After the financial crisis and economic downturn of 2007–08, the global chemical industry underwent a decade of solid growth and value creation, outperforming the world market index in total returns to shareholders (TRS). In the last five years, however, chemicals has fallen behind, and new realities have resulted in a challenging outlook.
To begin, organic revenue growth in Europe has come to a halt after decades of slowing down, and despite years of outstanding growth, China’s economy is expected to grow slower than ever before.1 In addition, industry segments have been hit by various disruptors. Increased emphasis on the circular economy has affected petrochemicals. Specialty chemicals can no longer simply rely on material or technological innovations, as value is now often created by tailoring certain materials to specific applications or end customers. Finally, the COVID-19 crisis has introduced additional uncertainty and led to delayed investments, potential supply-chain changes, and increased regionalization.
In each of these circumstances, focused chemical players (those that earn more than 80 percent of their revenue from, at most, two chemical segments) have outperformed less-focused players (Exhibit 1). However, increased uncertainty and changing market environments have widened the spread over the past two years. This is due, in part, to increased flexibility to adapt to new realities in specific segments, which are sometimes vastly different than others.
Traditional value-creation pathways, such as cost-cutting efforts, have been depleted. And while many companies have chosen to focus on portfolio management, few have updated their operating models to incorporate strategies that reflect the new realities of the industry. This article explains how companies can overcome today’s challenges and unleash their full potential by rethinking their business needs and moving to new-generation operating models.
Evolving operating models in chemicals
Roughly 30 years ago, most chemical companies implemented operating models centered around key functions, such as marketing and sales, R&D, HR, and procurement. This is particularly true of larger players, which often aimed to achieve the maximum possible scale effects through centralized functions.
In the past ten to 20 years, however, an increasing number of companies have switched to business-oriented operating models. During this time, chemical players typically built several business units that utilized product-oriented technology push marketing (effectively “pushing” their products in front of customers). This strategy was mainly driven by an increased emphasis on innovation and the continuous improvement of products. Ultimately, focusing on businesses and products helped chemical companies overcome functional silos and make the most out of their superior technology assets.
Today, the chemical landscape—and its end industries—has become more complex. The semiconductor industry continues to push the boundaries of Moore’s law (the idea that the number of transistors in an integrated circuit doubles every two years, approximately), and disruptive changes in how the vehicle of the future will look have led to both increased pressure on prices in the automotive industry and a shift to new value pools for materials. Meanwhile, most end industries in chemicals no longer need to wait for the next technological revolution, instead shifting to customer-centric solutions. In turn, they require the same approach from their chemical suppliers. Most prominently, geopolitical tensions, sustainability, and advanced analytics are changing established value-creation pathways.
The chemical industry is quite granular, with more than 25 segments all serving a multitude of different end industries. Thus, adapting to the new normal requires flexibility. With this in mind, we analyzed the top 1002 chemical companies in the two years leading up to the COVID-19 crisis and identified the measures they took to react to both increasing changes and the more granular evolution of the industry. Such measures include the following:
- adapting the corporate portfolio through divesting businesses or assets, through mergers and acquisitions, or by shutting down assets
- evolving the product portfolio through expansion into higher margin or growth (specialty) products, streamlining the product portfolio, pursuing product innovation, or rationalizing capacities for specific products
- promoting restructuring, such as reorganization or switching to new operating models
- driving performance improvements through operational excellence or efficiency improvements
Nearly half the companies we looked at strove to adapt their corporate portfolios, with M&A and divestitures as the most frequently mentioned countermeasures (Exhibit 2). More specifically, 50 percent of chemical players aimed to evolve their product portfolios, mainly by expanding higher margin (specialty) products. Comparatively few players (23 percent) were willing to undergo structural changes. Even fewer companies (15 percent) aimed to drive performance improvements before the pandemic.
A comprehensive operating-model transformation, however, entails changes to the product portfolio as well as structural changes and performance improvements. In other words, many players aimed at a different playing field rather than adapting to the new rules of the game.
In other words, many players aimed at a different playing field rather than adapting to the new rules of the game.
Furthermore, many chemical companies have diversified for less-focused portfolios, which require different operating models for different business units. Others do not differentiate operating models between businesses, even though they should. Most often, an operating-model change is only triggered by external factors or changes, such as the appointment of a new CEO or the intention to sell parts of the business. Rather, the change should be part of a periodic strategic consideration, assuming the business setup allows for strategy implementation and the desired performance.
Different needs for different business archetypes
How can chemical players move to a new-generation operating model? First, there is no single, perfect solution for how companies should react to the industry’s new realities. Every chemical player needs to understand the specific dynamics of its markets, products, and customers before identifying the best operating model for its businesses. With regard to markets, it is important to disentangle true growth markets from those that are only slightly growing, remaining stable, or declining. For products, chemical executives need to ask themselves if they are in the “push” or “pull” game (pushing products in front of customers or pulling customer interest with solutions), as well as if their model is sustainable in the future. And for customers, chemical players must ask themselves if their base matches their strategic vision.
A potential starting point for an integrated perspective is assessing the archetype of each of the company’s businesses. Four such archetypes symbolize the different requirements for value creation: technology push play, application pull play, end-market play, and cost and asset play (Exhibit 3).
- Technology push play. These companies drive innovation in the market. Their unique, differentiated technology can shape customer needs and set new industry standards.
- Application pull play. Companies in this archetype work closely with customers to improve products and tailor them to specific applications across markets. These companies typically have strong customer-facing application teams that translate customer needs into chemical solutions.
- End-market play. The end market is the final evolution to customer centricity. These companies provide a portfolio of products or services to fulfill the needs of their customers’ clients and are typically the primary supplier for their customers’ businesses.
- Cost and asset play. These companies supply products to a broader set of markets or customers. Aiming to minimize costs, they leverage asset integration and operational excellence.
Each business archetype is informed by many factors, including the required R&D investments; the selling, general, and administrative costs that can be allocated; the share of raw materials sourced; the overall capital intensity of the business; and, perhaps most importantly, how to serve their customers. These factors have strong implications for which operating model is required.
As an example, a company in a former technology push play archetype—organized by siloed businesses and pushing hard on R&D—found itself in a situation in which customers no longer waited for the new intrinsic performance improvement of their products (adhesives, pigments, additives, or coatings). Instead, customers moved to dedicated end markets such as cosmetics, packaging, automotive, and food and beverage to solve specific problems—for example, matching the color of lipstick to bags or clothing, increasing the reusability of packaging, or developing a UV-resistant coating for cars sold in the Middle East. Such external changes require the following big moves:
- Focus R&D resources. Shift from budgeting for all businesses, as per current revenues, to focusing on a few winning solutions (such as 3-D printing) and a strong shift toward more application development (such as a new finishing lab for automotive coatings).
- Pursue a true customer-centric setup. A customer-centric commercial organization organized according to customer needs (and not products or businesses), with the customer steering the business priorities.
- Establish front-back models. While the customer-facing aspects of the organization typically require a market-back setup, manufacturing, supply chain, and sometimes innovation and back office services can be run most effectively across different end markets, which dissolves classical profit-and-loss units.
Many chemical companies have evolved over the past ten years according to their unique situations, sometimes resulting in vastly different operating-model needs in their businesses. As a result, developing or switching to a new operating model can be quite complex and cumbersome due to countless interfaces and interdependencies within the company, as well as the political maneuvering and finesse required. Furthermore, the corporate center often determines the degree of operating-model flexibility of businesses, which can make operating-model changes that much more difficult.
Thus, the question remains: How can executives succeed in designing and shifting to their new operating models? For each specific environment, companies need to set up a distinct operating model that best supports their strategies, specific to their customers and business needs.
Embracing a successful new-generation operating model
The starting point of each operating-model discussion should be a strategic recap and a deep understanding of how value is created now and how it will be created in the future. For instance, key value levers of cost and asset play archetypes include cost leadership, functional excellence, and standardized product quality, among others, while value levers of an application pull play include application-development capabilities, proximity to customers, and levels of service. By exploring different value levers, chemical executives can challenge the status quo and identify the most important areas in which to take action.
Because value creation is strongly rooted in individual chemical segments, there are no universally valid operating-model best practices. Those with multiple business units should differentiate their operating models. This can be done according to the four archetypes and subsequently tailored as needed. In addition, leaders should decide on the role of corporate, especially when the company’s business units adhere to more than one archetype. In this case, granting autonomy in day-to-day operations can allow each business unit to flourish, as centralized operations can stifle differentiation.
With all this in mind, a set of guiding principles can support chemical companies in maneuvering the design and implementation of their new operating models.
Revise the product portfolio based on the business archetype, and adjust as needed
The product portfolio should reflect the value-creation logic and the key value proposition of the business. For instance, chemical executives aiming at cost leadership need to consider removing R&D-heavy products from their portfolios. By contrast, companies in the technology push play should focus on innovative, R&D-heavy products and eliminate commoditizing products from their portfolios. Making such adjustments to product portfolios will help chemical companies bring their value propositions to life, while at the same time avoiding inconsistencies with new operating models.
Set ambitious cost and performance targets, and capture them through diligent tracking
Market dynamics will push businesses to “should costs,” or projections based on efficiency, in the medium to long term. Hence, to be successful, chemical players should triangulate current costs with peer benchmarking and zero-based budgeting to set cost and performance ambitions for their businesses. While incremental functional improvements can only yield smaller cost improvements, operating-model changes (such as changing to digital channels or automating back-end processes) still offer step changes.
Diligent tracking not only ensures the full potential is captured but also drives commitment for the operating-model changes through the link to value potential.
Think beyond traditional ‘boxes and lines,’ and focus on roles, responsibilities, and performance management
Structure, products, and performance are equally important and require the attention of top management.
The organizational chart is an important component of the operating model, yet it is not the only one. Structure, products, and performance are equally important and require the attention of top management. Many companies successfully bring key aspects of their operating models to life via crystal-clear roles and responsibilities. Also, performance management is often overlooked. For instance, setting a profitability key performance indicator (KPI), such as gross margin or EBITDA3 margin, can lead to significantly different business outcomes than setting a capital-efficiency KPI, such as ROIC.
Drive the operating-model design from the top down, but clearly articulate how and why things will change
There is a truth behind the idiom, “Too many cooks spoil the broth,” especially when it comes to operating-model design. Operating-model design is typically not successful as a democratic process with a large number of project team members due to its highly sensitive nature and many different personal agendas. Senior executives are better off collecting input from key stakeholders across the organization but making decisions in a smaller, top-down circle. Different operating models might require different managerial or operational mindsets, and successful managers of one archetype are not necessarily successful in others. Hence, chemical leaders need to select the right talent for managing the new operating model and performance ambitions of the business; they must also put an effort into change management for the broader organization, to adopt necessary behaviors and skills.
A new operating model will not be able to halt changes to political legislation, the environment, or the customer landscape, nor will it halt the impact of sustainability and advanced analytics. Leaders need to carefully monitor affected businesses and act swiftly. Top executives should also keep the corporate perspective in mind. By overhauling the strategy and operating model of the affected businesses, leaders can generate substantial value for shareholders, employees, and society.