, page 10). A natural supply chain designed for efficiency would primarily serve high-volume, price-sensitive customers that had consistent delivery needs. The supplier could offer longer lead times and predictable logistics costs and service requirements. In this efficient supply chain, the manufacturer optimizes production and supply chain management for the lowest costs and greatest manufacturing productivity. Customer

One supply chain can be designed for efficiency and a second can be designed for agility.




Exhibit 3 An illustrative example of two natural supply chains: one designed for efficiency and a second designed for agility










Efficient supply chain • Standard commodities • Stable supplier • Make-versus- • Ship directly • Statistical buy analysis from plant with lowest forecasting or central total cost • Operation • Production plan warehouses excellence to minimize • Shipment changeovers consolidation Agile supply chain • Custom specialty goods • Demand sensing • Suppliers with • Flexible assets • Network with short lead • Scenario planning flexible capacity • Quick time changeovers • Production plan • Nearshoring • Less-thanwith flexible truckload capacity shipments • Postponement • Small volume • Buys based on quality more than price • Price sensitive • High volume • Predictable


Source: Stategy&

service is available but purposefully constrained to avoid adding extraneous costs into the relationship, and thus uncouple the supply chain from product value. By contrast, a natural supply chain designed for agility would be best suited for small-lot orders from customers that prize high quality and customization and are less price-sensitive; in other words, these customers are unpredictable but willing to pay for their capriciousness. Accordingly, the agile supply chain would seek to capture these potentially higher profit margins by providing customers with benefits like shorter lead times, tailored products and services, flexible order and logistics channels, and frequent innovation.



Natural supply chains in chemical and material companies
In our experience, building natural supply chain capabilities in the chemicals industry, we have found that companies have vastly different types of supply chain characteristics and therefore must carefully tailor the right mix of capabilities to effectively manage complexity. Specific requirements vary widely among chemical subsectors, such as agrosciences, advanced materials, and commodity polymers — and there are specific benefits from natural supply chains for companies in each of these sectors. • Agrosciences companies tend to be seasonal businesses that have recently enjoyed high demand growth, especially in emerging markets, and that rely on an active pipeline of new products. Because seasonal demand is unpredictable — due to uncertain weather patterns and changes in usable crop acreage — agrosciences companies must have an efficient and extremely responsive supply chain to profit from unstable demand. Consequently, in establishing natural supply chains, an agrochemicals manufacturer must have strong demand planning and sensing capabilities and well-designed production scheduling systems to better forecast and respond to seasonal variations in volume. These companies must also have tight synchronization across their global operations to ensure that active ingredients, product formulation, packaging production, and shipment schedules are integrated to get the right material to the right place at the right time. Last, agrosciences companies need to be able to efficiently postpone, pool, and deploy inventory as needed to meet seasonal demand shifts. In our experience, these tailored capabilities can deliver significant improvements in customer service, lower costs, and better inventory productivity.

Companies must carefully tailor the right mix of capabilities to effectively manage complexity.



• Advanced materials companies are caught in a classic bind, squeezed by rapidly commoditizing markets, a geographic mismatch between demand and supply, a heterogeneous customer base, and the need to continually innovate. To implement natural supply chains in this environment, advanced materials providers must have strong capabilities in customer segmentation and in optimizing their global manufacturing assets. Equally important, they must have seamless alignment and strong cooperation among key functions — sales and marketing, product development, R&D, and manufacturing — to respond frequently to more demanding customer requirements, especially in emerging markets where demand for new products is rising at a rapid clip. Their inventory stocking policies — e.g., maketo-order and make-to-stock — must be closely linked to market requirements, so that they can serve customers well while also minimizing waste. • Commoditized polymers manufacturers are being buffeted by fluctuations in the price of raw materials, particularly oil derivatives, along with steep discounting by competitors and very tight profit margins. The demand for their products varies with each economic cycle and is extremely sensitive to “boom and bust” conditions in high-capital process industries. As such, these companies must strive to drive cost efficiencies and focus on establishing a strong position among lower-cost suppliers of raw materials. In order to thrive from natural supply chains, commodity chemical companies must be able to purchase raw materials at their most inexpensive price levels, by nimbly identifying shifts in global supplyand-demand balances and through relationships with suppliers that hold long positions in these materials. Additionally, commodity chemical companies must keep manufacturing costs to a minimum with efficient production scheduling that ensures high factory utilization, skilled management of in-process inventory buffers, and finely tuned plant operations to reduce planned and unplanned downtime. Lean logistics for high-volume products is yet another capability that commodity chemical companies should develop to drive down freight costs and improve inventory turns.

Advanced materials providers must have strong capabilities in customer segmentation and in optimizing their global manufacturing assets.



Aligning the operating model for sustainability
Once a chemical company designs and implements a natural supply chain, it will also require an aligned operating model to capture sustainable benefits. Without distinct rules and systems, anyone in the organization could alter processes and policies, leading to a plethora of customer and operating practices, the very mistake that required natural supply chains in the first place. The critical supporting elements to align in the operating model are: • Organizational structure: Natural supply chain capabilities are cross-functional, with roles from all key functions — sales, marketing, manufacturing, finance, engineering, and product development, among others. • Information flows: In order for companies to manage the end-to-end policies within multiple natural supply chains, they need transparent information flows, through effective enterprise applications with timely reporting. High-quality information is required to achieve benefits across functions; without it, the company will not be able to motivate employees. These information systems must provide full visibility across product, demand, supply, and inventory. • Decision rights: Natural supply chains require strict policies for maintaining the relationship between customer requirements and supplier capabilities. Decision rights specify who can set policies and has the authority to make exceptions to these policies, ensuring that deviations are limited to rare circumstances, with trade-offs that are well understood. • Motivators: Aligning natural supply chain performance targets to functional and individual incentives ensures that everyone in the organization is focused on the right priorities. Employees generally don’t deliberately act counterproductively but instead respond to what they see, what they understand, and how they’re rewarded. For example, sales compensation should include incentives for accuracy in demand planning, in addition to the typical sales incentives for exceeding planned volume.
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Companies need transparent information flows, through effective enterprise applications with timely reporting.

Threefold benefits: Growth, cost reduction, and asset productivity
Natural supply chains typically deliver tangible benefits in as little as six to nine months, although more complicated situations could stretch this time frame to more than a year. Over the short or long term, however, we believe the effort will lead to gains across three key performance dimensions (see Exhibit 4, page 15): • Improved service and growth: Fifteen to 25 percentage point gains in on-time-in-full (OTIF) service performance, due to improved sales and order management, more efficient manufacturing operations, and more beneficial logistics agreements between the supplier and the customer. Moreover, more accurate demand forecasting and inventory management methodologies give customers greater confidence that they can count on and partner with their chemical providers, generating incremental growth. • Cost reduction: Cost reductions in distribution, manufacturing, raw materials sourcing, logistics, and supply chain management, leading to a 5 to 10 percent improvement in EBITDA (earnings before interest, taxes, depreciation, and amortization). • Asset productivity: Thirty to 40 percent reduction in inventory for raw materials, intermediate goods, and finished products, by implementing more analytical inventory, pooling, and postponement. As a result, many companies can realize a one-time cash gain.

Natural supply chains typically deliver tangible benefits in as little as six to nine months.



Exhibit 4 Tangible benefits of natural supply chains for chemical subsectors (client examples)

Chemical subsector

Improved capabilities

Service and growth improvement

Cost reduction (per year)

Asset productivity (via a one-time inventory cash release) $80 million

Agrosciences firm Annual revenue: US$7 billion

• • • •

Demand planning and production scheduling Synchronized multi-tier manufacturing Postponement and inventory pooling Efficient seasonal inventory management

• 95% on-time in-full $20 million (OTIF) service • $90 million per year in incremental EBITDA $60 million

Advanced materials firm Annual revenue: US$2 billion

• • • • •

Customer segmentation • 95% OTIF Optimized global manufacturing assets • $20 million per year in Alignment among key business functions incremental Market-based stocking and inventory policies Freight and toll manufacturing improvement EBITDA

$30 million

Commoditized polymers firm Annual revenue: US$4 billion

• • • • •

Lowest total cost of supply Efficient production scheduling In-plant operations excellence Lean logistics Analytical inventory management

• 95% OTIF

$100 million

$200 million

Source: Stategy&

Conclusion For many chemical companies, the current operating environment is extremely chaotic, to the point where their ability to execute is suffering. As they fight to hold the line on profitability and revenue levels, established chemical firms may believe they simply can’t make the investment in management time and focus needed to develop new capabilities. But natural supply chains offer these companies a golden opportunity — the chance to improve service, reduce costs, and better manage complexity. Implemented correctly, this approach will not only allow chemical companies to effectively compete; it will empower them to thrive amid the chaos.



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