Sunday, March 6, 2011

Value Creation in Commodities: 'Water Lessons' for Managers

After air, water ranks as the most important element in human life. Water constitutes seventy to eighty percent of the human body. Unlike air which is a perpetual integral part of the environment, water which is fit for industrial and human use, is provided by the nature seasonally. When the human population was thin and industrialization was low centuries ago, such water was plentiful and unpolluted. Even today, despite the humongous growth in population and increase in pollution water is a more natural commodity than say, oil or metals; and is one of the most liberally wasted natural resources, either by failure to capture rain water seasonally or to control day to day consumption. Historically, it has been the responsibility of the governments all over the world not only to store the water but also treat it and supply it to the society. A striking feature of modern living has been the emergence of packaged drinking water as a product offered by private enterprise. This blog post, however, is not about water per se but about how the management of a commodity like water as a premium, differentiated product offers valuable lessons for managers who succumb to the commoditization of even high technology products.

Curious economics

The price of a good branded packaged drinking water in India is Rs 15 to Rs 20 per liter pack. The price of good branded packaged dairy milk is Rs 20 per liter pack. The similarity in pricing levels of packaged water and packaged milk, despite the complexities and costs involved in the latter is amazing. Water is freely available with minimal costs of collecting and extracting while raw milk has a significant cost of availability per se. The value chain involved in delivering the packaged milk product to the consumer on a 24X7 basis is extremely complex, comprising rearing of milk-yielding animal stock, collecting milk, processing, pasteurizing and packaging milk, and distributing the packaged milk in cold chain conditions. The picture becomes even more curious when the family consumption patterns of purified water and pasteurized milk are factored in. An Indian middle income household typically consumes 750 ml of milk per day per person in various forms, ranging from plain milk to milk converted into yogurt. The household also consumes 2 liters of packaged drinking water per day per person. Assuming a six member family, the household is willing to spend twice as much on water as on milk (Rs 180 per day on water versus Rs 90 per day on milk).

As one moves up on the richness scale, the consumer would be seen to be willing to as much as three to four times on an imported packaged water brand in a restaurant or hotel, providing an even more curious twist to the socio-economic puzzle. One cannot explain away the enigmatic dimension either on purity assurance or once-in-a-way indulgence of the rich. A life saving Dextrose infusion solution is priced probably at half of the price of the imported water brand. A life saving pharmaceutical product which is produced with the consumption of millions of liters of treated water, and recycling and treatment of millions of liters of effluent water is priced on par with packaged water, weight by weight. The issue perhaps is not in the quixotic behavioral patterns of the consumers. The issue relates more to the ability of managers to appreciate the compulsions of commoditization and the enablers of value creation in a more pragmatic manner. It is the managerial capability that creates value in an essential commodity like drinking water and depletes the value in a relatively optional nutritional product like milk or in a critical life saving or lifestyle product. Without making value judgments on the business behaviors and the social perversities involved in these curious scenarios, the intention in the discussion that follows is to understand the lessons that water as a packaged product teaches to managers in the competitive dynamics of commoditization.

Understanding commoditization

Commoditization is a function of demand-supply balance. An ordinary fossil fuel like coal would cease to be a commodity feedstock if coal-fired thermal power plants are required in greater measure or if the availability of coal mines becomes dramatically impaired. Gold and platinum see escalating value due to scarcity of mines and mining on one hand, and economic hedging coupled with social passion for jewelry on the other. The rare earths such as promethium and terbium are rare not because of lack of availability in earth’s crust but because of the complexity of their extraction and separation as well as radioactive impact of the effluents. China’s move to curb the export of rare earths is triggered not only by the desire to conserve the elements and avoid pollution but also by the desire to move up the value chain of producing value added products from the rare earths. Pricing of a product inversely correlates with commoditization; the greater the commoditization the lower the price. On the other hand, impact of technology has random behavior.

Steel is a perfect example of economy linked supply factors overriding the technological challenge and investment intensity of steel production. Poor growth in infrastructure lowers the demand for steel, creates oversupply of the product and makes steel a commodity. As basic steel making technology is mastered by a greater number of producers steel became a commodity product. Technology has a random impact in addressing the challenge. For example, steel could be a commodity but automotive steel is not. At a gross level, technological improvements in input material quality control, conversion efficiencies and energy consumption can reduce the cost of steel production and either protect the margins or spur the demand. On the other hand, forward integration into value added products such as automotive steel, on the basis of technology, could make steel producers create niche positioning. As industrial managers face the grim prospect of commoditization of even high technology, high investment products by their own actions, they need to appreciate how a naturally occurring commodity product like water could offer lessons in de-commoditization.

Function-value matrix

Every product offers functionality and value as its two fundamental dimensions. Water offers functionality as the essential nutrient and osmotic agent. Water provides a balance in the body – homeostasis. It provides an absorption of the water-soluble substances, transportation of the nutritive elements to the target cells and the excretion of waste products of the metabolisms of the body. Water is taken so much for granted that its elevated role in ensuring homeostasis is never understood in detail. On functionality and value, the packaged water has traditionally been split in terms of purity and branding, with a perceived correlation between brand popularity and water purity. Industrial managers, however, have succeeded in vesting water, which has been a co-element of life from the inception of life, with several additional dimensions of functionality and value. The fundamental functionality is in terms of a matrix of portability and storability; ensuring the availability of the product from the smallest bottle size of 200 ml to the largest size of 2 liters for individual use and the smallest can size of 5 liters to 50 liters for use directly as storage carriers or in tandem with water dispensers. The distribution logistics have been so perfected that the user has now a total assurance that he can access a packaged water bottle wherever and whenever he needs it. By making the packaged water available ubiquitously, the producers and distributors have liberated the user from the need to carry water around, and created value around supply assurance.

On the purity front, producers perfected the purification processes to achieve continuously higher levels of purity and taste. Fundamentally, by adopting multiple sources for water extraction from public treated water to mountain springs, manufacturers tried to assure lower impurities from source. Typical multi-step purification process includes reverse osmosis, ozonation and carbon filtration at the minimum. Each of these steps, even individually, and collectively is designed to remove manufactured molecules such as chemicals and pharmaceuticals, as well as naturally occurring substances such as impurities and heavy metals. By keeping the Total Dissolved Solids (TDS) below the levels mandated by the FDA, manufacturers create new standards. TDS is the sum of all solids dissolved in water measured in parts per million (ppm). Examples of substances that can account for TDS include carbonates, bicarbonates, chlorides, sulfates, phosphates, nitrates, calcium, magnesium, sodium, potassium, iron, manganese, and a few others. Value creation often entails investments in product development, manufacture and distribution to breach higher technological barriers, and higher marketing expenditures to convey the superior function-value matrix to the consumer in terms of brand explanation. The question that arises is whether commoditization has any scope for innovation.

Innovation for de-commoditization

It is often assumed that commoditization is only a one way street, and except for demand-supply factors there is no way to de-commoditize a product, particularly once a commoditized product has been stretched to the limits as is the case with current branded packaged drinking water products. Not really, as innovation has no limits and could turn even commoditized products into differentiated products. For example, the current filtration processes remove all the TDS while a new technology that could retain essential minerals such as calcium and potassium could provide a value edge. At a higher level, purified water with added nutrients and taste agents could provide additional value. Given the extensive use of plastic in packaging water, innovations in the use of plastic which is absolutely non-reactive and non-carcinogenic over an extended shelf life could provide added value assurance. Quality control and quality assurance on plastic bottles assumes greater importance given the higher dependence on recycling. Similarly, in distribution additional protection that assures dust-proof protection and dust-free delivery would provide additional delivery assurance.

Innovation in commoditized products could take the shape of positive environmental balance as well. It is counter-intuitive that a water packaging corporation could generate more water table than the water table it depletes. This would, however, be possible on an overall global scale by resorting to rain water harvesting, creating rain water reservoirs around manufacturing complexes and providing community watershed schemes. At a different level, by conducting research on the role of hydration therapy for persons of different clinical conditions such firms could help establish better linkages between water and life. Comparative studies between different sources of water in terms of impurities and TDS and related manufacturing efficiencies could help achieve better manufacturing economics. Developing linkages between water quality and other beverages could help beverage manufacturers achieve better taste and consistency parameters. Given the propensity in emerging economies to counterfeit, reuse-proof, theft-proof and tamper-proof plastic containers could constitute an agenda for packaging innovation. In sum, if a simple natural product like water could lend itself to enormous value differentiation and de-commoditization other more complex products could provide a significant potential for value creation.

'Water lessons' for managers

Water provides several business and technical lessons for managers. Ten of these are summarized as follows. Firstly, it demonstrates how product management could alter the lifestyle choices, leading at times to skewed deployment of resources and returns. Managers must therefore understand their own ability to influence consumption patterns and utilize the power in a socially responsible manner. Secondly, product strategies need to simplify life in terms of portability, mobility and universality. Managers must try to optimize a total eco-system around core and related products rather than focus only on optimization of their core product alone. Thirdly, governmental and regulatory standards are guidelines and offer opportunity for firms to differentiate themselves beyond. Managers must accordingly focus on futuristic bar-setting and technological efficiencies to be ahead of the curve. Fourthly, all products, whether of human consumption or non-consumptive usage, have an impact on health. Managers must endeavor to correlate product performance and health impact. Fifthly, corporate social responsibility requires that what is taken from the environment must be more than made up. Managers are, therefore, responsible to develop and implement environmentally regenerative strategies.

At a product level, managers must have faith in the technical characteristics of the products they develop and manufacture. If water can have marketable properties, a chemical product or an automobile product would have several properties based on which they can be differentiated. Managers who fail to study and grasp the technical attributes of their products, and who attempt to market them solely on price considerations are value destroyers for their corporations. On the other hand, managers who undertake techno-economic marketing of their products create not only outstanding value for their products but also lasting value for their companies. Secondly, the quality of raw materials and intermediates influences to a great extent the product quality and manufacturing efficiencies. Managers must therefore focus on incoming quality as much as on in-process and outgoing quality. Thirdly, manufacturing is a key differentiator in terms of attainable conversion efficiency and deliverable quality standards. Managers who develop manufacturing systems that achieve tighter manufacturing tolerances, lower number of operations, and lesser effluents with greater recycling contribute to operational sustainability. Fourthly, quality needs to be perceived transparently at the time of purchase and in regular usage. Managers who ensure integrity in product delivery and usage with good packaging, transportation, distribution, delivery and after-sales service practices contribute to overall conservation of resources. Fifthly, and most importantly, irrespective of whether the product is commoditized or prone to commoditization, innovation can slow down or reverse commoditization. Managers need to support innovation across the value chain as much as they seek cost economics.

Multi-point value chain

There are fundamental differences between companies which choose to be completely commoditized, to have a mix of commoditization and innovation and opt to be completely innovative. The first group operates in a negative spiral of managing on costs, and having no wherewithal to reinvest. The first group brings down not only itself but all of its suppliers and vendors. The group believes it is operating in low risk-low return class, but actually runs the highest risk of industrial sunset, as customers who constantly evolve would see declining value or relevance for such products. Typically, such companies convert their industries into sunset industries. The second group operates at multiple value points ranging from pure commodity, low value, low cost and mass products to pure innovation, high value, high cost and niche products. The second group consistently innovates products, and moves them down the value chain as markets evolve. A sub-set of the second group has the capability to introduce products simultaneously at various value points. The second group has the utmost capability to achieve long term sustainability. The third group of totally innovative companies operates at the highest levels of risk and reward but is the essential trigger for evolving new sunrise industries. The third group has the ability to create markets, and even industries, around its innovations.

Water is a product that cannot be differentiated visually or in use. Yet, as this post has brought out differentiation could be done creatively even for an apparently commonplace product. Clearly, various other products which have so many technical complexities and nuances offer manifold opportunities for differentiation. Managers, irrespective of the industries they operate in, must use their intellect and perseverance to innovate against commoditization. Long term sustainability stems from innovation rather than commoditization. Water, as an industrial product or as lifestyle packaged product, has several instructive lessons for managers in building value for products and corporations.

Posted by Dr CB Rao on February 6, 2011.


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