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In this tale of tiers, pricing pressure affects some more than others.
Russ Banham, CFO Magazine
May 1, 2001
American BOA Inc. is feeling squeezed. As a second-tier supplier in the auto industry, the Cumming, Georgia-based maker of exhaust interface products must satisfy first-tier suppliers--its customers-- that are demanding price reductions, while buying its raw materials from third-tier suppliers that refuse to cut prices. "We're stuck in the middle, with no place to go," says Bruce Hirabayashi, vice president and CFO of the privately held company, which has nearly $100million in annual revenues.
Although major automobile manufacturers like Ford Motor Co., DaimlerChrysler, and General Motors Corp. like to call the industry's reconfigured supply chain a "value chain," that value is elusive for many suppliers like American BOA. When automakers impose a 5 percent price cut on their suppliers, as Chrysler did in January, a first-tier supplier such as ArvinMeritor Inc. must find ways to make and sell its components for less. If you're ArvinMeritor, a $7 billion company with power over a galaxy of second-tier suppliers like American BOA, you simply pass the cost-cutting mandate on to them.
Unfortunately, American BOA can't do the same. "Our suppliers are the big steel companies," notes Hirabayashi. "If ArvinMeritor comes to us and says, 'You will reduce costs by 5 percent or you won't ever do business with us again,' and we go to one of these giant companies and say the same, we'd hear them chortling at the other end of the phone. If we tried to make them kneel and whimper, they'd say, 'What's your name again?'"
American BOA is not the only supplier for which the value chain is becoming a noose. Compelled to cut costs, invest in expensive Web-based technology, and produce more modular components that require expensive process changes and new machinery costs, suppliers are being squeezed to death--literally. In an industry that once numbered some 50,000 suppliers, today there are fewer than 30,000; that figure, says Dick Gabrys, Detroit-based vice chairman of Deloitte & Touche, will "shrink dramatically" in the next 10 years.
Many industries are evolving along the lines of the fast-track computer sector, where such companies as Dell Computer Co. set new standards for delivering customized products. Shorter product cycles driven by mercurial consumer tastes are becoming the norm. Ford, for example, is in the midst of a reengineering effort that will enable it to manufacture cars on a "reasonable" build-to-order basis. That will amount to a fundamentally different buying experience for consumers: enter a dealership today and spec out the car of your dreams, and you're usually told it will take months to deliver. "You end up skipping the black interior or the red stripe," explains James Gouin, CFO at Ford Consumer Connect, the Dearborn, Michigan-based division of Ford that is in charge of its customer build-to-order strategy. "Our vision," he explains, "is to provide the consumer [with] the product they want, when they want it, and deliver on that promise. A car is a lot more problematical in terms of actual components and suppliers than a computer. To achieve the Dell model, we have to completely reimagine a century-old supply chain."
The Role of Technology
Ford launched the first phase of its build-to-order strategy as a pilot program in Canada this year. Called "locate-to-order," the system determines whether a customer's dream car is already at another dealer or in the manufacturing pipeline. If so, the car is shipped to the customer's local dealership, typically within 15 to 20 days. If not, it's the usual months-long wait.
Dramatic improvements to the supply chain promise to reduce not only that wait but also the price, by more than $1,000 per vehicle, according to analysts at Goldman, Sachs Investment Research in New York. Savings will accrue from lower inventory, scrap, rework, and administrative costs; increased labor and asset utilization; and the alignment of all material spending with low-cost suppliers. Whether the savings will be passed on to consumers or simply pad automakers' margins is uncertain.
That has provided much of the impetus for trading exchanges like Covisint, the massive E-marketplace funded by General Motors, Ford, and DaimlerChrysler. Partners hope to shift their current $240 billion in purchases of raw materials and vehicle parts to the Web, slashing billions of dollars off their bottom lines--thanks to transaction efficiencies and more-competitive pricing.
By embracing the Internet, the major automakers are forcing many suppliers, particularly those in the first tier, to forgo the millions of dollars they have already invested in EDI (electronic data interchange) systems--which they adopted at the automakers' insistence to begin with. Some major companies, such as Dana Corp., a Toledo, Ohio- based chassis supplier, don't seem to mind. "We were already embarking on the Internet anyway, so the junking of EDI is not an issue," says Doug Grimm, Dana's vice president of global strategic sourcing.
That despite the fact that by Dana's estimate, more than 95 percent of tier-one companies' communications with automakers is conducted via EDI. The silver lining lies in the other direction: downstream connections to second-tier suppliers are about 25 percent EDI, and that figure drops to 10 percent for tiers two and three. "The promise of the Web," says Grimm, "is for us to connect to our downstream supply base": those firms that can't afford EDI.
That won't just bring greater efficiency to the supply chain, it will also facilitate new business processes, ones that will help companies cope with pricing pressure. "Right now, I really don't have that connectivity," says Grimm, "and that affects my demand planning [forecasting] and production controls. So when Ford orders an axle from me, I may or may not be connected to the tier-two supplier that makes the gear for that axle. And it is even less connected to the steel supplier providing the raw material for that gear. With the Web, when Ford orders an axle from me in the future, everybody in the chain sees that demand immediately."
In theory, at least, all the companies in the chain can move in lockstep, combining their resources to build the product to the customer's specifications and time demands. "Right now, we all have inventory in safety stock," says Grimm. "The 'Net gives us the ability to pare these inventories, which should lead to significant reductions in ROI."
Not everyone is as sanguine, however. Hirabayashi, for instance, is concerned that the transparency offered by exchanges like Covisint could inadvertently allow intellectual-property abuses. "It gives me pause," he says. "We're an innovative company that lives or dies on our ingenuity. My fear is that with Covisint, the danger lurks that someone will take our innovations and publish them elsewhere. We're told that this fear is unfounded, but I can't help but wonder."
How far can it go? Can the auto industry, and sectors like telecom and aerospace, become as virtual as the high-tech sector, where some firms concentrate almost exclusively on marketing and branding while outsourcing manufacturing and other functions? Some believe carmakers can, that in fact they are already headed down this road, and that it will result in more competitively priced, higher-quality automobiles. But to date, the journey has been rough. "Automotive suppliers are being asked to cut costs, change the way they do business, invest in a new technology infrastructure, and, by the way, do all this and charge me less for your products," says supply-chain analyst Karen Peterson at Gartner, a Stamford, Connecticut-based research and advisory firm. To do all that and embrace a new business model is a lot to expect, she says.
Others agree. "There's a love-hate relationship between the OEMs [original equipment manufacturers; that is, carmakers] and suppliers," says Kevin Prouty, automotive research director at AMR Research in Boston. "Suppliers have to love the OEMs because they bring them business, but they hate the way they dictate terms." When the auto business is in high gear, Prouty explains, it fuels more supply orders, driving up suppliers' inventories to meet the demand. "Then, suddenly there's an economic downturn and volume drops off, and the tier-one suppliers have all these plants and inventories, and no volume to cover them," he says. (Car sales are expected to fall, from 17.4 million vehicles in 2000 to 16.5 million this year.)
"The OEMs are in the same situation in terms of inventory risk, but they can pass on the problem to suppliers by demanding they take the cost off their products," says Prouty. "This is standard business practice, and many suppliers are used to it in the 3 percent annual range. But when the price cut hits 5 percent, as it just did with Chrysler, suppliers fret about their existence. The margins are so thin they're cutting to the bone."
While the industry likes to call its suppliers "partners," that's just talk, says Stacie Kilgore, senior analyst at Cambridge, Massachusetts-based Forrester Research. "It's a lot of one-way mandates, as opposed to true collaboration," she explains. "This is not a chain of relationships, but one company mandating something to another company, which pushes it to another company, on down the line. I know of one automaker that actually fines its suppliers tens of thousands of dollars for every hour they're late delivering in a just- in-time environment. The suppliers are forced to stock inventory a mile high just so they can deliver on time. Is that partnership?" Kilgore declined to disclose the OEM.
Asked for his analysis of the OEM-supplier relationship, Hirabayashi says simply, " 'strained' is an oversimplification."
Avoiding Road Kill
In fact, the squeeze goes beyond tier-two suppliers; tier-one suppliers feel the pinch as well. "There's a greater sense of urgency now because of deteriorating volume and the DaimlerChrysler situation," says Dana's Grimm. "Everyone in this industry is realigning capacity and asset utilization." To some degree, this isn't new. As Grimm notes, "For at least 15 years, suppliers have delivered annual cost savings to the OEMs."
But some suppliers are now pushing back. "Chrysler decreed the 5 percent price cut, and we responded that we would negotiate on our various product lines, but that we would not accept it unilaterally for all our products," says John Brooklier, vice president of investor relations at Illinois Tool Works (ITW) Inc., a Glenview, Illinois-based designer and maker of fuel filters, door-handle accessories, and other automotive components. "We haven't given a price increase to Detroit in 15 years, but this, we felt, was too much," he says. "In some product lines, we'd be willing to bend, but not all."
There's another way suppliers are meeting OEM demands. Several tier- one and tier-two suppliers are aligning through mergers or partnerships to build multicomponent modules for automakers. The first to grasp this strategy was Lear Corp., a Southfield, Michigan-based tier-one supplier. Six years ago, Lear was in the business of making automotive seating for companies like Ford and GM, reaping roughly $3.1 billion a year from the enterprise. Today, it makes complete automotive interiors- -basically, the entire inside of an automobile, including dashboard, flooring, side panels, electrical systems, and even acoustics--bringing home some $14.1 billion in 2000 revenues. "We design and build the interior in collaboration with the OEM, which then bolts it into the car," says Jim Vandenberghe, Lear's vice chairman.
This may well be a sign of where things are headed. "Suppliers are typically more efficient than OEMs, especially when it comes to taking cost out of the product," says Vandenberghe. "We can also help them make better cars. For example, now that we make several interior elements, we've discovered how to make vehicles quieter. That gives us the opportunity to make a [cost] tradeoff with our customers by giving their customers [consumers] more value." That is, innovation preserves margins.
To do this, Lear has engineered 17 acquisitions since 1994, among them Minneapolis-based Automotive Industries, which makes door panels; Masland Industries, a Carlisle, Pennsylvania-based flooring and acoustics company; and Dearborn, Michigan-based United Technologies Automotive, which makes electrical and electronic systems.
Plymouth, Michigan-based Metaldyne Corp. followed a similar path, acquiring a range of supply houses to become to transmissions what Lear is to interiors. "We figured if we could combine the largest forging house with the second-largest machining house and the largest supplier of transmission valves in one company," says Tim Leuliette, Metaldyne's president and CEO, "we'd have a powerful value proposition for the OEMs."
ITW and ArvinMeritor also have restructured to manufacture multiple- component pieces. "We're looking more and more to provide fully integrated modules for which we do the design, engineering, and assembly work," says Thomas A. Madden, senior vice president and CFO of ArvinMeritor Inc., a Troy, Michigan-based tier-one supplier with $7 billion in 2000 revenues. "Our ongoing target is to improve operating margins by 50 basis points a year," he says. "This strategy gets us there. Basically, by doing more for OEMs, they'll want to do more with us."
One might wonder whether such consolidation makes supply-chain issues moot: Will there be a chain at all, or simply a handful of OEMs dealing with a handful of subassembly manufacturers? Madden believes things will move from a network of discrete companies trading with one another to, essentially, one big virtual organization. "Upstream and downstream, we will all be connected by the Internet and collaborative software, making each supplier a de facto department of the OEM," he says. "We would still be separate companies from a legal standpoint, but from an operating point of view, we'd be a single virtual corporation," one highly dependent on supply-chain technologies.
But the metaphor of a chain may become less apt. Says Madden, "I see suppliers as a flock of birds flying in unison following the leader, which is not the OEM--it's the consumer."
As OEMs outsource more of the subassembly to the supply base, it liberates them to focus more on brand equity management. "At some point, they'll just own the brand and the dealership channels," says AMR Research's Prouty. "Others will do the building and assembly."
Ford's Gouin doesn't believe the industry will change so fundamentally, but agrees that "the suppliers realize that to survive, they must capitalize on the Internet for collaborative design and engineering capabilities that facilitate more-sophisticated subassembly work."
While all these developments would seem to bode best for the OEMs, the transformation of the supply base into ever-larger and more- integral suppliers may backfire. "As tier-one suppliers grow through mergers and consolidations, they obtain more leverage," says Prouty. "Next time Chrysler demands a 5 percent price reduction, a large supplier might laugh, and say, 'We can't be yanked around anymore.'"
As the computer industry has shown, the OEM is not always the channel master in a supply chain. "Just look at Intel," says Peterson. "They're a supplier, but they also do the dictating because of a near-monopoly in chips. They tell the OEMs how they expect them to act and react, not vice versa. Compaq would never tell Intel to cut its costs 5 percent."
The scenario makes American BOA's Hirabayashi smile. "One would think the OEMs are intelligent people--that they know they can only squeeze so far," he says. "But if they're not, and consolidation runs rampant, they may shoot themselves in the foot. Instead of three different suppliers of a component, there may be only one. Then who'd have the power?"
Russ Banham is a contributing editor at CFO.
A Way to Beat the Squeeze
Given Illinois Tool Works Inc.'s $10 billion revenue base and diversified markets (it also supplies equipment to the food industry), the company can sometimes just say no to pricing demands. It's a different story at American BOA. To cope with pricing pressure, the company is in a constant cost-cutting mode. As CFO, the pressure is on Bruce Hirabayashi. "I've got my controllers constantly scrutinizing operating costs and the bottom line," he says. "They carefully examine contracts and cost-control strategies, from reducing cell phone usage to suggesting delays in replacing computers--which is not our preference, of course. But something's got to give."
He frequently asks his tier-one customers to share operating costs, as when, for example, his company must buy new tooling to effect product upgrades. Such product enhancements may also offset demanded price decreases. "Value equals functionality over cost in this business," explains Hirabayashi. "You have to think how you can provide value to your customer by increasing functionality, which then allows you to either keep prices flat (in the face of a demanded decrease) or increase them."
In other words, suppliers can beat the squeeze on components by improving them, thus preserving margins. They may also do this by helping their customers to innovate. A door-handle maker, for example, who helps a door manufacturer find a way to attach the handle less expensively may not have to cut the price of the handle.
AMR Research's Kevin Prouty says Web-based collaborative design, procurement, and supply-chain management systems are abetting this need. "Instead of cutting their prices 5 percent, suppliers are trying to figure out ways to help their customers pull 5 percent out of their costs," he explains. "They're doing this via the Internet, using self- service design portals and tools to collaborate more efficiently to design and engineer better and less-expensive products." -- R.B.