The End of Luxury Margins

...luxury at low cost is a potential disaster for the industry...

Diana Kurylko at Automotive News has a front-page story in the January 21st issue [online here arguing that "$30,000 is the new luxury-car hot spot". The evolution of CAD systems (linked now to engineering databases) and the revolution in materials science means that it is feasible to provide the NVH (noise vibration handling) of a luxury vehicle at little or no incremental development cost and a modest manufacturing cost. Leather remains necessary – a $1,000 cost premium for two front buckets and a rear seat?) – and additional speakers and other spiffs add cost. But safety mandates mean that stability control, keyless entry and so on are either present or can be added at low cost as the underlying IT backbone is in every vehicle.

While a boon for consumers, luxury at low cost is a potential disaster for OEMs as it will undermine their ability to earn fat margins on their upper-end vehicles. Yes, there are consumers for whom a car is used to enhance their social status, and so expensive cars won't go away. Ditto those auto enthusiasts who want unnecessarily large engines or other add-ons (and have the wherewithal to buy them). But my sense is that at present many consumers buy higher-end vehicles because of their NVH attributes. They don't mind the status symbol aspect, but what they really hanker for is simple ... or not so simply ... luxury.

Now having test-driven a wide array of vehicles the past few months, my own personal observation is that a few really stood out for a combination of comfort, quiet and superior drive. And I didn't drive any luxury cars. So maybe those are yet nicer; I suspect not. I've also been in anechoic chambers a couple times in my rule as a judge for the Automotive News PACE supplier competition, evaluating the (lack of!) contribution of one or another component to vehicle noise. I've seen presentations on recycled materials that turn out to be both inexpensive and really good at insulating drivers from noise. I've been in the Chrysler wind tunnel. Creating a quiet car does entail cost, but it's now at a point that can be fit into the cost target of a $30,000 vehicle, both in terms of purchase price and weight (because adding lots of rubber goop adds lots of weight and attendant indirect costs.)

The old saw that small cars mean small profits continues to hold; absent the ability to differentiate (here I think of the Mini) you get the old progression of larger size and larger price, without of course a commensurate increase in costs. The luxury end accounts for a disproportionate share of industry profits.

That may change -- not that the higher end won't generate higher profits, just that it will generate a lot less profits. Can the BMW's of the world maintain their relative position? Perhaps. But it may be harder and harder for Lexus, Cadillac and Lincoln to provide potential purchasers with a good value proposition when a Ford offers comparable luxury.

...mike smitka...

Henry Ford, A Documentary

Public Broadcasting Service Premiere of 

American Experience Presents Henry Ford 

Tuesday, January 29th, 2013 9:00 – 11:00 PM on PBS

 – A Review by David Ruggles –

additional comments by Mike Smitka

Henry Ford changed the world with his assembly line method of auto assembly, patterned after processes he observed in the meat packing industry. One might think there is nothing new to be learned about the man, his life, and his legacy. And perhaps there isn’t. But I have never found such a wealth of information and insight in one place as in this wonderful documentary directed by Sarah Coit and to be presented by PBS in conjunction with the 150th anniversary of Ford’s birth.
A study in contrasts and contradictions, Henry Ford was a genius who did a lot of good for mankind, while at the same time his behavior presented a case study for the psychiatry profession. Henry Ford began his career at a time in our history when a few plutocrats had combined net worth equal to a major portion of the entire GDP of the country. Before the turn of the century, John David Rockefeller’s net worth alone exceeded 10% of the GDP of the United States. In today’s dollars, that would be the equivalent of about $1.5 Trillion. Together with Andrew Carnegie, J. P Morgan, John Jacob Astor, Andrew Mellon, and others, monopolies controlled the U. S. economy and government policy was bought and sold at will, at least until Teddy Roosevelt signed the Sherman Anti-Trust Act in 1890 and the graduated income tax was passed in 1913.
When Henry Ford historically doubled the wage of his workers from about $2.50 per day to $5.00 per day, it was a giant step forward for the country’s middle class. He also pioneered both 8 hour work day and the 5 day work week. Ford didn’t make these moves for altruistic reasons alone. His assembly line production method burned out employees. In the face of overwhelming employee turnover he was interested in employee recruitment and retention. He also attached conditions to the wage which were onerous for many employees. Ford’s “Sociological Department” monitored employees through a network of thugs and spies. Heavy drinking, gambling, and other adverse behavior was strongly “discouraged.”

But Ford was visionary in that he understood that by paying a high enough wage, so his own employees could afford to purchase the product they built, he could become more successful himself. It was a radical theory at the time and enraged his competitors, who were forced to match wages or risk losing their best skilled employees to Ford.
At the time, automobiles were toys for the wealthy. Ford’s Model T soon became a necessity for the masses and spawned a mobile culture that led to the country’s highway system, a burgeoning oil industry, motels, fast food, and hosts of related businesses that fueled economic expansion. And Henry Ford showed that the wealthier could do even better if they had a thriving and consuming middle class to sell to. In that respect he did not regard economics as a zero sum game.
Ford later turned on his employees, unleashing the infamous Harry Bennett to intimidate workers.
Ford resisted offering any color other than black to consumers until it became clear his company would fail if he didn’t. [ms: in the days of lacquer-based paints, Ford offered an array of colors; the first successful oven-drying enamel was only available in black, and to offer a mass-produced vehicle required that he move away from the earlier paint technology that required hours to dry between multiple coats. but by 1920 DuPont had developed an array of colors that were used by GM, to Ford's detriment. the DuPont family became GM's largest shareholder]
It was the same with financing. Ford thought debt was evil, and a person did not deserve one of his vehicles if it couldn’t be paid for in cash. He ceded huge market share to General Motors, who pioneered auto financing through General Motors Acceptance Corporation, until Ford was forced to enter the business of auto finance.
He hated the wealthy, even though he was one of the richest men in the world. He regarded investors and stock holders as parasites. He created his own idyllic country retreat, now called Greenfield Village, so he could return at will to the more rural simple life from which he came, despite being the singular impetus himself for modernization and industrialization.
He abused his only son Edsel to the point that Edsel died prematurely of stomach ulcers. It took Edsel standing up to his father to finally get approval to replace the Model T with the Model A. That was the son’s high point in dealing with his father. But Henry resented being proven wrong, and went out of his way to punish Edsel for being right.
Adamantly anti-Semitic, he regularly published inflammatory articles from the local Dearborn newspaper he bought for the purpose. [ms: yet his factories were designed by Alfred Kahn, a leader in the Jewish community in Detroit]
The documentary is full of movie clips from the period, bringing the history of our country’s industrialization and its dependence on the automobile to life. Students of history, economics, the auto industry, AND psychiatry shouldn’t miss the premiere of this most entertaining and enlightening presentation.

Velocity Overdrive, the Road to Reinvention

A Book Review

by David Ruggles and comments in italic by Mike Smitka

Dale Pollak’s third book, “Velocity Overdrive,” is another winner and is must reading for dealers and any student of the auto business. That includes auto manufacturer executives.

Dale’s ability to put into words the changes the industry has been experiencing has helped hundreds, if not thousands, of auto dealers, both new and used. He has rightfully pointed out that the delivery of information via the Internet has brought “efficient market” economic principles to the pre-owned business in particular, compressing available “spread.” New data driven management methods that are based on rapid inventory turn at lower, but real world gross profit for the specific market, actually produce considerably higher total gross profit through higher velocity, a concept difficult for some to grasp. In some areas of retail the benefits of sacrificing margine to increase inventory turns is commonsense. Automotive retailing is catching on: Daily, market realities are making believers out of skeptics.

My favorite chapters include 8, “Dealership Department Silos,” and 14, “The Extra Mile in Reconditioning.” In these chapters Pollak dares to challenge long and stubbornly held beliefs that the pre-owned department exists to be pillaged by the fixed operations departments. After all, it was thought, sales people and managers sell from their cost, not based on any kind of rational retail market value. And gross profit booked by charging retail prices for internal reconditioning, or “retail recon,” is retained regardless of what happens to the used vehicle, they thought. There are dealers who have followed this “retail recon” policy for another reason. They would rather pay management compensation based on fixed operations rates than sales manager rates. The Internet has changed all of that. Dealers still in denial on the issue especially need to read this book!!

In my mind, the idea that “you can’t manage what you can’t measure” has cost dealers a lot of money. What one could have gotten, should have gotten, but didn’t get, is never quantified. In “econo speak” that means “opportunity costs,” or opportunities unrealized. Figuring opportunity costs is hard, sloppy comparisons and the failure to dig up relevant data abound. There's less excuse for the following common errors in our internet world: Trade-ins under bid and/or units wholesaled instead of retailed because of “retail recon” cost money that can’t be totaled. And many dealers remain oblivious of this fact. My own piece on this blog on the issue can be found here.

The pre-owned business has long been a combination of art and science. The science side has become more important than ever although some old dogs like me might think things have gone overboard in some cases. For example, I’m not thrilled about managers failing to walk around a vehicle and actually drive it before hanging a number on a trade-in because they are relying on an appraisal tool. But then neither is Pollak. Some managers think all they need is their technology driven appraisal tools.

As far as science is concerned, Pollak has already conceived and implemented the most essential and highly used technology tools in use in the industry. His company, vAuto, now offers a new technology tool called Provision®, an inventory management tool. It distills market data into management metrics that dealers and used vehicle managers use to easily and quickly understand the risk and rewards inherent in every vehicle.

Looking forward, Dale dedicates a chapter to trends that will result in further margin compression for dealers. Younger buyers are more internet enabled then older ones and they have different values than older generations. They don’t think in terms of the value a dealer relationship offers them. They tend to be ruthless in their pursuit of the best price, using the internet to obtain it. Unfortunately, in the middle of this generational driven trend OEMs are pressuring dealers to build ever more expensive facilities in an era when consumers are less willing to pay for them. Increasing fixed costs when margins are falling does not lead to a happy ending. Pollak cites Glenn Mercer’s comprehensive study on the subject on behalf of the National Automobile Association (here on the NADA site).

This book is well worth the investment even if a dealer only reads the chapter, “A Peek Inside Dale’s Crystal Ball.” Dealers who ignore Dale’s advice do so at their own peril. Increasingly, the “efficient market” that is the auto business will tend to leave only the leanest operations standing. For a Dealer in search of significant ROI, buy the book and read it.