 "Top three cost management tips for chemical companies")
Over the last few decades, the Indian chemical industry has evolved from non-differentiated basic chemical manufacturing to a more sophisticated manufacturer of R&D intensive chemicals. The industry had started from basic chemicals (petrochemicals, bulk chemicals, fertilisers) that were characterised by low differentiation, high entry barriers (capital expenditure and regulations) and high volumes. The next stage of evolution was the manufacture of specialty chemicals (adhesives, resins and other specialty chemicals) that had significant value-add and differentiated themselves on quality and innovation. The industry is now potentially capable of manufacturing knowledge chemicals (agrochemicals, and others such as pharmaceuticals and biotechnology products) that involve significant R&D and are significantly differentiated chemicals.
As per estimates by FICCI, the Indian chemical industry has grown at a compound annual growth rate of 10.8% over FY 2006-FY 2012 and is currently estimated to be Rs 6,300 billion. Currently, India is the third largest producer in Asia (in volume terms) which accounts for three per cent of the total global chemicals. Base chemicals (including fertilisers) and petrochemicals account for around half of the Indian chemical industry followed by pharmaceuticals and specialty chemicals. The knowledge and specialty chemical segment has been growing faster than the base chemicals segment.
While the growth has not been an issue for the industry, there are other challenges impacting the industry. Based on KPMG analysis on performance of select chemical companies in India during the period of FY 2007 to FY 2013 (sample of 115 companies shortlisted based on turnover, market capitalisation and consistent financial reporting between FY 2007 and FY 2013), the return on capital employed (ROCE) of the chemical sector has declined over the past few years as shown in Graph 1. The key reason for decreasing ROCE has been declining operating profit margins. Thus, cost management is a relevant issue for the Indian chemical industry.
In order to improve their margins, the companies can focus on operational and strategic levers. Operational cost management would involve reducing:
Three key strategic cost management drivers are manufacturing footprint, scale of operations and scope of operations.
Manufacturing footprint
There are several factors that impact the choice of a manufacturing site; yet one can observe that sourcing (availability of feedstock), distribution and environmental regulations appear to be most relevant.
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One of the key determinants of the manufacturing location is availability of feedstock. Soda ash manufacturing is concentrated in Gujarat due to ease of availability of limestone and common salt; a key raw materials for this product and also on account of reliable power supply. Gujarat as a location provides both proximity to feedstock and reliable power supply. This can also be seen in the fertiliser sector, where the existing players are facing shortage of feedstock (natural gas for urea and rock phosphate for phosphatic fertilisers). As a result, some of the leading Indian fertiliser companies have chosen to set up manufacturing facility internationally.
The other important determinant of the manufacturing location is ease and costs related to distribution. For example, production of formaldehyde is generally close to the point of consumption. It is easy to produce formaldehyde. It is usually sold as 37% solution, and hence outbound transportation over long distance is not economical. Accordingly, most formaldehyde producers have either captive requirements or supply to local markets only.
Stricter environmental regulations and compliance could impact future expansion viability of any company, and hence environmental regulations are important when deciding the manufacturing location. Some of the existing chemical companies located in a densely populated metros such as Mumbai and Chennai are facing issues as far as their expansions are concerned.
Scale of operations
The scale of operations can have significant bearing on the competitiveness of companies, especially in base chemicals (organic, inorganic), fertilisers and petrochemicals. While scale benefits have helped petrochemical players in India, small scale of operations continues to impact the performance of organic chemical companies negatively.
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Scale of operations, for key organic chemicals in India, is significantly lower compared to that of global players. For example India’s largest phenol plant has a capacity to produce 40 kilo metric tonnes, while international players have plants which have capacities eight to fifteen times that of India’s largest plant. Similarly, for methanol, the largest plant in India has a capacity of around 269 kilo metric tonnes while international players, have plants which have capacities four to six times that of India’s largest plants. Due to lack of scale, and hence lower competitiveness, domestic production of organic chemicals has declined at around six per cent per annum while imports have increased at a rate of 17-19% between FY 2006 and FY 2011. As a result, a large part of demand is met through imports.
Scope of operations
Scope of operations is the third strategic lever that can influence long term competitiveness of a company and involves decisions pertaining to backward and forward integration of companies. Sectors which face significant supply variability (either supply or price) have chosen to integrate backwards. This is evident in various segments within the chemical industry.
In the fertilisers segment, leading companies have formed alliances with global companies to ensure supply of rock phosphate. India’s leading polyvinyl chloride (PVC) pipe manufacturer has backward integrated and has commissioned PVC resin plant. Similarly, India’s leading paints manufacturers have commissioned resin manufacturing plants and production of emulsions in an attempt to backward integrate.
Forward integration can be seen primarily in industries such as chlor-alkali, fertilisers and petrochemicals. Several fertiliser manufacturers have diversified and are also involved in manufacturing of industrial chemicals. This diversification helps companies in maintaining growth and profitability, especially when the core product portfolio is facing challenges.
Conclusion
The Indian chemical industry is growing with increasing consumption in end user industries. However, in some of the sectors, the domestic production is lagging behind the demand, leading to increasing dependence on imports. Moreover, the operating margins are under pressure. Focus on operational levers for cost management can bring in some improvements in the addressable cost base. Beyond this, chemical companies in India need to focus on strategic levers which can structurally impact profitability. Depending on the business dynamics of specific sub-segments, companies may choose to:
Biswanath Bhattacharya is the Partner - Management Consulting, KPMG in India
Ashish Ladha is the Associate Director - Management Consulting, KPMG in India
Ashish Srivastava is the Manager - Management Consulting, KPMG in India
As per estimates by FICCI, the Indian chemical industry has grown at a compound annual growth rate of 10.8% over FY 2006-FY 2012 and is currently estimated to be Rs 6,300 billion. Currently, India is the third largest producer in Asia (in volume terms) which accounts for three per cent of the total global chemicals. Base chemicals (including fertilisers) and petrochemicals account for around half of the Indian chemical industry followed by pharmaceuticals and specialty chemicals. The knowledge and specialty chemical segment has been growing faster than the base chemicals segment.
While the growth has not been an issue for the industry, there are other challenges impacting the industry. Based on KPMG analysis on performance of select chemical companies in India during the period of FY 2007 to FY 2013 (sample of 115 companies shortlisted based on turnover, market capitalisation and consistent financial reporting between FY 2007 and FY 2013), the return on capital employed (ROCE) of the chemical sector has declined over the past few years as shown in Graph 1. The key reason for decreasing ROCE has been declining operating profit margins. Thus, cost management is a relevant issue for the Indian chemical industry.
In order to improve their margins, the companies can focus on operational and strategic levers. Operational cost management would involve reducing:
- Direct material costs, through yield improvement, manufacturing process improvement, procurement efficiency improvement etc
- Indirect cost, through benchmarking and reducing costs such as information technology, travel, facilities etc
- Supply chain costs, through network and transportation optimisation, storage cost optimisation etc
- Conversion costs, through efficient management of energy, repairs and maintenance, stores and spares expenses
Graph 1
Based on our experience, these operational levers could help reduce the addressable cost base by four to eight per cent. These operational improvements would enhance company level competitiveness for the medium term, but it may not be able to enhance long term competitiveness. On the other hand, strategic cost management involves decisions that have impact on the competitiveness of the companies over the long term; it involves determining and analysing strategic cost decisions (economics of scale, scope, etc.) and their influence on costs level, costs structure, and competitiveness of the firm.Three key strategic cost management drivers are manufacturing footprint, scale of operations and scope of operations.
Manufacturing footprint
There are several factors that impact the choice of a manufacturing site; yet one can observe that sourcing (availability of feedstock), distribution and environmental regulations appear to be most relevant.
ALSO READ: Entry into EU via the Netherlands can lead to cash flow optimisation
One of the key determinants of the manufacturing location is availability of feedstock. Soda ash manufacturing is concentrated in Gujarat due to ease of availability of limestone and common salt; a key raw materials for this product and also on account of reliable power supply. Gujarat as a location provides both proximity to feedstock and reliable power supply. This can also be seen in the fertiliser sector, where the existing players are facing shortage of feedstock (natural gas for urea and rock phosphate for phosphatic fertilisers). As a result, some of the leading Indian fertiliser companies have chosen to set up manufacturing facility internationally.
The other important determinant of the manufacturing location is ease and costs related to distribution. For example, production of formaldehyde is generally close to the point of consumption. It is easy to produce formaldehyde. It is usually sold as 37% solution, and hence outbound transportation over long distance is not economical. Accordingly, most formaldehyde producers have either captive requirements or supply to local markets only.
Stricter environmental regulations and compliance could impact future expansion viability of any company, and hence environmental regulations are important when deciding the manufacturing location. Some of the existing chemical companies located in a densely populated metros such as Mumbai and Chennai are facing issues as far as their expansions are concerned.
Scale of operations
The scale of operations can have significant bearing on the competitiveness of companies, especially in base chemicals (organic, inorganic), fertilisers and petrochemicals. While scale benefits have helped petrochemical players in India, small scale of operations continues to impact the performance of organic chemical companies negatively.
ALSO READ: Optimising gas processing assets using process modeling tools
Scale of operations, for key organic chemicals in India, is significantly lower compared to that of global players. For example India’s largest phenol plant has a capacity to produce 40 kilo metric tonnes, while international players have plants which have capacities eight to fifteen times that of India’s largest plant. Similarly, for methanol, the largest plant in India has a capacity of around 269 kilo metric tonnes while international players, have plants which have capacities four to six times that of India’s largest plants. Due to lack of scale, and hence lower competitiveness, domestic production of organic chemicals has declined at around six per cent per annum while imports have increased at a rate of 17-19% between FY 2006 and FY 2011. As a result, a large part of demand is met through imports.
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Three key strategic cost management drivers
On the other hand, Indian petrochemical companies have relatively higher scale of operations for base petrochemicals and the downstream products. One of the India’s leading petrochemical company is the world’s largest producer of polyester fiber and yam, fifth largest producer of polypropylene and para-xylene, ninth largest producer of purified terephthalic acid (PTA) and fifth largest producer of monoethylene glycol (MEG) globally. Indian companies have developed scale and self-sufficiency in basic petrochemicals, like ethylene, propylene, butadiene, styrene, benzene and toluene. More investments have been planned and announced in this sector, which will likely increase the competitiveness of Indian companies.Scope of operations
Scope of operations is the third strategic lever that can influence long term competitiveness of a company and involves decisions pertaining to backward and forward integration of companies. Sectors which face significant supply variability (either supply or price) have chosen to integrate backwards. This is evident in various segments within the chemical industry.
Forward integration can be seen primarily in industries such as chlor-alkali, fertilisers and petrochemicals. Several fertiliser manufacturers have diversified and are also involved in manufacturing of industrial chemicals. This diversification helps companies in maintaining growth and profitability, especially when the core product portfolio is facing challenges.
Conclusion
The Indian chemical industry is growing with increasing consumption in end user industries. However, in some of the sectors, the domestic production is lagging behind the demand, leading to increasing dependence on imports. Moreover, the operating margins are under pressure. Focus on operational levers for cost management can bring in some improvements in the addressable cost base. Beyond this, chemical companies in India need to focus on strategic levers which can structurally impact profitability. Depending on the business dynamics of specific sub-segments, companies may choose to:
- Redefine their manufacturing footprint, going global if required
- Evaluate suitability of their scale of operations in context of the market
- Identify strategic options to adjust scope of operations
Biswanath Bhattacharya is the Partner - Management Consulting, KPMG in India
Ashish Ladha is the Associate Director - Management Consulting, KPMG in India
Ashish Srivastava is the Manager - Management Consulting, KPMG in India