The global automotive industry has always been fascinated by the latest trends, but this focus on novelty may have led it to ignore – to its great peril – more fundamental realities. This paper, written by Glenn Mercer (NA) and Andreas Zielke (EU), McKinsey & Company, is exclusive to just-auto and highlights what they see as ‘four truths’ about the auto industry. It will be published in two parts (part two next week). Part one – reproduced below – examines the first two of their four truths: ‘the false promise of global convergence’ and ‘we must value the invaluable’.
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Our industry has for decades had an ongoing romance with the latest trend, be it the rise of build-to-order, the establishment of quality circles, the reduction of the numbers of Tier One suppliers, the implementation of CRM, or any number of others. Part of this interest is due to the long time horizons the industry must deal with, which makes it vital to identify emerging trends early in order to prepare long lead time investments (such as investment in diesel engine capacity in Europe). And part of this interest may just be based on hope: given that so many automotive firms underperform (in terms of total returns to shareholders), there is a yearning that the next fad to come down the road might restore them to solid profitability (e.g. booming demand in China).
Anticipation of such trends and planning what to do about them is of course a crucial task for management. Indeed McKinsey & Company invests a great deal of brainpower and time in identifying trends and laying out suggested responses1. Yet while automotive executives must dedicate serious study to the latest trends, to focus on them exclusively may lead them to ignore or discount more fundamental realities about the automotive industry. These realities – in this article we have identified four – will have a greater impact on the long-term health of this industry than whether fuel cell powertrains hit the market in year 2015 or 2020, or whether China starts exporting cars to the West in five years or ten. The following discussion is intended to bring these underlying phenomena to the fore, and invite informed debate. It is our firm belief that only through the unprejudiced resolution of these deep-seated issues the industry will be able to reclaim its attractiveness for vital resources, both financial and human.
1See for example the HAWK Report on the future of automotive technologies or the Race for 2015 Report on how the OEM of the future will handle issues such as the challenge of engineering the software-intensive vehicle.
1. THE FALSE PROMISE OF GLOBAL CONVERGENCE
For decades many industry observers have believed that the inexorable pressures of economics would mold the various national automotive markets into one gigantic homogeneous global entity, and product offerings into a few dominant mass-market clusters. The metaphor was the same one hypothesized for the home appliance industry, which was thought to be headed for a future where 3 or 4 companies provided 3 or 4 models globally that would sweep the board in any country. Not only has neither convergence occurred, rather in some ways momentum to divergence has been gaining strength.
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By GlobalDataFor virtually all of its life the automotive industry has embraced the idea that economies of scale were so essential to the competitiveness of any participant that anything which could be built up to a global level was inherently and clearly advantaged over merely regional or local equivalents. This belief was reflected in the attempts at creating a “World Car” and at building a “Welt AG”. As marketers have found out to their chagrin, however, consumers’ tastes remained stubbornly different.
To be more precise, addressing relative differences in tastes from country to country remained as important to commercial success of an OEM as ever, even if absolute differences among cars steadily dwindled. That is, it is true that a car sold in France today is in much of its engineering more similar to its counterparts in Japan or the USA than ever before, in terms of things like powertrain design (see the steady decline of pushrod engines), chassis design (see the dominance of disk brakes on the front wheels), or electrical systems (see the global dominance of electronic ignition). But the remaining differences seem to matter more to customers than ever before. The examples are numerous: a European-designed model fails in the USA due to something as seemingly trivial as “cramped rear seat headroom,” an American-based model flops in Japan due to fit and finish issues that would go unnoticed in the States, and a Japanese car fails in Europe because the engine’s torque curve is the wrong shape. Thus a Toyota executive a few years back remarked that “The versions of the Corolla we offered around the world in the past were like sisters: in future they must be more like cousins, to address divergent customer expectations.”
The persistence of these national differences runs counter to the global trend to larger and larger platforms and thus more and more parts sharing. Of course, everyone knows that what the customer sees and cares about cannot be commonized away, and that platforming must be done with great care and discretion, but it is clear by now that the triumph of the World Car has been deferred if not defeated entirely2.
2The exception of course is at the ultra-high-end of the market, the world of Ferrari’s and Maybach’s, where by ensuring that a car exceeds the expectations of all national markets and all consumers, it can be sold globally. What has disappeared entirely is the world car at the other end of the spectrum: the days of the original VW Beetle are long gone. At the low end of the market the cost of local tailoring is almost always higher than the thin margin these cars bring can justify, although we await with anticipation the results of international low-cost experiments such as Logan.
But regional demand differences go beyond lists of features and functions to differences in the entire concept of a car. This is most clearly visible in the relative importance of brands, which typically mean a lot to European buyers, much less to Japanese customers (who tend to favor individual models’ names over those of their respective makers), and the least to American customers, whose considerations are dominated as much by price and dealer service issues as by product properties. Another field in which such divergence is visible is in the relation of driver to vehicle. In Japan the driver may see his car as “home away from home,” and thus demands very high quality interior materials and high-end entertainment and navigation systems. The American household does not so much “own a car” as “manage a fleet,” and while in love with cars overall, has less attachment to any one vehicle when there are four in the driveway. In contrast in Europe the prevalence of one car per family induces the owner to express a great deal of his personality and self-image in his choice of vehicle3.
In addition, of course, “all marketing is local,” in that scale effects in this area do not easily cross borders: purchasing 100 hours of TV advertising in Japan does nothing to address the market in Germany, for example. And given that marketing costs (including discounts) as a percent of total car costs continue to climb, ignoring the absence of these economies is foolish.
It stands to reason, therefore, that even if it were possible to build a basic product that would find some buyers everywhere, adapting the marketing processes needed to sell it locally, and making the engineering changes needed to make it acceptable locally, would add on prohibitive amounts of cost. This leads us to believe that scale effects in the realms of distribution, marketing, and engineering (in so far as it involves local adaptation) are generally greatly overstated by industry analysts.
All OEMs today have strong regional biases towards their home markets or – in the aftermath of their strategies to become more global – had to face a significant cost in terms of lost management attention and outright value destruction in their pursuit of scale economies across diverse markets. The few examples that seem to point the other way – e.g. the Renault/Nissan alliance – do upon closer inspection in fact reinforce the point, because they have not put customer-visible cross-border synergies at the center of their strategies. The “bang for the buck” in these mega-deals has come from sharing costs in areas the customer hardly sees, not from dragging model X from country A into country B’s lineup, or in sharing dealerships, or in pooling advertising. To the extent acquirers assume these savings exist, they will overpay for their targets.
Thus, for the time being, mastering the regional “rules of the game” will remain a prerequisite for success.
3It has also been suggested that the lower incidence of home ownership in Europe versus the USA (that is, a greater reliance on rental properties) also leads car buyers to rely more on the car as the signal of social status and wealth.
2. WE MUST VALUE THE INVALUABLE
The automotive industry has collectively invested massive cumulative time and effort into optimizing its processes, becoming ever more productive and trying to eliminate every bit of cost that was not absolutely essential to its delivery of customer benefit. Progress along this path has taken the industry remarkably far and the benchmarks of performance along practically all measurable dimensions are widely shared and well understood. Intra-industry communication is reasonably intense and best practice spreads quickly, facilitating the emergence of a common operating standard across the industry. This development is still ongoing but clearly it will over time curtail the opportunity to truly differentiate oneself from competition through superior operational efficiency – as long as the scope of what is being included in determining cost and return does not substantially increase.
However, there are several economically important factors that the current perspective of most participants in the industry does not adequately reflect and consider. The future inclusion of such factors will enlarge the solution space for optimization decisions and in all likelihood lead to different decisions on a variety of issues, as explained below. We believe that the early explicit and systematic adoption of these factors into companies’ strategy formulation processes will convey significant advantage, but also require fundamental change across their organizations and with regard to the mental models held by many of their employees. To prepare for this change and to shape its progress will hence be a significant challenge and – if successfully mastered – a significant source of value.
There are three factors that we would like to point out for illustration purposes. There may be more. All of them have in common the fact that they reflect more abstract aspects of a company’s activity than typically considered in its cost accounting and reporting systems. These three are risk, flexibility, and trust.
A. Risk
Risk is of increasing importance in the automotive industry along several dimensions. First, the increasing complexity of each individual vehicle’s content and the growing interdependency of its components contribute to a higher risk of quality problems or even product failure. Second, the increasing volatility of demand and the greater variation of unit volumes over the product lifecycle lead to a higher risk of capacity underutilization. Third, the most commonly used return measures, such as RONA or ROIC, and the targets based upon them often fail to recognize that different strategies to reach those targets will implicitly create markedly different risk exposures, without adjusting expected and actual returns appropriately, e.g., through reserves. In each of these examples the issue is not so much the avoidance or reduction of risk, but the rather its allocation. Further, risks should be handled where they can best be managed. This is not consistently the case in the three examples mentioned above, and detailed below:
- Quality related problems cause enormous costs for the automotive OEMs: they do not only have faulty parts to replace, they also need to sustain resources and processes that check and assure quality, and they suffer the loss of price premium that a reputation for lower quality leads to. Some of these problems originate from parts coming from suppliers. These suppliers will of course invest in quality assurance only up to the point where the additional investment begins to exceed the avoided incremental cost of quality problems. Since typically only a small portion of the OEMs’ quality costs will have to be covered by suppliers (e.g. not the cost of brand damage), suppliers are structurally incentivized to underinvest in quality assurance. In other words: although the quality risk is largely borne by the OEM, it could often more materially be influenced by the supplier, who sees little gain in doing so. Risk allocation is clearly not optimal in this case.
- Overcapacity has been a structural issue for the global automotive industry for some time. Clearly the use of invested capital is at the industry level not very efficient: witness the low market-to-book ratios that most manufacturers exhibit. With demand becoming ever harder to predict due to increasing market fragmentation and the growing influence of fleeting fashions, the cost of underutilized assets will go up. The OEMs will therefore use a variety of pricing mechanisms (including financing and incentives) to stabilize demand over time and keep unit volumes in line with their forecasts, upon which they based their capacity decisions. They will rationally invest in such promotional pricing up to the point where the investment begins to exceed the avoided cost of underutilized assets. Since the OEMs will typically only count their own assets in this equation, and not those dedicated throughout the different layers of their supply chains, they too are structurally incentivized to underinvest in keeping demand stable. In other words: The risk of underutilized assets is to some significant extent borne by the suppliers without much of a chance to influence it at the source (final consumer demand). Again risk allocation is not optimal.
- Finally, most OEMs do not have effective risk management tools in place that would allow them to measure, monitor and make adequate provisions for risk in their ongoing operations. Quantitative assessments of risk are rarely used when targets are to be met and a selection among a variety of courses of action needs to be made. This leads OEMs and suppliers alike to adopt risk-prone strategies without appropriately building reserves into their calculations. In the final analysis a strategy with lower returns and significantly reduced risk could turn out to be the superior choice to an alternative strategy with more attractive returns, but disproportionately increased risk exposure. In other words, OEMs tend to calculate the benefits of plans more accurately than the risks linked to these benefits.
B. Flexibility
Flexibility is one essential characteristic of many steps in the automotive value chain. It can be described as the ability of a process, a resource or an asset to deliver satisfactory returns not just under one set of conditions but for a range of circumstances. A flexible asset can thus be used for the production of a variety of products with only minor losses of productivity, whereas a less flexible one would be specifically dedicated to a single purpose. Similarly a flexible supplier would be one who could easily operate in different geographies, adjust to design changes, or absorb short-term volume fluctuations.
Clearly there are costs associated with having flexibility. The more flexible machine tool will simply cost more than a single purpose device; the worker who can man ten different stations on the assembly line will earn higher wages than his co-worker who has mastered only three. While the cost of creating and maintaining flexibility can be well anticipated, the benefits are generally more difficult to assess. Theoretically the avoided investment into a second single purpose device would easily pay for the higher cost of the tool that can be used in several applications. But as traditional accounting systems always depict only one state and do so only ex post facto, the ability to also have generated satisfactory results under other circumstances than the ones that actually prevailed in hindsight has no value. Investments in flexibility will therefore be structurally discouraged and where they occur be based mostly on intuition rather than on strict rationale.
Also, the value of flexibility increases with the range of conditions under which satisfactory returns are reached as well as with the speed with which the adjustment to such unforeseen conditions can be effected. This makes it even more difficult to value or price it correctly, which in turn leads to markets for flexibility being rather inefficient. Specialized providers of flexibility could potentially be of great benefit to the automotive industry overall – as they have been to the electronics manufacturing industry – as they would help to eliminate the costly and unsystematic build-up of flexibility throughout the value chain (but a stable business model for such an offering is still missing, as third-party assemblers regularly suffer business failure).
Even within a single company such pricing mechanisms do typically not exist. There is little incentive for the sales function to invest in improving the quality of its volume forecasts because it gets all products at a constant price even if the forecast is significantly missed. Only if deviations from the forecast would carry a price does rational behavior set in. This implies that vehicles ordered above the original forecast number, or with a much shorter lead time, should charge a higher transfer price for the sales function, thereby amortizing the factory’s investment in the flexibility that made their production possible.
Being able to correctly value and price flexibility will therefore not only create a competitive advantage for individual players through their ability to internally allocate scarce resources more efficiently, but also allow the entire industry to adopt a more efficient structure through the design of new and more specialized roles among its participants, thereby significantly enhancing the potential for collective value creation.
C. Trust
Trust is at the core of any relationship that is to endure beyond the fleeting moment of just one transaction between two parties. Its economic component reflects all those costs incurred by the two parties involved that have a value beyond the initial transaction. With its high level of specialization and typically low degree of vertical integration, the automotive industry is particularly dependent on correctly valuing and explicitly considering the economies of trust.
Investments in trust occur, for example, through establishing technical standards that facilitate engineers of different organizations working together towards one integrated product, as well as through agreeing on terms of trade (e.g. warranty charge backs) that allow efficient interfacing between OEMs and suppliers for a series of transactions. Both examples involve costs that can only be justified when considered against the longer time horizon of a mutually beneficial relationship. Trust is particularly evident when two parties explore the potential of cooperative behavior before their relationship is governed by a contractual relationship, e.g., when a supplier offers an innovation to an OEM customer in hopes of its being purchased.
As in the other examples above, the costs of building trust can be measured much more easily than its benefits. Among the latter are improved access to new ideas from suppliers, the ability to engage in more cooperative forms of problem solving along the entire value chain, and the greater efficiency of exchanges (as less effort would need to be expended on negotiations). These effects are hardly ever made explicit let alone quantified and therefore not normally considered, although their general existence and even their importance is often stressed as important by industry leaders.
Trust must not be confused with the absence of self-interest or collusive behavior. The fact that two parties find it more economical to invest in their relationship does not imply that they do not compete fiercely for the surplus generated by their joint activity. There is a risk, however, that this competition can be taken to the point where trust is destroyed, after which transactions might take place on a one-by-one basis or not at all, because the inherent transaction costs become too high. Innovation or even just joint idea generation for cost savings through the adaptation of technical specifications will be very difficult to incentivize under such conditions. Leaving money on the table, on the other hand, in order to reward “trust” will lead to a loss of competitive edge and negative long-term implications from having a very stable relationship with an inefficient partner.
In the automotive industry the perspectives on the value of trust appear to differ widely. While in North America the OEM’s willingness to invest in a supplier relationship much beyond what the immediate next transactions require is typically limited, their Japanese counterparts make long-standing commitments to their respective keiretsu networks (both formal and informal). The European situation seems lodged somewhere between these extremes. This highlights the lack of a shared approach towards valuing such investments and commitments. Given the importance of continued access to the best ideas, the ability to correctly place these investments, monitor their performance and account for them responsibly will be an important competitive asset for those players who master it early.
[To be continued next week with the third and fourth of the ‘four truths’.]
Readers with comments or questions are invited to contact the authors at glenn_mercer@mckinsey.com and andreas_zielke@mckinsey.com
