The automotive industry is one of the lowest valued stock market sectors – in 1990 the major vehicle manufacturers accounted for above four per cent of the Euro index but now languish below 1.8 per cent. In Europe, VW has faced a dramatic fall in profits, Ford is making substantial losses, despite significant savings GM Europe is still in the red, and Fiat continues to struggle. While returns are better, the premium manufacturers also face significant challenges. Yet, why are returns so poor given the industry sells extremely expensive products that represent high emotional purchases tied-up with ‘self-image’, aspiration, and other related intangibles? Buyers are willing to direct significant discretionary spend to their cars – which suggests an industry that should achieve at least average returns.
Low returns and consequent low valuations are driven by two related factors. First is huge capital intensity and an inability to reduce the asset base significantly. Second is overcapacity, but compounded by overproduction and worse, incorrect production. In a supposedly ‘consumer focused’ industry, the core businesses still spend a substantial part of their time and marketing budgets in trying to sell consumers the wrong product. But then, few people who run car companies ever have to buy a car themselves! Combine this situation with increasing product variety and complexity, it is easy to be pessimistic about the future. This article explores some of the challenges that the industry faces and points to some possible developments.
The problem is…
The major car manufacturers rely on a business model unsuited to today’s mature car markets. Both mass production (Ford) and lean production (Toyota) evolved at a time when demand was greater than supply. Production plans, and importantly investment, are based on often high or seemingly arbitrary estimates of future demand. When design costs are overrun and low target prices are required, then achievement of profit requires volume. High fixed costs and factory capacity requires that these volumes be maintained. The consequence – discounting, increased specifications and addons, large fleet sales and rapid pass-on to used car markets, depressed resale volumes, segment prices down and… poor returns. Below the premium segments (where supply tends to be constrained), the new vehicle market is perpetually flooded with cars desperately seeking buyers, meaning that potential profit margins are relentlessly competed away. New technologies, added features and on-going design improvements have increased variety and choice, yet in real terms price increases cannot be enforced. The market share of the top 10 selling models in Western Europe has declined from 27 per cent in 1980 to below 10 per cent today, yet the inflation adjusted list price of a basic Golf has remained broadly constant over the last ten years. Respite is only temporary, driven by the latest cost reduction initiative or successful new vehicle launch.
Profit per car
What has this to do with supply chain – apart of course from a relentless pressure on partners? The issue, at least for the larger vehicle manufacturers (VMs), is essentially a supply chain problem. Despite considerable efforts to reduce order-to-delivery times and increase flexibility, ‘build-to-inventory’ is at the centre of the industry’s problems. A business model that relies on its distribution network to move cars on at any price is fundamentally flawed. The current approach will not achieve the level of sustainable returns necessary to support a rise in valuation. Instead emphasis needs to move away from reducing cost per car to one of maximising profit per car, fully reflecting the high levels of sales incentives currently paid to dealers and consumers.
This change has long been championed by proponents of new ‘Order-to-Delivery’ (OTD) processes in the industry. Talk of the five-day or three-day car is nothing new, although 15 days for a true ‘make-to-order’ car is probably about achievable today on a sustainable basis. The capabilities required, whether flexibility on the supply side or demand ‘sensing’ and management on the market side, are well understood in principle. In practice it has been hard to make change happen, particularly with stagnant volumes over the last three years.
Significant barriers to progress have included: Shortened lead times require destocking of the supply chain of both manufacturers and dealers, with consequent oneoff sales impact which manufacturers have been unable to absorb because of lack of growth; Combined with wholesale ‘push’ driven by focus on volume rather then margin management, compounded by volume based incentives and failure to align and optimise targets across sales and manufacturing functions; A need for a major shift in dealer selling skills from selling ‘off the lot’ supported by incentives, to a consultative approach supporting consumers as they work through the complex trade-offs between configuration (including financing and insurance), price and availability; Declining profitability in dealer networks, with changing dealer contracts and network relationships, in part driven by the new EU Block Exemption Regulation introduced last October, in part by manufacturers’ pressure to reduce selling costs often through poorly managed or communicated initiatives, and further compounded by tightening of dealer financing as new banking regulations come into effect under the Basle II agreement. Nonetheless, while these barriers are substantial, the successful automotive suppliers will be those who manage to increase the element of ‘pull’ in their supply chains, using OTD processes to increase both profit from an improved customer proposition and manage cost by a better alignment of supply and demand balancing decisions.
The capabilities required for such a model take time and significant investment to build. Vehicle manufacturers are developing and testing elements of the model required, focusing on critical elements such as shortterm consumer demand monitoring, upgrading of vehicle configuration software and order management systems at dealers, and building increased flexibility in assembly and the supply base.
However, the winners will be those VMs who recognise and can best address the changes in behaviour, at both vehicle manufacturer and dealer level necessary to create an integrated ‘pull’ model. This requires a substantial change in processes, IT, performance measurement, and ultimately attitudes along the chain.
One consequence of VMs’ effort to improve flexibility and cost is that more responsibility will be given to fourth party logistics service providers for scheduling and management of both inbound and outbound flows. Onetime opportunities to reduce cost from better labour rates or load planning have been largely tapped. The next opportunity is from development of shared networks, creating the lowest cost logistics solution across VMs. Such multi-client solutions of necessity require that logistics service providers have greater responsibility for scheduling and management of logistics flows, enabling them to apply improvement levers such as: Continuous-move strategies to improve utilisation; Re-balance lead-time with network density; Leverage consolidation points to reduce ‘last mile’ costs; Change pricing policies to maximise profitability per lane; and reduce search cost to find better load matches across multiple hauliers.
Logistic service providers are already developing cross-VM logistics delivery platforms for inbound components in both the US and Europe. On the outbound side, opportunities to share distribution, thereby improving utilisation – and delivery times – of car carriers are also being explored. This puts logistics service providers into an expanding role of multi-client ‘network managers’. However, the IT intensity of processes implicit in multi-client networks introduces scale as an important factor, which can only be captured in a multi-user environment. Consequently, looking beyond shared networks, this role positions logistics service providers best to develop leading edge supply chain IT solutions including integration of funds flow, inventory management capabilities – and ultimately collaborative platforms.
Moving on from issues with its traditional business model, the automotive industry faces additional challenges driven by technology change and new market requirements. This will be marked specifically by a dramatic increase in the use of electronics and software, leading to increasing complexity in the product. In ten years time standard compact cars will offer a complex array of networked ‘infotainment’ and navigation systems, customised-by-driver conditions (seat adjustment, air conditioning, software driven ‘feel’), active safety features including head-up displays, as well as smaller but supercharged low emission engines.
The cost increases arising from such additional features will need to be offset by improved productivity in the total supply chain. In part new process technologies, particularly those permitting more flexibility of manufacturing and assembly across models and life cycles, will support this productivity improvement. However, new product technologies and increased modularisation in design will lead to an enhanced role for Tier 1 suppliers. Their role will continue to shift from being functional providers of components and systems modules, to that of knowledge-based specialists and integrators deeply involved from concept, through design, to final assembly, enabled by development of specifications for standard electronic interfaces and protocols. As a consequence, vehicle manufacturers’ share of value creation will decline, but with greater emphasis being placed on risk sharing with suppliers.
Collaboration with selected suppliers will therefore tighten, driven from product development. Currently suppliers tend to be at a structural disadvantage in negotiation with their VM customers. VMs can demand price concessions for current programmes by holding participation in future programmes hostage, or by using competitive benchmarking tactics (such as Ford’s zero based targets (ZBT), Chrysler’s cost regression analysis (CRA)) to identify and force the adoption of supplier cost reductions. While suppliers must continue to manage their costs aggressively in their manufacturing and delivery networks, exploiting scale where possible, a shift in their role toward that of knowledgebased specialists and integrators will support their ability to create a source of profit that is less readily copied and consequently more defensible longer term.
The automotive industry is highly capital intensive, but is also marked by increasingly volatile demand. Assets tend to be highly specific against model. There has been substantial increase in the number of models available, with shorter product life cycles, and increasing uncertainty and fluctuation in volumes over the life of a model. In an industry where asset utilisation is an issue (particularly for the ‘mass’ vehicle manufacturers), alternative approaches are already being considered. ‘Badge engineering’ and model specific joint ventures (for example, Saab 92 and Subaru in the US) are used increasingly to introduce niche models quickly that would otherwise be disadvantaged by low volumes. Another is increased sharing of components and platforms between models and between VMs (such as, GM/Fiat power train and procurement joint ventures, Ford/PSA engine partnership). Both production technology advances and component standardisation will allow more variety to be managed across assembly lines, enabling improvement in asset utilisation.
Nonetheless, other industries with high asset base and volatile demand have come to use outsourcing or contract manufacturing as an industry-wide solution for improving the asset base. In many consumer goods sectors branding is becoming increasingly separate from manufacturing. In electronics for example, outsourcing of manufacturing has supported variety and short life cycles while enabling brand leaders to make substantial reductions in their asset base. Increasingly, supported by closer alignment of vehicle architectures, business structures will evolve that allow more flexible capacity to be ‘shared’ across VMs. It remains to be seen how this will be driven – and whether by the traditional VMs, or by manufacturing outsourcing specialists incorporating expertise from process engineering companies, parts and equipment suppliers or others. However, in an industry in which many players consistently fail to cover their cost of capital through the business cycle, such options for reducing the capital base are clearly open for discussion.
James Gardiner is a principal at management consultants, Booz Allen Hamilton