Cost drivers and economies of scale in the automobile industry

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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

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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).

In the long run, economic theory suggests that all costs are variable, therefore all different types of costs become relevant for an economic decision (Begg and Ward

2004). Therefore, in the long run 1 , cost drivers mainly consist of investments in production facilities, in product development and in marketing. Moreover, long term financing costs of a company such as dividends and debentures could be regarded as cost drivers in the long run. In the automobile industry, investment costs include automated production lines, but also high costs of product development and extensive marketing. Especially overcapacities in production lines are long run cost drivers. Downsizing is not always possible as production equipment is highly specialised and not interchangeable between different suppliers. Also rising marketing costs due to increasing competition drives costs up. Moreover product development gains importance as the product lifecycle shortens and competitive advantage can mostly be derived from innovative qualitative products (SEIDEL et al 2005). Also location disadvantages could derive in long term costs as labour is significantly cheaper in Asia than it is in Europe and America.

Furthermore, suggested by Varian (1993), a type of fixed costs called quasi –fixed can appear. These costs occur as soon as any amount of a product is put to market. In the automobile industry, the costs for establishing brand names could be regarded as quasi-fixed costs. These costs do not depend on the output but on the quantity of distinctive brand names of a company. Despite having advantages in targeting different market segments, GM, Ford, DaimlerChrysler and VW with each marketing a huge

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number of different names, have a substantial cost disadvantage compared to Toyota and BMW with each promoting only three car brands (Economist 2005).

Comparing the cost drivers in the long and the short run, it could be argued that short run cost drivers as raw material increases affect virtually all car manufacturers more or less equally, whereas long term cost drivers separate the wheat from the chaff in the automobile sector. In the short run, despite trying to hedge risks as raw material costs by long term contracts, none of the players can anticipate or obviate them. On the other hand, not all manufacturers are trying to compete on price at the expense of high distribution costs but rather gain competitive advantages by establishing qualitative products or well-known brands. In the long run, some cost drivers are highly relevant to GM, Ford and VW while being of no major influence to Toyota or Hyundai. All automobile companies are more or less successfully trying to establish a competitive advantage by reducing their long run costs. While all producers establish a platform strategy to limit development and production costs, major players including GM, VW and DaimlerChrysler are nevertheless struggling because of their existent overcapacities in terms of facilities and labour as well as a disadvantage of production facilities in countries with high labour costs (Economist 2005). On the other hand, Toyota succeeds in producing their cars in lot of locations within different relatively cheap countries (Toyota 2005).

Economies of scale

The total average costs curve in the long run is u-shaped with first decreasing later on increasing costs (Appendix 2). In theory, reasons for this phenomenon lie in economies of scale in the first part with decreasing and diseconomies of scale with increasing average costs (Begg and Ward 2004). Economies of scale in production generally exist because of cost-advantageous production techniques and geometric relations being more favourable to large scale production. In distribution, management and administration, higher output leads to economies of scale as a result of indivisibilities of a lot of costs factors in these areas (Chandler 1990). Moreover specialisation and the resulting learning curve, linked production processes, financial economies, and a bigger buying power head towards economies of large scale businesses. In contrast,

1 As variable costs in the short run, despite being still relevant in the long run, have been taken into account before, they

shall not be discussed again in this chapter.