Tata Nano not suitable for China

Three ways to fight against rising costs

Gasgoo.com: We can see all the unfavorable factors concurring this year, namely rising cost from materials, and the step-up of environmental protection, stronger labor law, and aggressive price cut. What kind of influence will all theses bring to China's auto industry?  

Stephen W. Dyer: This year has indeed been a perfect storm of negative events in terms of cost pressure for the automotive industry in China. We have continuously increasing oil prices, which affect both consumers in terms of their price sensitivity, as well as, probably more importantly, the cost of plastic resins used in injection molding for many of the main components for automobiles; we also have increased steel and other raw material prices. These have increased over several years at a rate of over 25% to 30% a year, unprecedented increases in the price of steel and oil, even going back to the 1970's when there was a so-called oil crisis. This time the oil crisis is even more serious than that time. At the same time, we have increasing labor costs within China, and this is due to a combination of factors.  Certainly the changing labor laws will continue to increase costs, especially related to temporary workers that are often used at suppliers and sometimes at OEMs themselves, because these workers will be promised certain benefits that they were not eligible for in the past. But another reason for labor cost increase has been simply demand versus supply for labor, as the demand for Chinese manufactured goods has increased, the demand for labor, and especially skilled labor that is required in the automotive industry, has continued to increase. The price of a commodity will go up any time demand increases over supply. In this case the commodity is labor. On top of that, we have increasing cost of living.

Consumer Price Index is increasing, which means that the labor force also is expected to be compensated for changes for inflation essentially. On top of all of these raw material and labor cost increases, we have the appreciation of the Chinese currency relative to the U. S. dollar. This affects the automotive industry in two ways. In the first way, it affects the significant portion of imports that are used still to this day in assembling vehicles in China, these are imports typically  of relatively high technology, components and modules, that are either not available in China or not available at the same level of technology that western suppliers can provide. It also affects the competitiveness of Chinese exports. The primary exports for the automotive industry currently are components, as opposed to complete vehicles, secondarily, commercial vehicles, which are exported typically to developing nations, such as Russia, India, Pakistan, the Middle East, Southeast Asia to some extent, etc. Thirdly, it may impact the export of passenger vehicles, but as a third effect. 

So this storm of competitive pressure indeed is unprecedented in the Chinese automotive industry. The automotive industry, especially the passenger vehicle industry, has been growing at a rate of about 30% over the past years year on year. This is historically a first anywhere in the world -- there is no other place like China in terms of the auto industry growth. Therefore many companies have been focused on how to establish their brands, how to position themselves to win in the endgame after restructuring occurs. But now these automakers are forced to focus on competitiveness in terms of their cost structure.

We expect that the influence on automakers will indeed be strong, as they compete to reduce their cost bases, and there are many tactics or strategies that they can implement to address these cost competitive problems.
   
Gasgoo.com: How much would the automakers' extra spending on the rising cost be? 
 
Stephen W. Dyer: The actual amount that the cost will increase due to all these factors is still unclear, because along with all these negative factors, we have the positive factors in terms of productivity, which means that for every hour of labor that goes into the vehicle, essentially the per hour, or the per vehicle, cost of labor may even go down, even as the unit cost of labor goes up, and that still increases productivity, and productivity comes from improvement programs that deal with lean manufacturing and deal with operational asset effectiveness, using the existing assets more effectively to produce vehicles and produce components. This would tend to offset some of the labor cost increase and material price increase. So if we want to talk about an estimate of how much or what percent of the automotive cost would go up, it's still hard to say, because there are those offsetting factors.
 
Gasgoo.com: In the long run, will the car price go up because of the rising cost?  

Stephen W. Dyer: When we think about price and cost, we can actually separate those things to some extent: price typically is driven by the market; cost is driven by the supply market. At this point, those two things are still fairly dislocated; they don't necessarily have a one-to-one relationship, so we can talk about them separately for now. For cost, we can think about the cost in China, in the long term, approaching the cost in some of the more developed countries, which means we would expect the cost to reach a steady state that is similar to even the developed world. Now the components of the cost also will shift slightly, as these factors evolve: raw material costs, labor costs, currency issues, and productivity in use of the labor.

The price has continued to go down in the Chinese auto market over time significantly, and that would likely continue for the next several years. These two factors will eventually hasten, potentially, the restructuring of the industry, and /or prevent the continuing number of new entrants into the industry that we've seen over the past five to ten years.

Gasgoo.com: How do you see the restructuring of the China auto industry as you mentioned?

Stephen W. Dyer: The Chinese auto industry is extremely fragmented; there are over a hundred of manufactures of automobiles, if we include both passenger cars and commercial vehicles. It's not a situation that will last forever, certainly. A.T. Kearney has conducted many studies of the evolution of the industries over time, and there is a curve that most industries tend to follow in terms of consolidation, and we talk about the top three players and what percent the market share they control. Currently in China the top three players control a very small percentage of the market share, compared to the more mature markets. We expect that in the long term, there will indeed be restructuring in the industry. 

So, as I mentioned, these competitive pressures will serve to hasten the restructuring of the automotive industry in China. However, in the short term, there are still enough regional and local incentives to maintain their independent automakers that will prevent the restructuring in the major way in the short term. It's possible that the overcapacity that we've seen of roughly 30% over the years in China will not continue due to these competitive pressures. We expect to see that leveling off in the future, and that will also force a lot of automakers to look at overseas opportunities, either in the short term to export to unitize their current China capacity, but also to look for additional markets in which to grow, given the competitiveness in the Chinese market.

Restructuring in the Chinese auto market will still take some time. Certainly it will be accelerated a little bit by the ongoing cost pressures that are increasing, but still there are significant regional and local government constrains to allowing a free restructuring of the industry that we may see in the totally open market.

Gasgoo.com: What are the solutions to the cost increase problems, especially to the auto parts manufactures that are facing double pressure from the market, also from the OEMs?

Stephen W. Dyer: The cost competitiveness problem that exists currently in China is a very challenging problem, and there is no magic solution to this problem. Chinese companies need to first focus on the fundamentals in terms of managing their internal processes, especially in the manufacturing and purchasing areas, some areas for improvement include basic lean manufacturing principles to get better use of their production assets, improve quality, and reduce the internal cost of quality. The other is related to Operational Asset Effectiveness, and this is related to productivity as we mentioned, as well as the technology or the throughput possible in these manufacturing plants, and the quality, or the yield, the number of acceptable parts in vehicles that are being output.  We expect that companies will continue to focus on these operational improvements to improve their efficiency and their effectiveness, producing more with a given set of assets and labor force.

The second area in which companies can initiate improvement programs is in general financial management. This includes seeking after long term contracts with supplies, for raw material suppliers such as steel and plastic resins. At this point in the industry this is very difficult.  Steel manufacturers are unwilling to sign such contracts, so it may require that Chinese companies become very sophisticated in their use of commodity futures and options to guarantee or to mitigate the risk of the future raw material price increases.

Another area where they may mitigate risk through financial measures is currency appreciation. It may be necessary for these companies to adopt more sophisticated currency hedging schemes so as to ensure that the continuing number of imports that they have to bring into the vehicles here can be purchased at a reasonable price, or at least they have some insurance against dramatic price increases. If we think about currency hedging in terms of exports, perhaps the best method may be to establish overseas assembly bases for their vehicles.  Certainly it makes sense from a long term perspective to assemble vehicles in the place where they are sold and to bring as much localization to the entire vehicle production as possible around the world. We've seen this from the Japanese and the Korean manufactures as they have established manufacturing and supply bases in North America to supply their biggest market for vehicles, and this to some extent was driven by the Japanese Yen appreciation, as well as just the possibility of currency fluctuation in the future.

A third area is, it's very important for the auto makers to increase their competitiveness by driving product innovation and asserting their brand in the market place. Brand and innovation are the things that can allow vehicles to achieve higher price in the market, and it's clear there are significant improvement opportunities among the Chinese. either the joint venture partners or the local Chinese companies, to improve their internal product development capability, to allow them to manage and produce innovation that customers will value, and therefore stop the continuously reducing vehicle prices, and move up-market into the higher price segments which will allow them higher margins.

So operations effectiveness improvements, financial management measures, and product and brand innovation, are three keys to dealing with this crisis of competitiveness.

OEMs benefit from long-term relation with innovative suppliers

Gasgoo.com: Can Chinese companies really learn something from setting up joint ventures with foreign companies? Is there technology protection?

Stephen W. Dyer: In forming joint ventures with foreign auto makers, the Chinese companies have achieved one goal -- attain market share and capture manufacturing capability and expertise. One thing that has been very slow is technology transfer, especially new technology development capability. I'm sure that has not met the expectations or the hopes of the Chinese joint venture partners to date. A very different situation in the automotive industry today from that perhaps 30 years ago is we see much of the innovation in products coming from suppliers, so it is key for automakers to understand how to take advantage of innovation at the supplier level, and how to manage that innovation to provide a product that the consumers will demand. That's different from 30 years ago, then automakers themselves were the key innovators in the industry. That actually bodes well for Chinese automakers to be able to improve their innovative capabilities, and that means they can develop long term relationships with suppliers who have the capacity to innovate, and are willing to work with those suppliers and fund research and development, so they can have some significant control over the innovations that the suppliers develop. That could be a potential path to success for Chinese auto makers.

Gasgoo.com: You mean from the concept car session, the OEMs should join hands with suppliers to design the parts of a car. Is that right?

Stephen W. Dyer: That is right. It's very important that OEMs work closely with top suppliers to develop innovative modules, systems and components. One example is working with seating suppliers to develop safe seats, that consumers will pay extra for, or at least will maintain a high brand image for the Chinese suppliers. Currently, there is a struggle between cost and innovation, certainly innovation requires expenditures, and it will still take awhile for some of the Chinese automakers to shift their focus more to innovation and less on cost and production, because sometimes it can stifle innovation or prevent innovation from happening. If the foreign high technology suppliers after several cycles of experiences dealing with Chinese auto makers realize that regardless of how long they spend doing joint product development with these auto makers, the auto makers in the end will only focus on the cost of the components of modules and leave the development partners that they work with over years, for example, out in the cold, and not allow them to participate in the final program of the vehicle, so this will take a few cycles before both the Chinese auto makers understand how best to work with these technology providers, and for the foreign Tier-1 suppliers to understand how to work with the Chinese companies.

Emergence of Indian market won't affect China dramatically

Gasgoo.com: Compared with Indian market, which also enjoys low labor cost and great potential from the market, will this rising cost finally make China's advantage disappear? Will the competition situation between China and India change somewhat?

Stephen W. Dyer: The Chinese and Indian markets are the two fastest growing auto parts market in the world. Certainly they are the markets that the OEMs and suppliers have their eyes on. Currently the Chinese passenger vehicle and components market is about five times bigger than the Indian market, which means China certainly has a head start in several senses. First of all, there are many more large suppliers of components in China than in India. The Chinese supply base has been developed to serve a market that is five times larger. China, because of this early development, was the initial focus for foreign automakers and suppliers to purchase parts for exports, using China's local cost manufacturing base. India has been a follower in that regard, simply because they didn't have the broad and extensive supply base that China has. If we look to the future, because of this difference in size, we can say that the Chinese automotive market probably will not grow as fast as the Indian automotive market over the next decade, because Indian has a long way to catch up. We might expect that as the Indian market grows, there may indeed be a small shift in terms of low cost country sourcing from China to India, but the interesting thing about these two markets is that they are so large themselves that many of the companies are focused mainly to establish operations in these markets for supplying the local market, instead of using them as an export base. As we think about that, there will tend to be fewer crossovers between the markets, less mutual interaction between the markets.

So in the short term I do not expect that the growth of the Indian automotive industry will affect the Chinese automotive industry dramatically. I think the effect will be very small. There will probably be a small shift -- foreign suppliers looking to India more than China as a low cost export base. But in terms of establishing operations within the two countries for supplying the local markets, I think that will continue and there will not be too much mutual interaction. The consumer demands in these two markets are very different. The Chinese consumer demands in terms of the size of the vehicles seem to be much more similar to North America or Europe than Japan for example. Chinese tend to gravitate more towards larger vehicles as soon as they can afford them. Whereas in India, because of the relatively lack of highway infrastructure, small vehicles not only are important, but are more affordable, and also able to navigate through the smaller streets and more complicated traffic situations in India.

Tata Nano not suitable for China

Stephen W. Dyer: So we've seen recently the development of the Tata Nano, which is a car that theatrically will cost at least a base version of US $2500. No one thought that was possible a year ago. People saw it as an objective, but they were very skeptical that it would be achieved. It's remarkable that Tata has achieved this objective. However that vehicle is more suitable for Indian market than it would be for the Chinese market, therefore I would not expect to see many Nano's here in China for a number of reasons. First, small vehicles, although in demand for the lowest market, certainly are not the long term future of the Chinese automotive market as it matures. We would expect that the demand for the mid-range vehicles would increase much more than the smaller vehicles, just due to Chinese consumer preferences.

Secondly, Chinese safety standards are very similar to European safety standards, they are not quite exactly the same, but they are essentially based on the European safety standards. There are significant questions whether the Nano could achieve the safety standards to compete in the Chinese market.

Gasgoo.com: Do you think the distribution method of the Tata Nano wills also function in China. It is said that the Tata Nano is sold in a MacDonald's way. Tata deliver the auto parts to a dealership, the dealership assemble and then sell them. Do you think the sales method, not the product will make sense in China?

Stephen W. Dyer: If we think about models for automotive industry, one of the very innovative models is to think about mass customization, which means developing a vehicle that could be quickly and easily assembled as close to the customers as possible, to satisfy the needs of each customer. This is very difficult in practice on a large scale, especially as the technology in the vehicles and the safety requirements and the emissions requirements increase, there is a lot of manufacturing and assembling expertise that is required to assemble such a high standard automobile. If we think about the sales model in China, it's very similar to the European and U.S. models; at least the government's intention is to increase the standardization of the selling models within China to approach that of western countries. I would see that is a continuing trend, I would not see a trend of on-site assembly of vehicles in China; I would see it mainly mimicking the modeling of the U. S. or European sales model.

Gaasgoo.com: I think that is a very effective way to cut cost, such as the logistics cost. Also according to local news report, Tata is considering online sales for Nanos. Do you think that is an innovation?

Stephen W. Dyer: After-sales service is usually supplied by the dealers. So that is not innovative. But if what you are saying is true, if the vehicles are shipped in pieces to the dealers, that is definitely very innovative. And I could see how logistics cost and inventory would be improved, because the dealer is able to assemble and customize a vehicle, if that's the case, in different colors, different configurations, certainly that's very innovative. The question in my mind is how that would impact quality. In the more mature market, that method may be difficult to succeed with, because of the potential negative impact on quality if you have vehicles being assembled by a network of dealerships throughout the country, it's very different to control how well those vehicles are assembled. Therefore it would be a serious risk to adopt such a practice in a market in which quality is better understood and expected.

Gaasgoo.com: Maybe Tata Motors would send some technicians to the dealerships. And they have received serious training before doing the on-site assembling and sustaining.

Stephen W. Dyer: The reason that automotive plants are of certain size is that there are economies of scale. Some of the economies of scale relate to having a pool of workers that are flexible and interchangeable, so that you can produce high volume quantities of vehicles at a very low cost. If you are producing vehicles at a dealership, the volume is very low, so the productivity there would also be very low. Right now that may make sense in terms of cost effectiveness and quality, because for one thing labor cost potentially of those technicians is still very low; secondly, the consumers that are buying the Nano is not as focused on quality as consumers that are buying a higher end vehicle. For that vehicle, it may make a lot of sense to adopt such a late-stage assembly method. But it may not make as much sense for a higher end vehicle; it may not make as such sense as the Indian labor cost increase. But now, if that's the case, indeed it's highly innovative.    

Will there be a Chinese Toyota?

Gasgoo.com: In the 1980's, appreciation of Japanese Yen finally leads to fast globalization of Japanese automakers. They were also forced to improve their internal management. For instance, Toyota has leading to world's No.1 with the lean production method. Nowadays, do you think the pressure the Chinese automakers face will lead them to world's leading companies?

Stephen W. Dyer: It's very valuable to study the examples of Japan and Korea, when thinking about what the future holds for the Chinese auto industry. Japan indeed experienced a period of rapid currency appreciation that increased the cost of exports of these vehicles to its major markets in North America and Europe. As a result, we see that the Japanese companies focused on establishing their manufacturing and supplying networks within the markets that the vehicles would be sold, and reducing the amount of complete exported vehicles. As we look at the Chinese situation, similar approaches are likely when Chinese companies focus on an export market.  Because of the rapidly appreciating Chinese Yuan, that it is very probable that they will also take the same approach of establishing supply bases and assembly plants in the target export markets, as opposed to exporting complete vehicles. So we would expect that follow a similar trend. If we think about the competitive pressures that drove companies such as Toyota to adopt continuous improvement in their internal management practices, certainly as we mentioned earlier in this discussion, there will be intense pressure for Chinese companies to do the same. However, I would expect that they would take a slightly different approach than the Toyota model, for a couple of reasons.

Toyota had almost a century of experience with this model, not always in the automotive market, but for a long time, this culture of continuous improvement, incremental improvements and eliminating wastes was something that is deeply imbedded in the Toyota culture, back when Toyota was making textile weaving equipments. The Chinese companies are relatively new to the game, and therefore this culture of internal focus on continuous improvement is not quite as deep as it would be in a company such as Toyota.

Secondly, because of the rapidly growing Chinese auto market, companies have been focused on how to position themselves to achieve success in the endgame, which means how to grow, how to improve their brand image, how to establish their brand, so that in the end when the competitive pressures force restructuring, their brands and their sales networks and their scale would be such that it will help them to survive. I would expect that the focus on competitiveness would be still a secondary consideration for these companies.

If we think about the future, will there be a Chinese Toyota? I think that it is highly probable that in the long term there will be one or two, or maybe even more, Chinese global players that would have the stature of some of the global players, such as Hyundai or Nissan. It's not clear at this point which company that will be, because the focus is on capturing market share in the internal Chinese domestic market. But there may not be a Chinese Toyota,i.e. a Chinese companiy clearly mimics Toyota in focusing on continuous improvement. But it's probable that the Chinese global player that succeeds in the future will be one who is highly innovative, and brings very cute or attractive products to a market at a very affordable price. That may be the next company that is talked about in global automotive circles in addition to the Toyota way.

Gaasgoo.com: You don't think the Toyota way is suitable for Chinese companies to mimic, because of culture difference?

Stephen W. Dyer: I think Lean Production and Just In Time Production have already become a necessary factor of competing in the automotive industry. We've seen all of the U.S. manufacturers adopt lean principles in their production, sourcing and design. They have followed Toyota in that respect. Although they have followed Toyota, they have never quite achieved the level of success in that area as Toyota. Therefore they have tend to compete in a different terms, whether it be cost or innovative features. We may see the same thing in China, certainly Lean Principles and Just In Time manufacturing methods will be adopted in China, there is no question. Will they be adopted to the extent that Toyota has adopted them? It's very difficult to say. Because of the history and the alternative focus on brand and innovation here in China, I would say that would be a more probable path for the development of global Chinese automotive player.

About A.T. Kearney and its expertise in China auto industry

A.T. Kearney is a global management consulting firm; we have offices in over 36 countries around the world and China clearly is one of our growth areas for management consulting. Some of the industries that we currently are focused on here in China, as well as globally, are the automotive industry, the energy industry, including oil, gas and various electric utility industries, consumer products, financial institutions, and to a certain extent, telecommunications and high-tech industries. So we have a very broad offering in terms of industry expertise, as well as crossing throughout the value chain, including strategy, market entry, due diligence, mergers and acquisitions support, as well as operational support for companies interested in increasing their competitiveness, which is a key topic that's becoming much more important in China than it has in the past.

In terms of our automotive industry consulting here in China, A.T. Kearney works with almost all of the top global and local Chinese Original Equipment Manufacturers (OEMs), i.e. vehicle manufacturers here in China, as well as several of the important Tier-1 and even Tier-2 suppliers to the automotive industry. Typically here in China, although A.T. Kearney's history has been to improve the operational effectiveness of a company, that's not typically our focus here in China. Because of the market needs and market situation, most of our clients have focused on growth, how to grow their top line revenue, and how to position themselves strategically for success in the endgame of the Chinese automotive market.