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Ford has an ambitious revenue-management strategy, but can it save the company?
Russ Banham, CFO Magazine
October 1, 2003
Ninety years after Henry Ford decreed that all Model T's would be painted black, most automobile buyers still wait months for a custom order. Today, Ford Motor Co. is working hard to shorten that wait. The goal is not just to make customers happier and thereby acquire more of them, but to manage revenue to ensure the company makes as much money as possible on each car it sells.
The stakes are high. Ford's revenue-management strategy is a vital part of the troubled company's turnaround plans. "It has played a major role in our profit improvement in North America, especially compared with our domestic competitors," says Lloyd Hansen, vice president of revenue management. "Our success comes from an intense focus on providing value to our customers."
While Ford is not the only automaker targeting consumer car preferences, it is the only one with a vice president heading a unit on revenue management. Ford is also notable for its combination of three technology tools to sell the right car with the right mix of features to the right customer at the right price. It uses one tool to determine the car with the optimum package of features most likely to appeal to consumers in a specific market. Another tool, pricing software technology from Manugistics (J.D. Power, I2, and Trilogy offer similar products), determines which sales-promotion campaign should be offered on each car in each market. A third tool puts Ford dealers in the driver's seat to order the inventory most likely to wheel off their lots.
With this knowledge in hand, Ford can gear its production, sales, and marketing to get the biggest bang for the buck. "There is a clear link between what customers want and what we build," says Hansen. "The problem has been finding it."
Ford believes revenue management is that missing link. "Revenue management has the most leverage in industries with low profit margins. That's what makes it so critical in the auto industry, where pretax profit margins have historically averaged only about 3 percent," says Hansen. "If better pricing tools and processes can improve revenue by just 1 percent, and raise historical margins to 4 percent, bottom-line profits would grow by 33 percent. Because the improvement is essentially all cash, the increase in cash flow and market value is even higher. Very small improvements in revenue can have a huge impact on bottom-line results."
After phasing in its revenue-management strategy, the Dearborn, Michigan-based auto giant's per-unit revenue (average price net of any incentives) was up $699 (year-over-year) in the first half of 2003, while virtually every other carmaker's per-unit revenue was down. And even with the improvement in revenue, Ford has held its own on market share compared with its domestic competitors. Ford's retail market share through July was 18.7 percent—down three-tenths of a point. This compares with a decline of six-tenths of a point at General Motors Corp. and one point at Chrysler, according to R.L. Polk & Co., a Southfield, Michigan-based provider of automotive intelligence.
Perhaps most tellingly, in July the Ford division's retail incentive spending per unit was $900 less than at rival Chevrolet, estimates London, Ontario-based Autodata Solutions. "Ford's revenue management is making a difference," says Gary Lapidus, managing director of global investment research at Goldman Sachs in New York. "They're more selective about where they apply their money and where they don't," the veteran auto analyst adds. But Lapidus is quick to point out that Ford's profitability in North America "has collapsed over the last three years. The best I can say is that revenue management has helped them do as good a job as they can in the context of the current competitive environment."
"Ford's revenue-management strategy helps at the margins," says Sean Egan, managing director of Egan-Jones Ratings Co., a Philadelphia-based ratings firm that is not paid by issuers for a rating, "but the company needs to address some fundamental problems. We would derive much greater comfort if, rather than attempting to manage the last couple hundred dollars on each sale with a revenue-management strategy, Ford produced fresher products at a reasonable price."
"Ford is only 18 months into its revitalization plan," counters Hansen. "To date, we have seen substantial progress in all key elements—quality, revenue, and cost performance. Our bottom-line results, however, are still not where they need to be, and more improvement is planned. The most important part of our recovery plan is the launch of an unprecedented 65 new Ford, Lincoln, and Mercury products in the next five years.
"In the U.S.," he adds, "this product-led transformation begins with the new F-150 pickup, followed by two new minivans this fall and six cars next year. These products have been designed and packaged around customer wants and needs. They give us huge confidence in the future."
Growing Profitable Markets
The challenges facing Ford became all the more apparent on July 21, when GM stunned the industry by offering current owners of its vehicles a "loyalty" discount of up to $1,000 if they buy or lease a new GM car or truck. The discount was in addition to GM's zero percent financing offer and other cash incentives adding up to $4,000 on many vehicles. Ford elected not to match GM's loyalty discount. Says Lapidus, "Even the best revenue-management strategy can go awry when the competition takes an ax to its pricing."
And Ford's approach to revenue management needs to be very sophisticated, given the finicky nature of car consumers who want the sunroof without the navigation system, but must have the seats with lumbar support.
Ford can both satisfy its customers and optimize profits, says Hansen, because its supply-and-demand sides—production and sales—have conceptually accepted the benefits of revenue management and have put it into practice. "The company, and especially the sales organization, has a strong focus not just on market share per se, but on profitable market share," he explains. "It's all a question of organizing and training your sales organization to go after the business where you make the most profit."
For example, one of Ford's lowest-margin businesses is the rental-car market, where it sells primarily Ford Escorts. "We've now made the decision to consciously reduce our market share in the rental-car area because the business doesn't make that much money for us, and it has an adverse effect on retail customers of the Escort, which has a high depreciation rate because of the rental-car connection," explains Hansen. "Conversely, the police-car business is pretty profitable for us and has grown substantially. So we've increased capacity on those products."
Modeling a Car Purchase
Ford's revenue-management technology has been crucial at every step. A market-response model from Manugistics analyzes transaction prices per vehicle during the past five years in different regional markets. The transaction prices take into account the range of incentive programs offered in each instance. "Say we're offering a 2.9 percent, 60-month financing program and we want to see what would happen to sales if we lowered the financing rate," says Hansen. "The model will project the effect on sales from that incentive program. It allows us to determine the best incentive program to offer in each market." For example, according to the model, customers who buy Ford Explorers are motivated by low-rate financing programs, not cash rebates. Customers of the Ford Focus and the Crown Victoria are tempted more by cash back. Evidently the model picked up on the credit-availability problems of younger drivers and the dislike of interest payments among the elderly. "My 82-year-old dad drives a Crown Vic and is from that generation of people who hate to be in debt," says Hansen.
The next tool Ford is wielding is the Package Optimizer—a Web-based market-research tool marketed by Morepace International Inc. that packages the best mix of options to appeal to customers in a particular market. "We've seen a lot of revenue improvement by selling features like DVD entertainment systems, heated and cooled seats, and navigation systems," says Hansen. "Those are 'high-want' items in certain markets, but you need to know which markets."
"We do an Internet survey of people in a simulated free-demand situation in which they are asked to build their ideal vehicles within the constraint of prices they can afford," says Paul Malboeuf, senior vice president of Morepace, a Farmington Hills, Michigan-based market research firm. "We survey anywhere from 500 to a couple thousand people per region, then analyze the data to recommend the most profitable combinations." This is no easy task, given an average of 40 different features per car and the trillions of possible combinations.
The last piece of the revenue-management strategy is currently being rolled out to dealers as Ford's new Smart Order system, a Web-based tool that dealers can use to select the optimum inventory. "Forty percent of inventory turns over in 30 days, while 45 percent sits there for more than 90 days," says Hansen. "By helping dealers figure out what to order based on profit margins, customer preferences, and the most appealing price, dealers can close sales much faster."
Several Ford dealerships recently engaged in a pilot study of Smart Order. "I was one of the guinea pigs," says Michael Kennedy, president of John Kennedy Ford, a Philadelphia-based dealership founded by his father 50 years ago. "Every month we buy a certain number of cars from Ford, all different lines with different features. Smart Order guided me to slice and dice my orders according to a wide range of features to get the optimum level of inventory. Before, this was seat-of-the-pants guesswork." Kennedy says the system allowed him to decrease floor-planning costs—a ratio of inventory to dealership space over time—by 25 to 30 percent.
With some exceptions, analysts are generally supportive of Ford's revenue-management strategy. Low-rate financing, cash rebates, leases, and other dealer incentives added to advertising represents a whopping $15 billion marketing spend at Ford. Directing those dollars to best effect only makes sense. "Ford is using smart bombs when the competition is just carpet bombing," says Ron Tadross, senior auto analyst at Bank of America Securities.
"Ford is digging deeply to determine where it should spend its marketing and incentive money. If it spends $200 less per vehicle, that's an extra 30 cents in earnings. Ford and other big automakers are plagued by retirement benefits promised to union workers. It's just a lot harder for them to cut costs. Ford realizes that market share is not as critical as profit per vehicle," adds Tadross. "The problem is that the competition doesn't always agree."
But Ford division president Steve Lyons says the revenue-management system is designed to deal with competitors' pricing actions, no matter how severe. "In the case of the loyalty discount," he explains, "[the pricing model] gave us the impetus to sit tight, let them get a short-term boost, and resist giving away the sun, the moon, and the stars. Next month they'll struggle and we'll have the right product at the right price."
And it won't have to be black.
Russ Banham is a contributing editor of CFO and author of The Ford Century, a 100-year history of Ford Motor Co.
How Much for That Seat?
Ford is the first automaker to embrace revenue management (and the only one with a vice president heading such a unit), but not the first company. "The first industry to develop this was the airline business after deregulation," says Robert Phillips, a visiting professor at Columbia University's business school and a lecturer at Stanford Business School. "As new carriers like PeopleExpress came in and stole tremendous market share with very low prices, the older airlines developed tactical, segmented pricing strategies based on revenue-management principles."
For example, they offered competitively low prices to cost-conscious leisure travelers who booked early, yet saved enough seats for business travelers willing to pay a lot more for their last-minute reservations. "While PeopleExpress filled up with cheap seats, the older airlines left room for more-lucrative passengers, thereby maximizing the revenue per seat," says Phillips. "It's the same case at Ford, which wants to maximize the revenue per vehicle. If you price the airplane seat or Ford Focus too low, you don't get enough profit. If you price them too high, you end up with an empty seat or an unsold car sitting on the lot."
Continental Airlines was an early revenue-management devotee, using market research and pricing engines to develop the optimum customer-pricing promotions in the early 1990s. In 1995, then-CFO and now president Larry Kellner dictated that Continental's cargo department, which represented 3 percent of total revenues, create a similar revenue-management system.
"Larry wanted us to maximize the revenue we were making, since different cargo sizes and weights present different revenue opportunities that we were potentially not realizing," explains Ed O'Meara, director of cargo-revenue management at the Houston-based combination air carrier. The department installed a new booking-evaluation engine developed by Decision Focus Inc. (part of Manugistics today) that forecasts cargo demand over a booking horizon and relates it to individual aircraft cargo capacity, which it determines by analyzing the number of expected passengers and the size and weight of their luggage. "When you're a combination carrier without dedicated cargo freighters, you need a real good idea about passenger forecasts to figure out how much baggage weight and volume you expect to carry on each flight," notes O'Meara.
Once cargo capacity was determined, the technology guided booking agents to sell space to shippers with the optimum revenue-producing cargo—dense shipments weighing more than 10 pounds per cubic foot. "Dense cargo gives you a good amount of revenue by weight and leaves room in the belly for more cargo," explains O'Meara. Prior to introducing the revenue-management system in 1999, cargo bookings were taken on a first-come, first-served basis.
"Customers with low-density freight could book large amounts of capacity real early in the booking window," O'Meara adds. "At the last minute, when customers with freight of higher density and greater revenue value came knocking, we'd have no space left."
The new system analyzes historical booking trends for each cargo market to ascertain how demand will be spread over the booking window. "The system tells our booking agents when to accept a booking or reject it," says O'Meara. "Overall, by managing our revenues we've been able to achieve a 2.5 percent improvement each year in gross cargo revenues minus expenses. That's $14 million in net cargo revenue improvements since the summer of 1999." —R.B.
Tough Times at Ford
Ford Motor Co. faces a long road to recovery. Sean Egan, managing director of Egan-Jones Ratings Co., a Philadelphia-based credit-rating agency that is not paid by issuers for a rating, starts with the most nagging problem—$25 billion in unfunded pension and health-care liabilities. "It's a demon," says Egan, "and it won't go away.
"Then there's the 100 basis-point increase in funding costs over the last 12 months. Ford may say some spreads have come in, but interest rates have increased by 100 basis points over the past year," explains Egan. "If you consider that a typical vehicle costs $30,000, 1 percent of that is $300 the first year. Given the median life of a six-year car loan, even with a declining amount the cost works out to about $1,000 per vehicle. With Ford producing 4 million vehicles a year times $1,000 per vehicle, that's $4 billion in additional costs per year due to increased interest expenses. That is a huge hurdle."
On top of that, there's Ford's "very skimpy equity: $8 billion of shareholder equity versus $311 billion of assets," Egan adds. "That is really a sliver." To make matters worse, there's the century-old automaker's "stale" product line, he says. "They're introducing the new F-150 trucks, but most of their other products are fairly old, especially when compared to GM's new lineup and, in particular, its revitalized Cadillac division; Nissan; Toyota; and, to a lesser extent, Honda. But they're likely to come roaring back in a year or so."
Of course, the auto industry has its own migraines, to which Ford is not immune. "The industry is beleaguered by inventory overhang," says Egan with a sigh. "The time it takes to turn inventory over—basically sell a vehicle—industrywide has increased from 60 days in July 2002 to 78 days in July 2003. And from what I hear, Ford has greater inventory overhang problems than the other manufacturers." —R.B.