Facing New Realities: What Comes Next for the U.S. Auto Industry?

U.S. automakers must more creatively than ever before address customer preferences, vehicle innovation, digital autos, and product lifecycle and revenue optimization.

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Scott Corwin Michael Beck Ashok Divakaran Kasturi Rangan

Facing New Realities What Comes Next for the U.S. Auto Industry?

This report was originally published before March 31, 2014, when Booz & Company became Strategy&, part of the PwC network of firms. For more information visit www.strategyand.pwc.com.

Contact Information Chicago Mike Cooke Partner +1-312-578-4639 [email protected] Jan Miecznikowski Partner +1-312-578-4508 [email protected] Conrad Winkler Partner +1-312-578-4692 [email protected] Michael Beck Senior Executive Advisor +1-312-578-4769 [email protected] Brian Collie Principal +1-312-578-4637 [email protected] Ashok Divakaran Principal +1-312-578-4751 [email protected] Cleveland Evan Hirsh Partner +1-216-696-1576 [email protected] Kasturi Rangan Principal +1-216-902-4258 [email protected] Mumbai Vikas Sehgal Partner +91-22-2287-2001 [email protected] Munich Jörg Krings Partner +49-89-54525-574 [email protected] New York Scott Corwin Partner +1-212-551-6578 [email protected] Paris Rich Parkin Principal +33-1-44-34-3131 [email protected] Tokyo Cosmo Takamatsu Partner +81-3-3436-8659 [email protected] Steven Veldhoen Partner +81-3-3436-8483 [email protected] Kazutashi Tominaga Principal +81-3-3436-8598 [email protected] Zurich Ronald Haddock Partner +41-43-268-2132 [email protected]

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The U.S. auto industry is facing a period of fundamental change and vast disruption as it adjusts to a smaller, more competitive market. Although the Detroit Three have made significant progress since the beginning of the global recession—for example, reducing debt and post-retirement benefit obligations and introducing more appealing vehicles—more remains to be done. The global landscape is changing rapidly, as emerging markets increase in importance and competitors from these nations become stronger. Customer preferences are becoming more complex, as advanced “smart car” technologies proliferate in developed-market vehicles and low-cost cars proliferate in emerging markets. Moreover, automakers throughout the world will have to deal with an uncertain carbon future, when new powertrain technologies, stronger carbon emission regulations, and depleting reserves of fossil fuel will present a much different cost and consumer environment for making and selling cars. To earn sustainable profits in this rapidly altering landscape, automakers must differentiate themselves by developing distinctive capabilities. Specifically, they must more nimbly and creatively address customer preferences, vehicle innovation, smarter and increasingly autonomous vehicles, revenue optimization, and even more rapid product life cycles.

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Key HIGHLIGHTS • The U.S. automotive industry has survived the worst of the downturn, and there are signs that recovery is finally taking hold. • But significant challenges remain for the U.S. auto industry, including production overcapacity, quality gaps between Japanese automakers and American companies, uneven investment economics across product portfolios, and pricing and promotion policies that often favor short-term volume and market share over building residual values, brand equity, and life-cycle profitability. • To thrive, U.S. automakers need to develop differentiated capabilities in these areas: responding to customer needs; new powertrain and component technology for greener automobiles; electronic controls and software for smart and information-rich autos; and maximizing vehicle life-cycle profitability in both the short term (pricing and promotions) and long term (platform investment economics).


annually, last seen in 2007, they appear to be heading toward nearly 12 million vehicles this year. Volumes will likely continue to grow as an aging vehicle fleet drives replacement demand. Despite the improving picture—and reason to believe that further gains lie ahead—U.S. automakers still face enormous obstacles. GM, Chrysler, and Ford are saddled with weak balance sheets and operate at a cost disadvantage compared with global competitors. Indeed, even though union concessions have sharply diminished health and pension legacy expenses, labor cost parity with Japanese imports in the U.S. remains elusive. Under current agreements, parity can only be reached well in the future as the labor pool shifts to new, younger hires at lower rates—but that may not happen, as unions are already trying to reverse concessions made in the worst days of the recession when some automakers were on the verge of liquidation. Although Detroit Three vehicles continue to improve in quality, and Ford in particular scores well in surveys of

After an unprecedented economic downturn, macroeconomic conditions are becoming somewhat more favorable in the U.S.—and the U.S. auto industry is showing signs of renewal and turnaround. GM and Chrysler are out of bankruptcy. The Detroit Three are beginning to refill exhausted product pipelines, with a number of new launches receiving very favorable market reception, and the automakers are increasing investment in new vehicles. Credit standards are loosening as well, and auto companies are making attractive financial offers again, enabling some consumers to trade in their old vehicles for new ones at practically no incremental monthly cost. And while it is unlikely that U.S. light-vehicle sales will soon return to their peak levels of 17 million units


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Furthermore, looming over the entire industry are uncertainties about new policies to address greenhouse gas reduction and the potential for some form of carbon taxation. Existing engines and transmissions will require rapid and costly improvement to meet more stringent emission standards. In addition, generations of powertrain technologies based on fossil fuel internal combustion engines (ICE) will be supplemented or supplanted by some combination of hybrid technologies and zero-emission battery or fuel cell breakthroughs. The impact to automakers in production, innovation, and engineering costs, as well as sales by vehicle type of these potential “green” shifts, will vary by country depending on gas prices, energy supplies, entrenched transportation and energy infrastructure, government subsidies, and national tariffs.

consumer perceptions, the U.S. automakers still face a significant revenue gap with Japanese competitors for comparably equipped vehicles. Moreover, billions of dollars in government support have yielded unintended consequences for GM and Chrysler, as they are barred from shifting dollars from the U.S. to non-domestic operations and are therefore constrained from optimizing their global production networks. This global handicap will likely have its greatest impact as American manufacturers face off against automakers from emerging economies, like China, India, and Brazil, where vehicle sales are expected to grow far more rapidly than in the United States. American manufacturers may be hard-pressed to match the output of more entrepreneurial companies from developing nations that have their eyes on worldwide markets—such as China’s Geely, after its acquisition of Volvo—and are developing innovative vehicles, such as India’s Tata Nano and the fleet of electric cars announced by China’s BYD.

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Even as the U.S. automakers have demonstrated their ability to adapt to unprecedented economic conditions, widespread challenges remain. Initiatives are required for improvement in a number of areas: Better align supply with natural market demand Too much product is still chasing too few consumers. Production capacity

needs to be aligned more closely with realistic projections of market demand. Setting the right level of capacity is a complex optimization algorithm involving expected demand and variability, manufacturing flexibility, and cost of forgone sales versus excess capacity. In our experience, automakers struggle constantly to make the right set of trade-offs. Achieve superior quality, reliability, and durability (QRD) Although the quality of vehicles sold in the U.S. is better than ever, there are still meaningful gaps between companies ranked highest in quality and the rest of the manufacturers, especially in longer-term reliability and durability. American consumers

are savvy enough (at least intuitively) to understand that QRD impacts total cost of ownership and ultimately affects residual value and their consumer equity. To gain share in the U.S. market requires achieving parity with, or exceeding, well-established industry leaders in key automobile model segments. Close is not good enough! Require every vehicle to “pay its share of the rent” Investment economics of future products are not fully optimized because many manufacturers do not require each entry to earn its true cost of capital or have a clear strategic justification in the portfolio. But with industry margins tighter than


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ever, companies will need a return on investment for virtually all products in order to generate acceptable profits. Better transparency of investments per vehicle and more realistic estimates of likely volume and pricing are needed to drive improved product decisions based on reliable hard data and forecasts. Improve revenue management Bringing to market the right portfolio of vehicles—with attractive investment economics, appropriate levels of QRD, and production aligned to market demand—sets an automaker up for success. But pricing and incentives need to be managed in the medium and short terms for maximum profitability. In our experience,

automakers have too often chased unit sales and market share at the expense of life-cycle profitability, pushing out more volume than the market “wants” and thereby eroding residual values. Making the right pricing and promotion decisions requires advanced analytics to understand price/volume trade-offs and to estimate residual value effects. In addition, the company must be organized to drive decisions about incentives and pricing from the analytics and to ensure a balanced focus that includes longer-term brand building. Booz & Company research suggests significant (multibillion dollar) returns could be realized if pricing and promotions are optimized, residual values are maximized, and disciplined

approaches to model variations and incentive programs are adopted. Prepare for an even more globally competitive landscape The Detroit Three need to be ready for the emergence of new competition with potentially advantaged cost structures (notably companies from Korea, China, and India), with greater attention to emerging market segments (for example, the Tata Nano and other low-cost cars), and with earlier adoption of advanced technologies (for example, electric vehicles). Competing successfully will require continuous improvement in products, technologies, costs, investment economics, and business models.

Bringing to market the right portfolio of vehicles—with attractive investment economics, appropriate levels of QRD, and production aligned to market demand— sets an automaker up for success.

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Capabilities-Driven Strategy To compete over the long term, an automobile manufacturer, like companies in most other industries, will have to build what we call a capabilities-driven strategy. This involves establishing a differentiated and sustainable competitive advantage by focusing on, nurturing, and leveraging what the organization does exceptionally well. In this context, capabilities are defined as the interconnected people, knowledge, tools, and processes that form systems to create distinctive value for customers. Once built, capabilities systems are difficult to replicate, especially by companies with less coherent strategies. Advantages based on assets, technologies, and scale are increasingly transient in most industries, and as the intrinsic value of assets has diminished, the importance of capabilities has become greater. The right combination of capabilities helps extract value from assets and creates or develops additional assets. As Booz & Company partners Cesare Mainardi, Paul Leinwand, and Steffen Lauster wrote in “How to Win by Changing the Game” (strategy+business, Winter 2008): “A true capabilities-driven strategy is the most reliable way for a company to thrive when the rules of the game for its industry are in flux. Instead of looking inward at the capabilities you already have and trying to discern your strengths, start by looking outward at the capabilities you need. What must you be able to do to reach the customers you fundamentally want to attract? By designing a portfolio of skills and tools needed to win customers, you can end up changing the game instead of playing by the rules.”


To tackle these difficult operational obstacles, U.S. carmakers need to determine where in the value chain they can best differentiate themselves and then emphasize those special capabilities in every aspect of the business—engineering, design and manufacturing, marketing and sales (see “Capabilities-Driven Strategy”). With dynamic shifts in the industry, places where distinctive capabilities matter most are changing rapidly as well. We believe that, to thrive, automakers will have to differentiate themselves through one or more of the following capabilities: Advanced customer sensing and market responsiveness Although automakers have improved their understanding of customer needs and wants and their ability to design vehicles to match, these capabilities are still insufficiently developed. In an ideal world, auto manufacturers would develop dynamic, real-time sensing and response capabilities, with which they could gauge proactively and precisely what consumers want and then rely on business systems to meet those needs effectively

and efficiently. Though this approach sounds like the Dell build-to-order operating model, manufacturers need not risk committing to what would certainly be a radically different system for the industry. Instead, carmakers could emphasize the development of advanced customer sensing programs and then continuously fine-tune production systems to respond to the data generated by these programs. BMW’s KOVP effort, which allows dealers to tailor automobiles to purchaser preferences until 10 days before production, offers a good model for the value of late-stage customization. Powertrain and component technology for greener automobiles As pressure for reduced fuel consumption and greenhouse gas emissions rises, focus on improving drivetrain efficiency is increasing. There is a lot of potential in improved ICE drivelines, and large investments will be required in direct injection, HCCI, improved transmissions, and start/ stop systems. With respect to more transformational technologies, there is a temptation to hedge bets by experimenting with a variety of different powertrains until the shape of the automobile’s future is clearer. This is not likely to be the winning strategy. The key is to develop a high-quality understanding of what bets are most promising, spread chips across the best bets available, and


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develop a deep pool of expertise in core technologies such as electric motors, power electronics, and regenerative braking that are likely to be valuable. Vehicle and infrastructure electronic controls and software for digital autos As vehicles move from passive to more active electronic and computerized systems, technical specialists who understand how to use stateof-the-art technology for integrating vehicle diagnostics, driving controls, crash avoidance, and the like will be increasingly essential. Indeed, it is not too far-fetched to envision a time when vehicle-to-vehicle communications and “smart” guidance with GPS could produce driverless vehicles. Automakers will still have to address potential legal issues, convince consumers of the benefits associated with these futuristic technologies, and, in turn, monetize their investments. As Apple has amply demonstrated, new technologies can disrupt entire industries and create fresh revenue streams where none seemed possible, but this shift may require an infusion of a more digital-minded culture in the automotive industry. Vehicle life-cycle profit maximization Historically, automakers have maximized short-term revenue and

profit at the expense of longterm success and building brand equity. Now that the industry has reduced capacity significantly, there is a historic opportunity to align production with much more realistic estimates of natural market demand. There is also the real chance to improve shortand medium-term pricing and promotion decisions by developing sophisticated analytic capabilities, comprehensive and holistic processes, and improved measurement and reward systems that incentivize managers to seek profit maximization over the product life cycle. Building attractive vehicles and brands again “It’s all about the car” … and it always has been (see “The Rules of the Road Haven’t Changed Much”). Lost in all the turmoil confronting automakers is the fact that cars and trucks are still among the most visible, emotional purchases consumers make. They want once again to have a love affair with their car and take pride in the brand they own. Manufacturers need to give their customers reasons to truly value what they deliver, thereby building brand equity over time. Though much easier said than done, this approach must be at the forefront of a capabilities-driven transformation.

The Rules of the Road Haven’t Changed Much New realities and fresh challenges in the U.S. and global auto markets are forcing companies to consider new types of specific capabilities to develop. But the fundamental way to win in the automotive business remains the same. It has always been about creating vehicles that deliver sustained product excellence and QRD, which consumers are willing to pay relatively higher prices to own. Our research indicates that the most successful automotive manufacturers meet these goals and achieve superior performance by hewing to these core operational parameters: • Develop vehicles that consumers want to buy and are proud to own. • Build operating models and business systems that consistently and over long periods of time deliver superior investment economic returns. • Create product portfolios and advantaged product development systems in which each vehicle generates a positive return on investment. • Introduce vehicles to the market in a differentiated manner, clearly communicating marketing messages and optimizing pricing, promotions, configurations, and fleet mix to improve both shortand long-term profitability, create consumer value (especially through higher residual values), and build brand equity. • Minimize relative material and structural costs while also bringing new technology to market costeffectively and earning fair returns for product innovation. • Produce healthy returns for suppliers and dealers so they continuously make investments that improve the customer experience.

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The new realities of the automotive marketplace are driving profound and rapid changes in the way competitive advantage is created in the industry. The “new normal” will require U.S. auto manufacturers to reinvent themselves and build advanced capabilities in areas that they have traditionally neglected. Simply put, the U.S. auto companies will have to chart a path to transformation and profoundly change their operating models in order to compete effectively with large and small rivals from around the world.

The “new normal” will require U.S. auto manufacturers to reinvent themselves and build advanced capabilities in areas that they have traditionally neglected.


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About the Authors Scott Corwin is a partner with Booz & Company based in New York. He focuses on helping to develop enterprise transformation strategies for clients in the automotive, media, information, and consumer industries. Michael Beck is a senior executive advisor with Booz & Company based in Chicago. His focus is strategic and operational improvement for automotive and industrial clients. Ashok Divakaran is a principal with Booz & Company based in Chicago. He focuses on large-scale organizational restructuring strategies for global manufacturing companies. Kasturi Rangan is a principal with Booz & Company in Cleveland. He focuses on corporate and business unit growth strategies for automotive and other industrial companies.

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