University of Bradford, School of Management
FT MBA 2005/2006 Assignment in Business Economics

Cost drivers and economies of scale
in the automobile industry

by: Matthias Arnold

Introduction

This assignment aims at comparing and contrasting the driver of costs in the automotive industry, both in the short and the long run. Secondly it critically evaluates the benefits from economies of scale in the global automobile industry. The global automobile manufacturing sector accounts to a sales value of $ 1,172 billion in 2004 with a cumulated annual growth rate of 2.7% over the last 4 years. Whereas currently sales in the US are ranked first with stagnating 37%, followed by Europe with also static 30%, rising sales figures in China and India clearly show the growth regions of the next decade (Datamonitor 2005). This slack in well-established markets combined with hard competition from Asia as well as rising costs of production concludes in serious problems for the western giants (Economist 2005). In the first part of this paper, the cost drivers are analysed and implications for the automobile industry are drawn.

Normally a mature stage of a sector’s life leads to hard and fast competition and an industry consolidation with only the biggest one’s surviving. Interestingly, while clearly being in an mature stage of the industry lifecycle, the biggest companies, excluding Toyota, are the most unprofitable in the automobile sector (SEIDEL et al 2005). The second part of this assignment therefore evaluates the validity of the theory of economies of scale in the automobile sector.

Cost drivers

In theory, costs are partly fixed and partly variable in the short run (Appendix 1). Short run can therefore be defined as “the period of time for which at least one factor of production is fixed.” (Griffiths and Wall 1996, p.155) Variable costs depend on output and theoretically include labour and raw material. Fixed costs in economic theory consist of capital, which is needed for production in terms of investments in machinery, brand building, premises and other fixed assets (Begg and Ward 2004). In the short run, only variable costs can be influenced and fixed costs, in the short run sunk costs, are therefore not relevant for an economic decision. (Katz and Rosen 1998). In the automobile industry, besides labour, mainly raw material and distribution costs can be categorized as variable in the short run. Labour costs, while being theoretically variable, develop more and more fixed characteristics as labour laws and union agreements prohibit or raise the price of layoffs in Europe. But also in America, without such strict laws, pension and healthcare as part of labour costs can be regarded as fixed cost drivers (BusinessWeek 2005). On the other hand, distribution costs e.g. in terms of 0% financing and price reductions, are variable cost drivers in the short run. Mainly in America, GM and Ford try to stabilise sales figures with these short run stimulators, though resulting in soaring distribution costs (Globalinsight 2005a). Also raw material costs factoring as a cost driver in the short run. Due to rising oil prices as a result of psychological and physical scarcity, costs of all major raw materials for the automobile industry such as steel, aluminium, rubber and plastics followed that development. For example, pure raw material costs for cars more than doubled from $700 in 2001 to nearly $1500 in 2004 resulting in a total production cost increase of $1.7 billion for GM (Globalinsight 2005b).

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