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ESSAYS ON ISSUES

	 THE FEDERAL RESERVE BANK
	 OF CHICAGO

	 SEPTEMBER 2007
	 NUMBER 242a

Chicag­o Fed Letter
Transitions: The State of the Automotive Industry—A summary
by William A. Strauss, senior economist and economic advisor, and Emily A. Engel, associate economist

The United States automotive industry has been undergoing tremendous changes in
recent years. Speakers at a recent Chicago Fed conference explored these changes
and considered the road to the future for the auto industry.

In order to better understand the
changes taking place in the production
of automobiles and to gain some insight
into what the future holds for the industry in the U.S., the
Federal Reserve Bank
1. Share of light vehicle sales
of Chicago held a conpercent
ference on Monday,
100
June 11, Transitions:
The State of the Auto90
Imports
motive Industry.1 More
80
New domestics
than 100 economists
70
and analysts from busi60
ness, academia, and
50
Detroit Three
government attended
40
the conference and in30
dustry experts were in20
vited to share their
10
perspectives on this
0
topic.
1980 ’83
’86
’89
’92
’95
’98
2001 ’04
’07
Source: Wards Automotive.

The changing face
of automotive
production

The United States automotive industry
has been undergoing tremendous changes in recent years. Some of these changes
include significant reductions in employment, factory closings, bankruptcies
among the supplier base, downgrades
on corporate bond issuances, and consolidations. One needs to merely pick
up any daily newspaper to also see the
market share losses by the group formerly known as the Big Three (now
more appropriately called the Detroit
Three—Daimler Chrysler, Ford Motor
Company, and General Motors).

While the Detroit Three have been
dealing with mostly bad news, foreign
nameplate producers are enjoying a
very different environment. Rather
than closing plants, there are several
automotive production facilities being
planned by these “new domestics” over
the coming years.
If we look back to 1980, when there was
very little production by foreign nameplate firms in the U.S., the Detroit Three
made up nearly 73% of all the light vehicles sold, while foreign-nameplated
production in the U.S. was less than 2%,
and imports represented just over a quarter of the market (see figure 1). Beginning in the 1980s, an ever-increasing
number of foreign-nameplated vehicles
began to be produced in the U.S. at
factories that were referred to as transplants. Through the early to mid-1990s,
the popularity of the sport utility vehicle
(SUV) supported the Detroit Three’s
market share. In 1996, the Detroit
Three’s market share stood at 72.5%,
virtually the same as 16 years earlier.
However, imports’ share had declined
by 14 percentage points to just over
11%, and new domestics market share
had risen to more than 16% of the market. The gains of the new domestics
came at the expense of imports.
Over the next ten years, however, the
Detroit Three would not be as fortunate.
Challenged by the growing number of
foreign SUVs, rising energy prices, and

a flat overall sales market, the Detroit
Three’s market share began to suffer.
By 2006, their market share plunged
nearly twenty percentage points to 53%.
New domestics sales had risen to nearly a quarter of the market, and imports
sales rose to over 22%. So unlike the
previous 16-year period, the loss over
the past ten years of 20 percentage
points of market share by the Detroit
Three is the direct result of gains by
both new domestics and imports.
However, the market share of vehicles
being produced in the U.S. in 2006 was
still over 77%, several percentage points
higher than in 1980, but by a greater
number of firms than in the past. So,
what has happened over the past ten
years is less a concern about the loss of
vehicle production in the United States,
but more about the transition from the
domestic industry being comprised of
the Detroit Three to an industry that
has more producers. Consequently,
the Detroit Three are playing a less
dominant role in the industry.
While it is true that the new domestics
vehicles had been made with less domestic content than Detroit Three vehicles,
this pattern has been changing. Over
the last ten years, new domestics have
been increasing the amount of domestic
content, while the Detroit Three have
been lowering their domestic content,
as they outsource more components.
For example, 70% of the 2007 Ford
Mustang’s parts were made in the United
States and Canada, while over 85% of
the 2007 Toyota Sienna’s parts were
sourced in the United States and Canada.
Expanding on the role of foreign manufacturers and markets in the auto industry, Loren Brandt, professor, University
of Toronto, presented his findings on
China’s auto production. Brandt emphasized the importance of the Chinese
market because of its recent economic
growth. For all the countries producing
more than a million vehicles per year,
China’s production growth outstripped
all the others in the market: from 2000
to 2005, coming in at 181.3%. During
the same time period, the results for
other countries in that group were
quite mixed: U.S., –5.9%; Germany,

4.2%; France, 5.8%; Spain, –9.2%; South
Korea, 29.4%; Italy, –40.3%; and the UK,
–0.4%. The growth in the automotive
industry, in fact, has been so large in
China that it has begun to cut back on
its production of trucks, which are used
for business, and to focus more on passenger vehicles for its consumer market.
The four main factors that Brandt believes are fueling China’s auto sector
are: 1) greater competition, which is in
part due to tax cuts and China’s economic expansion; 2) a decrease in car prices due to an increase in efficiency, which
contributed to lowering of costs; 3) the
improving quality of Chinese producers
compared to the Western producers,
which is causing a quality convergence
among top tier suppliers; and 4) a substantial increase in the export of parts
and components, especially for the automotive aftermarket industry. These
factors leave North American suppliers
with the thought that Chinese firms
should be viewed as a serious competitor, as original equipment manufacturers
(OEMs) in North America continue to
increase their global supply base.
Finding the best production methods

Frits Pil, associate professor, University
of Pittsburgh, discussed value and profitability in the auto sector. His presentation highlighted how manufacturers
are building vehicles to optimize production at factories rather than to match
consumer desires. He started his presentation by noting that inventory needs
to be viewed at three stages of the market—parts suppliers, assembly plants,
and the distribution channels (e.g.,
dealerships). He highlighted that OEMs
have a strong financial motive to ship
vehicles from factories, since they book
the sale at that point, even if doing so
builds inventories at dealers’ lots. With
higher inventories than desired, the
industry is then forced to offer large
sales incentives (e.g., money back, or
special finance and lease rates) in order to sell this excess inventory. Without these sales incentives, dealers would
find it difficult to sell the inventories
on their lot, particularly those with less
desirable colors or amenities.

Pil pointed out that there are two basic
options available for automobile companies to produce vehicles: 1) build-toforecast, or 2) build-to-order. These two
philosophies differ in aim, key measurements, and risk. Build-to-forecast tries
to predict demand and consequently
minimize unit costs. It is based mostly
on market share, labor productivity, and
capacity utilization (how much of a factory’s total output potential is being used).
However, this approach often leads to
both overproduction and a slow rate of
feedback from consumers. Pil said that
when people buy vehicles because of
the large financial incentives being offered, the OEM regards this as a successful transaction and therefore believes
that the color and amenity combination
must have been a good fit. The OEM does
not get feedback that the consumer
would have preferred a differently configured vehicle. Additionally, the OEM
does not know that the consumer would
not have accepted the vehicle on the
lot had it not been for the incentives.
Build-to-order tries to maximize profit
by matching demand. In order to successfully implement build-to-order, the
OEM needs to receive actual customer
information. There are fundamentally
different ways of thinking about customers’ needs. Pil gave an analogy
from the athletic shoe industry—
NIKEiD shoes versus mi adidas. With
the NIKEiD shoes, the customer can
choose their color combination, shoe
model, and have a word printed on the
shoe. However, the mi adidas shoe is
actually created from the ground up
for your feet, with your personal measurements. In other words, your shoe is
built exclusively for you. Similarly, the
automotive OEM needs to receive actual information from dealerships to create an automobile that a customer
would actually want regardless of incentives. One possibility is to allow customers to customize their cars online. As
Pil observed, “The auto sector is just
starting on the path toward customer
responsiveness.” The build-to-order approach could also increase the profit
margin per unit, because there would
be fewer discounts, and the supply
chain would be more

efficient, because of the leaner stocks.
There is a larger cost for providing this
flexibility, and the main risk is demand
variability. On the other hand, Pil believes that build-to-order would be the
superior approach for the market because the companies would be focusing both on unit profitability and on
customers’ needs.
Susan Helper, professor, Case Western
Reserve University, observed that “United
States automotive manufacturing is not
dead yet,” but that there are challenges that the auto industry is facing. Currently, there are nearly 900,000 jobs that
are directly related to automotive manufacturing plants located in the U.S.
Additionally, there are approximately
4.5 million indirect jobs that are linked
to the automotive industry. Recently,
there has been more offshoring to lower-wage countries, but this had a wide
range of results, both beneficial and
not so beneficial. According to a Center
for Automotive Research (CAR) report,
large suppliers gained most from the
offshoring of information technology,
and engineering was reported to have
the next highest benefit. On the other
hand, offshoring of human resources
and sales positions was considered not
to be advantageous to the company.
With so many U.S. jobs invested in the
automotive industry, it becomes important to consider the best ways to utilize
those workers. Helper tackled this topic
with her discussion of lean performance
(achieving lower waste standards in factories). There are two types of lean
models—learning lean and lean standardization. The first model focuses
on organizational flexibility and quality
while also combining lower waste practices within manufacturing. It promotes
changes in training practices, which results in a work force with higher skills.
The latter model, lean standardization,
focuses on the technical aspects of reducing waste while it provides performance improvements; Helper believes
it does not produce better performance
than the learning lean model.
In addition to promoting efficiency at
plants, Helper also touched on fuelefficiency in vehicles. Since 1985, there

has been little progress in the fuel economy of vehicles. There are innovations
that are in development—the use of fuel
cells or hydrogen—but the capabilities
to produce and/or develop these advances will require a large effort on the
part of the automakers. Not only do
improvements need to be made on the
existing technology, but there is also
a shortage of skilled workers to make
these improvements. A National Association of Manufacturers’ study found
that 90% of manufacturers report a shortage of skilled production help, and
65% of manufacturers have a shortage
of scientists and engineers. Without
the increase in technology and skilled
workers, the needed improvements
will continue to be slow moving.
Learning from the past and
moving forward

Jerry York, CEO, Harwinton Capital,
spoke on the automotive industry challenges from the past, present, and the
future. York identified these respective
periods as three wars: 1) the rise of the
Asians; 2) value and variety; and 3) the
developing markets and green technology. York believes yesterday’s war was
manufacturing productivity (total hours
per unit produced). The Detroit Three’s
manufacturing productivity did not come
close to the numbers of the Japanese
Three (Toyota, Honda, and Nissan). In
1988, the simple average of the Detroit
Three’s productivity was 44 (the total
hours per unit produced); by 2005 it
had dropped to 34. However, the simple average of the Japanese Three in
1998 was 31, already below the 2005
simple average of the Detroit Three. For
the Japanese Three, the simple average
of their manufacturing productivity
edged down to 30 in 2005.
While the Detroit Three have come
closer to the manufacturing productivity of the Japanese Three, there is still
a large window for improvement. The
Detroit Three’s fall might have happened
ten years sooner, had it not been for the
development of mini-vans, pick-ups,
and SUVs. Despite the success of their
light vehicles, problems with the quality of Detroit Three vehicles became an
even bigger issue. A J. D. Power 2006

initial quality study (identifying problems
from the owners’ perspective in the first
90 days of purchase or lease2) showed
that the Japanese Three have fewer problems per vehicle than the Detroit Three.
Lastly, the “rise of the Asians” was the
result of differences in the time to market
from development to delivery of vehicles.
The time to market for the Japanese automobiles was in the range of three years,
whereas the Detroit Three hovered
around five years, which is a large advantage because the Japanese automakers are closer in time to the marketplace
when they create their automobiles. This
has led the market to find Asian cars to
be more stylish and have an increased
number of technological gadgets.
In addition, because the new domestics’ plants are more up to date, they
have a higher range of variability in
their manufacturing. For example, the
new plants are producing more than
one type of vehicle; therefore, these
new plants can respond to changes in
market demands more quickly. The older plants that are being closed by the
Detroit Three typically made only one
type of vehicle. In addition, the Detroit
Three produce a wide variety of cars
with greatly divergent profit margins.
The Japanese Three are producing a
more limited number of vehicle types,
Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; Jonas Fisher,
Economic Advisor and Team Leader, macroeconomic
policy research; Richard Porter, Vice President, payment
studies; Daniel Sullivan, Vice President, microeconomic
policy research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Kathryn Moran, and Han Y. Choi, Editors; Rita
Molloy and Julia Baker, Production Editors.
Chicago Fed Letter is published monthly by the
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Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2007 Federal Reserve Bank of Chicago
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with fewer trucks and luxury cars, which
helps keep their profit margins and
productivity more consistent.
York believes tomorrow’s war will focus
on political factors, low-priced cars in
the developing markets, and the greener
technology that will be available. The
political factors will include national
policy, currency exchange rates, automaker objectives, and local preferences.
The low-priced car will be affected by
deteriorating profit margins (the dealers need to take a percentage, as well
as the outbound transportation costs,
leaving the manufacturers with a small
amount of money to build the automobile). The greener technology that currently exists is both turbo-diesel engines,
which exists in Europe, and ethanol
fueled (E85) vehicles, which is available
in the U.S., but at few gas stations. The
automakers are well underway to creating gas–electric hybrid powertrains.
In the future, there may be an all-electric plug-in vehicle, which will require
a better battery technology than currently exists, or there is a small possibility for fuel-celled vehicles.

Kristin Dziczek, senior project manager, Center for Automotive Research
spoke about the importance of labor
relations in the automotive sector. Currently, the unionization rate in the U.S.
automotive industry is below 23%. Additionally, the Detroit Three are losing
market share to the foreign nameplate
manufacturers whose workers are primarily nonunion. Both the United Auto
Workers (UAW) and the Detroit Three
are working toward an agreement that
will allow the companies to be more flexible in this very competitive environment.
While the UAW understands that the
Detroit Three are struggling, it also is
still striving to maintain its basic principles for its employees: a middle-class
standard of living, equal representation,
the best health care for the workers and
their families, and an accessible way for
the workers to contribute to social progress and justice. At this time, the union
wants to “seek to raise the standard of
living for its members.” Meanwhile, the
Detroit Three want to further cut health
care costs, shut down plants that are not
being fully utilized, and restructure other
plants in order to help them become
profitable again.

Conclusion

The presenters at the conference helped
explain why the U.S. automotive industry has been undergoing major transitions over the past 25 years. The keyword
that seems to address the difference between the companies gaining share and
those that are losing share is flexibility.
Flexibility allows firms to build-to-order,
satisfying market demands more accurately and to modify production lines
quickly in order to respond to changing
preferences. Fuel-efficiency has played
a more important role over the last several years, and our presenters seemed to
believe that it will continue to influence
the industry in the future as technology
allows vehicles to be powered in new ways.
The Detroit Three are striving hard to
match the flexibility of the new domestics
and, with agreements from their unions,
they hope to be a more competitive force
going forward in order to stem the loss
of market share over the past ten years.
	 For details on the conference, please
visit the web site at www.chicagofed.org/
news_and_conferences/conferences_
and_events/2007_auto_transitions.cfm

1

2	

See www.jdpower.com/corporate/news/
releases/pressrelease.aspx?ID=2006082.