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So What’s the Big Deal with Chemicals?

Written By: Predrag Jakovljevic
Published On: December 24 2007

<Originally published - May 10, 2006

For the chemical industry, the last decade has been a rollercoaster ride. Until two years ago or so, sales of everything from petrochemicals to paint were sluggish; inventories all but overflowed the storage tanks, and the pricing power of producers was weak. But a reversal of fortune has almost emptied those tanks, and plants are operating around the clock (and still barely meeting the increased demand). This increased demand is giving sellers the upper hand in pricing. As a result, many chemical vendors are virtually minting money—in some cases reaching historically high levels of profitability and cash flow.

However, this boom should not deceive anyone, since the fact remains that chemicals are a mature, slow-moving industry. It might even expose quite a set of challenges and complexities within the industry:

  • low asset turnover
  • limited production flexibility
  • decreasing product innovation (especially for basic chemical manufacturers, such as commodity producers of plastics and rubber; fibers; raw materials and intermediates; inorganic materials; fertilizers; and so on), given the increasing rarity of new chemistry discoveries.

Furthermore, while the soaring prices of crude oil have been a godsend for some back-integrated petrochemical industries, the downside lies in increased prices for natural gas and other raw materials, which forces the same manufacturers to consider building new plants closer to the supply source in order to reduce costs and be closer to the demand source too (given their customers' likely relocation for similar reasons).

Globalization and the rise of the Chinese, Brazilian, and Indian economies have opened new markets. However, this has resulted in fierce competition and the dispersal of supply chains across the globe. All chemical players have thus been scrambling to reposition their offerings, which has typically resulted in a spate of mergers and acquisitions (M&As) and joint ventures, and a race to add new plant capacity as well as to eke out some return on colossal capital investments before the cycle turns downward yet again.

But, regardless of the economic cycle (up, flat, or down), chemical companies have to maintain tight but smooth supply chains that feature visibility, flexibility, responsiveness, and speed in forecasting demand, as well as the agility to ramp up (or down) plant output and manage customer expectations (and increasingly—the latest vogue—their consigned inventories). All players have been striving to create more predictable product supplies despite volatile demand given that customers will likely pay more to achieve this predictability. Success in this endeavor might be the best way for any chemical manufacturer to achieve enduring profits once the economic cycle returns to sluggish demand, chronic overcapacity, and downward pressures on prices.

This is certainly not an easy feat given the growing network of new products, plants, subsidiaries, trading partners, and above all, new inter-enterprise business processes. These have not yet been connected properly: each major function has a separate interface, often running on separate enterprise systems platforms. Adding to the difficulty are the industry's own idiosyncrasies (for example, some manufacturers can be their own major customers, and some companies often look to third parties—even including, occasionally, to fierce competitors—to outsource key process steps).

Forecasting Tools

Certainly, everyone needs powerful yet flexible forecasting tools in order to develop timely, accurate forecasts, starting with a statistical forecasting engine, which provides a first-cut projection based on methods and criteria tailored to a particular business. Some advanced forecasting tools are able to prioritize high-value customers and key accounts with individual attention, and to handle smaller and less important customers collectively. Emerging collaborative features enable key stakeholders to focus on important details, share information easily, and arrive at a consensus; customers can also be included in the collaborative process to achieve more accurate forecasting.

Also, in optimizing product mix and asset usage, the advanced analytical techniques of supply chain optimizing tools should help to map demand forecast across the supply chain, thus providing sales and production plans that accommodate capacity limitations while maximizing profitability. The product and customer mix can be analyzed interactively to find a business blend that improves the use of equipment, while alternative scenarios can easily be run to assess the impact of various customer and production options.

However, given the inevitable limitations of projection accuracy, of course it is vital that chemical manufacturers be capable of sensing major trends before it is too late to catch up. For instance, if a customer's tank sensors or radio frequency identification (RFID) scanners in the paint aisle of the retail home improvement stores are the first harbingers of increased or decreased demand, then the manufacturer's IT systems may be able to share this with trading partners. For more information on this trend, see As Hype Becomes Reality, a Radio Frequency Identification Ecosystem Emerges.

New streams of automated and actionable data—arriving from the plant floor, storage facilities, and so on, all with the help of real-world-awareness technologies—have to enable network members to more swiftly identify new market challenges or opportunities; reallocate inventories accordingly; reconcile customer needs with research and development (R&D) efforts; strike a balance between long production runs (for economy of scale reasons) and the flexibility needed to dampen demand (and inventory) spikes; and above all, create a unified view of their increasingly complex businesses.

Appropriate supply chain event management (SCEM) applications should monitor up-to-the-minute events within the supply network to aid in more rapidly identifying problems and corrective actions to maintain a balanced inventory. Deviations from the plan should be instantly highlighted in on-screen consoles to ensure that the performance of every inventory decision point in the supply chain is continually measured and communicated. This holistic planning and execution approach should help truly inventive chemical producers in several ways: aid segmentation of their product and services with respect to customers; help them redesign their supply networks; and assist in the implementation of price management strategies that reward the (hopefully) faster delivery of expected product supply to downstream customers in industries such as consumer products, automotive, and high tech and electronics.

Challenges

It might be beneficial to review several of the challenges facing all chemical companies today, regardless of whether their products are benzene, soda ash, semiconductor polishing slurry, pigments, food additives, paints, and so on.

First of all, the so-called inventory bloating “bullwhip effect” (whereby a small change in demand at the consumer level can lead to massive changes and inventory buildups upstream with suppliers, on short notice) is especially painful for basic chemical manufacturers (such as soap and cosmetics ingredients, chewing gum flavors, additives, dyes, and so on), since these companies live far upstream from the final product and end customers. Given the length of downstream supply chains (leading back upstream to basic chemical manufacturers), demand signals at the consumer level usually take quite a long time to reach the upstream trading members. Unfortunately, at this stage, little can be achieved about improving demand visibility, except for some end-consumer chemical producers (such as the paints and coatings sectors) that might have the privilege of leveraging point-of-sale (POS) data.

Secondly, the dichotomy between the efficiencies of long product runs and the adaptive capabilities of shorter runs is more apparent than in most other industries. Chemical production encompasses many types of inventory, such as raw material, work in progress (WIP), in-test or sample material, rework or scrap material, products in transit, safety stock, and cycle stock. In these contexts, changes in one component can significantly impact other components. Smaller batch sizes reduce WIP levels, but also reduce productivity, whereas cycle times can be shortened to reduce cycle stock, but end up increasing the time spent making production transitions.

Traditionally, chemical companies, especially those with a continuous production model, have opted for lengthy production runs coupled with an after-the-fact sales and marketing strategy. This was due to the maturity of the industry, especially on the basic chemicals side; efficiency comes via economies of scale, which means running plants around the clock around the year (except for annual maintenance shutdowns), with infrequent changeovers. Entire plants are often specialized for a single product (or a few at best). This rigidity leaves manufacturers vulnerable to the aforementioned bullwhip effect.

In fact, chemical companies tend to pride themselves on their “operational excellence”; the entire industry has invested heavily in capital assets for economies of scale and competitive variable costs, resulting in high fixed costs of depreciation and often limited refusal ratios. During lean times, the push for maximum capacity plant use and expedition of short production schedules actually consumes capacity, and introduces quality variability and reject material, which negatively affects manufacturing costs and profit margins. According to AMR Research, manufacturing operating costs make up more than 80 percent of bulk chemical manufacturers' total supply chain management costs, and average more than 40 percent of revenue, which is almost 3 times that of other industries. Most players are still unable to profitably respond to highly variable demand or to execute predictable product supply strategies.

The high fixed cost of the plant traditionally drives a management objective of maximum possible capacity use. A common approach to this objective is to set prices at a low enough level to drive to 100 percent use. But as use approaches the maximum, the demand for perfection in the supply chain plan increases, since changing anything at 100 percent use has a direct impact on other parts of the plan, supply chain, and customers. The system must recognize this fact and help manage the inherent conflicts (see Supply Chain Planning - Issues for Continuous Chemical Companies).

The logic is well-known: When the right products in the right amounts are in the right place at the right time, the enterprise is able to provide reliable deliveries to its customers while controlling inventory costs. However, the demands of the global chemical marketplace make this balancing act more challenging than ever, since distribution networks are increasing in size and complexity, which multiplies the difficulty of inventory decisions. On the other hand, customers demand shorter lead times and faster deliveries, creating pressure to increase rather than decrease inventory levels. As mentioned many times before, efficiency targets for production lines dictate longer runs for each product, resulting in larger stockpiles. Most importantly, unbalanced inventories are a significant drain on working capital, at a time when every manufacturer is under tremendous pressure to keep costs down.

About the Authors

Predrag Jakovljevic is a principal analyst with Technology Evaluation Centers (TEC), with a focus on the enterprise applications market. He has nearly 20 years of manufacturing industry experience, including several years as a power user of IT/ERP and related applications, as well as a consultant/implementer and market analyst. He holds a bachelor's degree in mechanical engineering from the University of Belgrade (in the former Yugoslavia), and has also been certified in production and inventory management (CPIM) and integrated resources management (CIRM), and as a certified supply chain professional (CSCP) by the Association for Operations Management (APICS).

Olin Thompson is vice-president of industry strategy with Lawson Software since November 2006. As an independent analyst, he was a frequent contributor to TEC of articles of general interest to ERP and manufacturing management. He has over 25 years of experience as an executive in the software industry, and has been called the “father of process ERP.” He is a frequent author and award-winning speaker on such topics as gaining value from ERP, supply chain planning (SCP), e-commerce, and the impact of technology on industry. He can be reached at Olin.Thompson@us.lawson.com.

 
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