From Booms To Bailouts - The Auto Industry

Daniel Hartman July 1, 2009 Economics 175: Economics of Management and Strategy Professor George Norman From Booms to Bailouts: The Auto Industry An Unprecedented Intervention The American Economy, and as a result the World Economy, is facing what President Barack Obama often considers the “greatest economic crisis since the Great Depression.” Because no political leader wants to govern over, and therefore be held responsible for, a second depression, the country has been witness to the most significant government intervention into the marketplace in history. There was almost complete agreement that something had to be done when the Emergency Economic Stabilization Act of 2008 was passed on October 3, and the Troubled Asset Relief Program (TARP) was put into effect in control of $700 billion to rescue the nation’s banks and financial institutions. The reason it was able to garner bipartisan support was the threat of systemic risk, in which the industry as a whole would be threatened by a failure or bankruptcy instead of the one or two companies going bankrupt. However, the reach of bailouts in a crisis moved beyond systemic risk. On December 19, 2008, President George W. Bush, with the support of then PresidentElect Barack Obama, issued $13.4 billion in financing to General Motors (GM) and Chrysler using the TARP program because the Congress would not pass such a rescue. But this bailout was arguably less because of systemic risk to the auto industry, which would continue to survive with General Motors and Chrysler in bankruptcy. It would have followed the traditional market principle of winners and losers, with companies like Toyota and Ford winning, and GM and Chrysler losing. Since then, the government has continued to finance GM and recently declared an orderly bankruptcy for the company on June 1, 2009. In this bankruptcy, the United States government holds a 60 % ownership of equity in GM.1 This type of government intervention where the government holds a majority stake in a company it is attempting to put through an orderly bankruptcy is unprecedented. The original outlook of this study was to look at other situations in which a government-owned company, one that was formerly a private company, was run in its post-bankruptcy period. But, since there is no precedent for such an intervention by the public sector, this paper will instead focus on why GM failed and why Toyota did not. It will analyze the auto industry, the competitive advantages, the globalization, and other industrial factors that led to the moment the two companies find themselves in today. Finally, this paper will predict the future of the auto industry in such a market and what changes need to be made by GM in order to truly be competitive with other companies. Strategic Failure The major reason GM is going through bankruptcy is rooted in a inflexible strategy lacking innovation and efficient improvement, and these issues were exposed recently with its 1

(The White House Press Office, 2009)

production of the sport utility vehicle (SUV) . In the late 1980’s and early 1990’s, the company was losing money on many of its smaller vehicles, and losing in competition to Toyota on compact cars. So, it found a niche that it could pursue that was quite profitable in the SUV. The SUV provided large profit margins of up to $15,000 per unit, a welcome change when you consider that GM was actually selling its smaller autos at a loss.2 Not only were the margins high, but the demand for these large vehicles increased as well. While GM was succeeding with the Chevy Blazer and Suburban, Ford joined in producing the Explorer and the Expedition. Therefore, even though they were paying higher labor costs due to their unionized workers, the massive profits from the SUV market made up for it and allowed GM and Ford to compete with Toyota. That being said, even Toyota entered the large vehicle market with its Tacoma later. GM produced 680,000 SUV’s in 2003, its peak production of the type. However, in the wake of Hurricane Katrina, and again more recently, the industry has felt the hit from an increase in gas prices. As gas prices raised, the demand for these large vehicles, which had very low fuel efficiency, went down. And the fact the GM has profits in SUV’s while it sells compact cars at a loss is indicative of their choice to put all their eggs in one basket—a poor strategy by any standard.3 Toyota also produced large vehicles and didn’t get forced into bankruptcy. This is because of the many improved efficiencies they have over GM and that have provided a competitive advantage over the domestic competition since it entered the North American market. The History of Making Cars in the USA The first of the advantages is in vertical integration, its relationship with the assembly line, and the assembly line’s ability to fit economies of scope. But to discover why Toyota had an advantage in manufacturing, it is important to analyze the history of automobile manufacturing in America and in Japan. In 1913, Henry Ford began mass producing the Model T and within six years, the model earned 42 % of the auto market in the United States.4 The mass production assembly line model developed by Ford included interchangeable parts that were standardized so that they would fit any car, in lieu of each part being created for a specific vehicle by hand. Furthermore, labor costs were produced because as more and more mechanisms were put in place, the need for highly-skilled mechanics were no longer needed, and allowed Ford to hire lower-skilled labor who he could task with simple, repetitive tasks; no prior knowledge of the automobile was necessary. As a result, mass production was allowing Ford to produce more cars at a cheaper cost, and had revolutionized the industry. The results of this technological advance were incredible when you compare 1908 to the 1926 statistics. “Output was increased from just over seven cars an hour to 146—which terrified competitors,” and as a result the price of the Model T dropped almost 65 %, from $825 to $290.5 The introduction of mass production was followed by the concept of vertical integration, first mastered by General Motors, which was a conglomerate of suppliers and producers of automobiles. This combination of mass production and vertical integration was the first 2

(Vlasic & Bunkley, 2008)

3

(Vlasic & Bunkley, 2008)

4

(Maxton & Wormald, 1995) p. 68

5

(Maxton & Wormald, 1995) p. 69

indication that the auto industry was going to be an oligopoly, as Ford and GM began dominating the markets and their strategy to develop economies of scale by owning not only the producers, but the inputs that go into it. Due to the cheap labor costs, the auto industry in the United States developed its own social structure as well, which ultimately would lead to its greatest difference with its overseas competitors. Ford famously paid $5 a day to its employees, a low but good enough wage for low-skilled labor. However, this type of wage, while taking advantage of the unskilled nature of the mass production system, did not utilize human creativity and ingenuity. This paternalistic, command and control type policy did not incentivize workers to give input or try harder, and therefore stinted the possible innovation from such incentives by creating a culture of complacency. As U.S. companies developed their social and cultural environment, a vastly different culture was taking advantage of the human side of production in Japan. Toyota began to develop its own techniques and strategies, one very different than those seen by Ford.6 Continuous Improvement in Japan Kiichiro Toyoda, the son of Toyota’s founder, traveled to the United States in the 1920’s and studied the way Ford’s mass production worked with the idea that he could take its strong ideas and improve upon to mass produce an affordable car for the Japanese people. Toyota Motor Company began in 1937 and started off struggling; “the first products were little more than modified knockoffs of Chrysler, Ford, and General Motors, vehicles.”7 After World War II, however, the company began to emerge and develop into the company it is today, focusing on continuous product and process improvement, as well as valuing its employees. Toyota introduced its first mass produced car, the Toyopet, in 1947, and sold 100,000 of them in its first year. The concept that Toyota was using in its production is known as kaizen, or “the daily and ongoing process of continuous improvement through the elimination of waste in the workplace.”8 This philosophy led to what is known as lean production. Lean production allowed for flexibility in the mass production process. For example, every Ford Model-T used to be black and could not be personalized because it was being mass produced. Lean production allowed for Toyota to design to the specifications of its customers, known commonly as “just-in-time” supply, and to change and improve on its processes. In addition, Toyota was able to hold fewer inventories because of lean production, which allows a company to be responsive to demand. Instead of GM’s strategy, which “pushes” a product on the public and the dealerships to sell, Toyota practices a “pull” strategy in which it produces based on consumer demand, lessening the possibility of a lot full of cars no one wants. This issue came to light this past year, as GM dealers were left with many more SUV’s on their lots than Toyota dealers.9

6

(Maxton & Wormald, 1995) p. 69-70

7

(Magee, 2007) p. 16

8

(Magee, 2007) p. 26

9

(Magee, 2007) p. 36-37

As all of these changes were made along the assembly line, it took higher skilled workers to adapt to an ever-changing workplace, and it depended on them for input and suggestions for improvement.10 Furthermore, this dependence created a culture in which Toyota’s workers felt a sense of selflessness and were part of the company in a team environment, a culture that led to fewer conflicts with management and amongst co-workers, and incentivized creativity and hardwork. So, as Ford’s system continued to foster a “staleness and mediocrity,” with no push for improvement on an already thought to be efficient system, Toyota produced a much more costefficient and productive system, a system whose advantage would be clear when Toyota started competing with Ford. As Ford and GM found, the culture at Toyota wasn’t built in a day, and attempts to move toward a complete Toyota-like system often failed when it was attempted by the two U.S. giants.11 The Vertical Chain Now that Toyota’s assembly line clearly had an advantage, another important reason why GM was at a competitive disadvantage also had to do with vertical integration. In Japan, companies like Toyota would ask for a part from a supplier, but instead of just purchasing an exact part itself, it would purchase its whole system, therefore entrusting the supplier with the ability to change its methods or engineering in order to make the product more efficiently. This resulted in longer-term contracts and a high level of trust between Toyota and its suppliers. Before recently, in America, and even more evident in Europe, a product would be ordered at an exact price through a contract and with a specific instruction on how the part is manufactured, giving less freedom to the supplier. America and Europe were as a result unable to create a similar trusting relationship with their suppliers. In 1995, 75 % of Toyota’s assembly was outsourced, a far cry from what was previously happening at GM.12 Of course, Toyota still shows signs of bringing certain processes and technologies inhouse. For example, as the electronics within a vehicle became more of a differentiating factor among cars, like anti-lock brakes, GPS navigation systems, or LCD screens, Toyota brought those electronic technologies in-house and declined to outsource. One, because these technologies were becoming more and more involved in the manufacturing of the car (not a part you can just add in), and there was high asset-specificity.13 When there is high asset-specificity with a supplier, the company becomes dependent on that one supplier, without the option to go elsewhere if they were to lose that supplier, giving the supplier the ability to charge higher prices due to the manufacturer’s high dependence on it. Therefore, the process is often vertically integrated to eliminate the risk posed by dependency. This is another example of putting all of your eggs in one basket. With a dependence on one firm to supply an input and with no threat of alternative suppliers to produce the input, it leaves the manufacturer open to great risk if the supplier were to fail, and gives the supplier significant power.

10

(Maxton & Wormald, 1995) p. 71-72

11

(Magee, 2007) p. 36

12

(Maxton & Wormald, 1995) p. 97

13

(Ahmadjian & Lincoln, 2001)

Thus, when determining a level of vertical integration, whether it be more apparent in the case of GM, or whether it depend on more outsourcing like in the case of Toyota, much of it would come down to culture and risk. For example, in America, it made more sense that, instead of taking the risk on relying on another party for a part, to just go ahead and produce it yourself. However, in Japan, there was more trust in relationship specific investments—there were no contracts needed and suppliers would actually send their engineers to work at the manufacturer’s buildings--and for that reason companies like Toyota had an easier time relying on outsourcing for specialized products based on the trust they developed through specialized relationships. The degree of opportunism and lack of trust in America was far greater than in Japan.14 Toyota Enters America Now that it is clear that Toyota not only had an advantage in its organizational strategy, but also in its outsourcing strategy, the next step was to enter a market where it could capitalize on that advantage. The North American market had been dominated strictly by American companies like GM, Ford, and Chrysler until the 1960’s, European companies entered. Companies like Fiat, BMW, Volkswagen, Volvo, and Mercedes-Benz entered the United States market and began to achieve success. However, this success was not completely due to the strategies of the European countries, but more due to being in the right place at the right time. From 1960-1969, the United States market for automobiles grew 44 % creating the boom that enhanced the success of the European companies.15 Therefore, this European growth could not be simply based on strategic success, but must be considered in comparison to the market. The Japanese auto makers entered at a much different time. The Japanese companies took a more long-term approach to their entry into the US market, entering in the 1970’s and early 1980’s. Prior to their entry, the US auto market only grew 7 % from 1970-1980, a very slow rate in comparison to the booming 1960’s. Japan’s expertise was producing smaller, and therefore more fuel efficient, cars. Their initial expectations were set low due to underperforming cars in their first attempt to enter the market: The original Japanese cars were small, noisy and had a tendency to rust. The first cars imported into the US and Europe were not seen as a threat to local producers. Local manufacturers were fooled into a false sense of security. Many stuck their heads in the sand as the Japanese vehicles improved.16 Thanks to these low expectations, the Japanese auto companies caught the US and the European firms off-guard. As the oil shortages of 1973 hit America, its citizens began to demand smaller, more fuel efficient cars (a situation very similar to the summer of 2008). However, because companies like GM, Ford, and Volkswagen weren’t threatened by the Japanese companies, they did not make any attempts to develop barriers to entry, either by entering the market for small cars themselves or through other means. Instead, the competitors ignored, and thus misinterpreted, the threat of companies like Toyota and Nissan. Another key element to the 14

(Miwa & Ramseyer, 2000)

15

(Maxton & Wormald, 1995) p. 84-85

16

(Maxton & Wormald, 1995) p. 75

Japanese strategy was that they did not enter the market with a lot of pomp and circumstance. Instead, they entered the market almost sneakily, thus lowering expectations even more and also lowering barriers to entry; by the time they grew to earn their 20 % market share by the mid 1980’s, it was too late for domestic companies to react and they had successfully infiltrated the North American automobile market.17 With the new competition added to the market, GM began to see its market share decrease. Its share of the US auto industry dipped from 50% in 1965 to 35 % by 1990. It, along with Ford and Chrysler, lost its shares of the market almost exclusively to the Japanese over that 25-year period. The Japanese held 28 % of the US market by 1991, almost erasing the market share that European companies had gained during the 1960’s.18 The strategy that they had planned to infiltrate the US market had worked. But, it’s important to recognize that for Toyota, it was not satisfied just with dominance in selling autos in America. It was going to produce them there as well. One of the reasons that GM faced more costs than Toyota in 2008, and thus needed to depend on the higher profit-margins generated by SUV sales, was the fact that Detroit’s labor structure (GM, Ford, Chrysler) was composed of the United Auto Workers (UAW). Toyota, when it started producing cars in the United States, was able to build factories in states where it could utilize non-union labor, and pay lower costs. When the union labor costs along with the payments for the pensions of retirees are considered, the extra cost of a car manufactured in Detroit is estimated to be $2,000.19 A $2,000 cost advantage for Toyota (and all other foreign manufacturers operating in the country) is one that is tough, if not impossible, to compete with. So how did Toyota get away with this? One of Toyota’s first manufacturing plants in the United States is located on 1300 acres in Georgetown, Kentucky. Georgetown attracted Toyota by offering $150 million in tax incentives if they chose to build in the town. And with the amount of economic growth the plant has brought to the area, including 7,000 jobs, it’s safe to say the investment was well worth it. Other foreign auto companies have also flooded the southern states with assembly plants as well, because they are all considered “right-to-work” states with non-unionized labor. The transformation of the South in America over the last 20 years has been significant: Through 2007, Toyota had invested more than $17 billion in 10 U.S. production facilities, which collectively employ more than 36,000 workers. Alabama, which didn't make a single car in 1995, last year produced 800,000, making it the fifthlargest auto-producing state. Tennessee just landed a $1 billion commitment from Volkswagen to set up a huge new plant in Chattanooga. South Carolina's upstate section has been remade from a faded textile territory into a thriving 21st-century industrial powerhouse since the advent of BMW in the 1990s.20

17

(Maxton & Wormald, 1995) p. 85

18

(Maxton & Wormald, 1995) p. 86

19

(Romney, 2008)

20

(Gross, 2008)

This kind of economic growth courtesy of foreign auto companies has turned them into domestic companies. No longer do citizens feel like they need to buy American and buy a Ford or a GM. They can buy American and buy a Toyota or a Honda, because chances are that an American assembled the car. This kind of assimilation into American culture is one of the biggest keys to Toyota’s own successes, and was an instrumental part of their strategy when they entered the market. Toyota originally imported cars, but routinely saw that Americans frowned upon cars manufactured outside the country. Not only could they appear to be American, as described before, but they were also able to avert the costs to transport vehicles, pay tariffs, and exchange rate risk by switching to local production in the US. The absence of union labor makes it easier for companies like Toyota to temporarily layoff workers when business is slow, and hire workers when things pick up, avoiding the administrative and legal barriers that Detroit companies face with the UAW. It allows for a strategy consistent with the business principles in Japan: flexibility in order to improve.21 Toyota knew the market structure was right for flexibility, but needed to find out if the American people could fit in to their culture in order to succeed with production in the US. Strategy and Learning in GM and Toyota Before ever deciding to build a plant in the United States, Toyota did its homework, and pursued a joint venture with the unlikeliest of partners: General Motors. In 1984, the two joined together on what was called New United Motor Manufacturing, Inc. (NUUMI) in which they would build cars in California. This provided advantages to each of the two firms. For GM, they would be able to let in Toyota management and learn the techniques, strategies, and overall system that was clearly competitively better than their own system. For Toyota, they would be able to hire Americans to work in this system, and therefore get an idea as to whether or not their philosophy of continuous improvement, flexibility, and employee input and development could be applied in the USA like it was in Japan. Seeing this, Ford and Chrysler immediately sued, but to no avail with the Federal Trade Commission (FTC). And, from the onset, it was already clear which company was going to take more advantage of the situation, as Toyota sent top-level management while GM sent mid-level managers to work at NUMMI.22 The products as a result of NUMMI were the Chevrolet Nova and the Toyota Corolla FX16. Both products were looked upon as a success. However, there was clearly a different way to handle success within the two different companies. GM looked upon this success as the finale, as if they had won a championship of some sort and they could relax and become complacent. Toyota’s managers pointed out that, while they received awards for their product, that there was still room for improvement, and that improvement should be pursued. The success of NUMMI led to the opening of the Georgetown, KY plant for Toyota. On the other hand, GM, while admitting it had learned valuable information from lean production, still faced the opposition to change by those in power. And because of that, only bits and pieces of true reform

21

(Gross, 2008)

22

(Magee, 2007) p. 134-136

was able to take place inside the company. As a result, GM never was able to adopt a true Toyota-like system to compete with its Japanese counterparts.23 Toyota’s Difference and Its Future Implications After arriving in the United States, finally able to compete at an advantage with the likes of GM and Ford, Toyota continued to grow by developing strong economies of scope. One of the key principles of companies demonstrating economies of scope is that they can reach customers of all different tastes. Just like Kellogg’s produces what it seems like every type of cereal imaginable, it is often the goal of auto companies to produce a variety of cars to suit the preferences of a wider array of customers. While GM tried to produce a variety of vehicles, it failed in instances where it created cars with similar attributes, and thus appealing to the same segment of the population. In other words, GM was developing new cars that competed with its other cars, thus doubling the output for a single segment. One example was in 1983, when GM produced the Chevrolet Celebrity, Pontiac 6000, Oldsmobile Cutlass Ciera, and the Buick Century; these four vehicles “were exactly the same size, the same color, and relatively undistinguishable from one another.”24 This serves an example of how complacent a company can get when it is at the top and doesn’t have that drive for continuous improvement, or the flexibility to pursue it. It’s almost an embarrassment of riches for GM to be able to develop models to compete against each other in the marketplace, but they should be embarrassed because of the poor strategy. While GM overlapped itself when it came to economies of scope, Toyota did just the opposite. For example, it knew that that it wanted to enter the luxury car market, but knew that the Toyota brand was not going to be able to create such vehicle without hurting its reputation, or killing its ability to sell a luxury vehicle based on its reputation for a standard car. So, instead Toyota created Lexus as its luxury car manufacturer. Lexus entered the market in 1989 and was competing with GM’s Cadillac, Ford’s Lincoln, and European luxury brands like Mercedes-Benz and BMW. And after only four years in the market, Lexus was already selling double the amount of cars as Mercedes. This was because, while it didn’t have the name and brand recognition of a Cadillac or a Mercedes, it was able to gain recognition based on its high quality at a lower price. Luxury car drivers immediately started migrating to the brand and it quickly began garnering demand. Further demonstrating its ability to increase economies of scope within car types, Toyota was able to offer different colors and other aspects of cars to personalize vehicles for customer demand. Once again, another advantage that comes due to the company’s flexible manufacturing system. 25 As one looks at today’s auto industry, the roots of this bankruptcy really are not from recent issues, but were planted decades ago when Toyota entered the market and started competing with the American companies. First, the flexibility of Toyota’s system was key to its success in America; the ability to adapt to demand and to sell consumers what they want is always a key ingredient to success; this led to fewer inventories and thus was a more efficient 23

(Magee, 2007) p. 137-138

24

(Magee, 2007) p. 118-120

25

(Maxton & Wormald, 1995) p. 75-76, 86-87

system, in addition to its consumer friendliness. Second, the labor cost savings when UAW workers are compared to those non-union workers in right-to-work states is significant and cannot be ignored. But most of all, this comes down to culture. Within the United States, GM and Ford used to be the kings of the industry, and they acted that way. While being propped up by favorable government policies, they did not take the threats of the Japanese auto manufacturers seriously. While, Toyota’s continuous drive for improvement, even when at the top, allowed for success in a downturn, something that GM could not do. All of the bad decisions made are all based on a mindset, and that mindset was a competitive disadvantage for General Motors. Today the auto market is much more globalized and interconnected than it was back when the Japanese were becoming formidable in the US in the 1980’s. With the tremendous economic growth in Brazil, Russia, India, and China, there is a demand out there that will continue to grow in the future. But in order to produce the most dynamic market, the free market must weed out those organizations that have made the incorrect strategic decisions, or have not put in the effort necessary to compete effectively. Yes, a failure of GM would greatly impact suppliers, many who also provide parts to Toyota, BMW, and Ford; but this would not destroy the industry the way a bank failure would do to its industry. The demand for car types may change from time to time, but the demand for cars will never cease. The risk involved in a GM failure is purely political risk, because even if American companies must go through a little pain, it will come out leaner and stronger than before. If America’s political leaders looked at issues in the long-term, they would know to reward the strategies that promote innovation and proficiency, and let those who don’t fail. In the long run, stronger markets with stronger companies and fairer competition should be the goal of all.

Works Cited Ahmadjian, C., & Lincoln, J. (2001). Keiretsu, Governance, and Learning: Case Studies in Change from the Japanese Automotive. Organization Science , 683-701.

Gross, D. (2008, December 13). Southern Comfort. Newsweek .

Magee, D. (2007). How Toyota Became #1: Leadership Lessons from the World's Greatest Car Company. New York: Portfolio.

Maxton, G., & Wormald, J. (1995). Driving Over a Cliff?: Business Lessons from the World's Car Industry. Wokingham, England: Addison-Wesley.

Miwa, Y., & Ramseyer, J. M. (2000). Rethinking Relationship-Specific Investments: Subcontracting in the Japanese Automobile. Michigan Law Review , 2636-2667.

Romney, M. (2008, November 18). Let Detroit Go Bankrupt. The New York Times .

The White House Press Office. (2009, June 1). Obama Administration Auto Restructuring Initiative. Retrieved June 24, 2009, from The White House: http://www.whitehouse.gov/the_press_office/Fact-Sheet-on-Obama-Administration-AutoRestructuring-Initiative-for-General-Motors/

Vlasic, B., & Bunkley, N. (2008, October 25). General Motors, Driven to the Brink. The New York Times .