Does backward intergration pay?

Aarati Krishnan

TRADITIONALLY, players in the FMCG market have not set much store by manufacturing their own products. It is common practice in every segment of the industry to outsource a part of the products sold from smaller, third party manufacturers.

The prevalent taxation system, which offers exemptions to small units and units in specific locations, has also encouraged the practice. The detergent industry is no exception. Though players such as Hindustan Lever and Henkel SPIC do have their own manufacturing facilities for detergents, they also rely on outsourcing to a great extent.

In the circumstances, it is Nirma that has challenged traditional practices. Not only has the company consistently invested in building manufacturing capacities for detergents and soaps, it has also integrated backwards to manufacture every conceivable detergent input. After making large investments in its backward integration efforts, Nirma now operates a 75,000 tonne unit for Linear Alkyl Benzene (LAB; a key ingredient in detergents) and a 4.20 lakh tonne unit for soda ash. It plans to expand the soda ash capacities further to 6.15 lakh tonnes.

Nirma claims these measures will help it reduce costs and ramp up operating profit margins. It also claims that the cost of soda ash and LAB, which took away 63 per cent of net sales in 1996-97, accounted for 51 per cent of sales in 2000-01.

5But sceptics challenge the need for backward integration. One of the arguments against backward integration is that the soda ash and LAB markets are dominated by a few large players which have significant economies of scale and depreciated facilities that result in a lower fixed-cost structure. A detergent manufacturer is unlikely to be able to match the capacities of the larger players, and could, as a result, have a higher cost structure for his backward integration project.

Second, obliging WTO commitments, India has dramatically cut import duties on most chemical products over the past five years. For instance, the basic import duty on LAB fell from 40 per cent in 1995-96 to 30 per cent by 2001-02, while that on soda ash fell from 40 to 20 per cent in the 2001-02 Budget. With chemicals becoming freely importable, detergent makers will have greater flexibility in importing inputs.

Third, backward integration into inputs such as LAB may prevent a detergent maker from examining alternative, low-cost inputs. The sharp rise in LAB prices, for instance, has encouraged soapers to look at alternative active ingredients such as alpha olefin sulphonates and methyl ester sulphonates. Should a substitution occur, players who have already invested in substantial LAB capacities may be unable to make the switch.

Till date however, after initial teething problems, Nirma's backward integration into LAB appears to have paid off. The company's capacity utilisation on this unit has been in excess of 120 per cent in 2000-01. The spike in petro product prices that year helped the company boost this product's realisations by 13 per cent, while costs rose just 3 per cent. Between 1998 and now, LAB prices rose steadily from Rs 39 per kg to Rs 53.9. This is likely to have bitten into the margins of Nirma's competitors, while protecting its own. However, whether this advantage will persist if there is a further decline in import duty on LAB, still remains to be seen.

The backward integration into soda ash has been less successful. The project has had its share of teething problems and the unit's capacity utilisation was around 50 per cent in 2000-01.

Nirma hopes to stabilise production in 2001-02. However, unlike the domestic LAB market, where the demand-supply equation is finely balanced, the soda ash market faces an overcapacity situation - at the domestic and global levels.

Despite the recent imposition of an anti-dumping duty on imports from China, soda ash prices are presently hovering at Rs11 per kg, down by about 35 per cent from around Rs17 in mid-1998. True, Nirma has been insulated from the temporary spikes in prices during the year. But the surplus situation in the market has ensured that upward spirals in soda ash prices are not sustained for too long. Both Hindustan Lever and Henkel SPIC have managed to absorb the increases in input costs and pass on part of the price increase to their consumers.

But integrated manufacturing facilities are probably of special importance to Nirma because of its aggressive marketing strategy. Be it soaps or detergents, Nirma owes the success of its new launches to the aggressive pricing of its products. It is through its value-for-money offerings that the company has managed to capture a significant share of the economy segment in soaps and detergents. Given that this is an extremely price-sensitive segment, Nirma would certainly like to make its operations less vulnerable to sudden spikes in raw material prices. However, the question is whether backward integration is the best option to economise on input costs.

The jury is still out on that question.