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Automotive suppliers: The inevitable car crash

After almost 10 years as Head of Finance and Accounting for a medium-sized automotive suppliers my verdict is bleak. The industry is facing a storm in the coming years, driven by the electrification of the traditional combustion engine. This might be the final push over the cliff-edge for smaller companies within the industry which over past years had been driven ever closer to the abyss by pressures to find cheaper ways to produce components, COVID and rising input costs especially in the western hemisphere. But let me dive a bit deeper into these issues and show you why I am personally finding it a less attractive industry to be engaged unless there is some change!

Personally I believe it is not difficult to see why a storm is coming. A few key facts underline the building pressures one the industry's supplier. Lets first talk about the electrification and what it means in absolute terms. There was a catchy Forbes article describing the ICE (internal combustion engine) a "dead man walking". In the article for which I provided a link below the fact was mentioned that an electric car requires only 20 moving parts compared to an ICE which needs more than 2000 moving components. This is is just the most obvious fact but beyond that an entire electric car needs less parts, whether it is a multi-speed gearbox, an exhaust system, fuel tanks, clutches, fuel injector systems, etc. UBS investment bank produced a very insightful study in which a Chevy Bolt was analysed and compared to a traditional ICE car of similar nature. I thought that a key-takeaway would be that there can only be losers in the industry because of an on-balance reduction in production inputs. But the picture is more complicated. I reached the conclusion that whilst some of the traditional suppliers will find it hard in the coming years some new entrants linked to the EV production will compensate the losses suffered by the incumbents. Overall there might not be such a heavy loss in occupation but more like a shift! So the question remains who will be the losers and who the winners which will be determined on a country by country level. The German "Handelsblatt" gave its readers a bit of a taster of how it could look like in Germany:

I wonder how it will look like in the UK with its 180.000 people employed in the automotive industry ( A few critical voices are already pointing into the direction that the UK car industry might not be as prepared for the EV revolution and I wonder whether it could be a repeat of the story surrounding the British coal and steal industry.

My own perspective:

My words at the beginning were blunt and sounded unforgiving but I what I have seen over the past years turned me into, I would not say bitter but less enthusiastic person with regards to the industry I am working in. So what follows might not be the most objective account and a general representation of how things work but I hope it will nonetheless resonate with readers as it is the bare truth as I see it.

Lets get started:

For any suppliers engaged in the automotive industry it is all about volume and how efficient you use your equipment and working capital (such as inventory, supplier payables and customer receivables). You are normally engaged in long-term contracts stretching up to 10 years. which on the surface sounds like a stable affair but in actual fact is more volatile than you think. So how do you enter into a contractual relationship with a buyer normally bigger player, due to the concentrated pyramid-shaped nature of the automotive supply chain?

In simple terms it is like this:

  • The buyer looks around for a supplier, able to produce a certain amount of components over a number of years.

  • The supplier will then quote the business, determining the amounts of investment into plant & machinery required, staffing, material costs and overheads. The supplier will then quote a price per part which is based on the promised amount of parts supplied over the contract period:

Easy example: A buyers puts out the business for 100.000 engine components per year over a 10 year contract period.

A supplier then estimates that it will need to spend 5million on machinery, which for simplicity will become obsolete after the contract finishes, 6milllion on material, 4million on staffing and 2 million on overheads. This in total makes 17milllion in costs or expressed per part: 17GBP per part. The supplier will add on a suitable profit margin of 10% giving him a selling price of 18.7GBP per part.

  • The supplier approaches the buyer quoting 18.7GBP per component.

From now on it becomes tricky. The purchasing lead, which could be a senior executive of the buyer will now enter into negotiations which is perfectly ok apart from the fact that these days the only thing that matters is price and price alone! As a company in the UK you will find yourself increasingly in competition with companies in the countries with cheaper labour rates. The purchasing executives are so obsessed with price, not unsurprising since remuneration packages are increasingly linked to finding the best deal and an underlying belief that suppliers want to "screw them over". It becomes second nature whether a suppliers can demonstrate a sound proof of concept, whether it can supply parts with consistently high quality standards or provide good working conditions. This is the crux with remuneration incentives, as much as they can achieve focus on reaching targets they can also create toxic side effects!

The UK supplier will be approached and made aware that it will need to cut its price should it want to win the contract. For smaller companies which tend to be more specialized in order to make a profit there is less choice given the there are not many market players and finding a new customer is a tedious and long-lasting endeavour. Imagine you make sth highly specialized such as an engine component like an oil pump which you have perfected over many years. You have obviously together with your team of engineers not wasted your time but concentrated making the production of oil pumps each year more efficient. Therefore you made a conscious decision staying and competing in the game, being more reliable, better in quality and more efficient with your inputs. This is important to understand because it counters the argument of just finding a new customer. Finding new buyers means you have to devote your already thinly stretched resources to new projects for which samples need to be produced and PPAP documents established (at least in the automotive industry). PPAP stands for Production Part Approval Process, which is basically a series of documents demonstrating that you have a workable plan to manufacture a certain component.

For a company such as the one from our example with yearly sales of 1.700.000GBP, a 10% profit margin translates into 170.000GBP profit per year. Imagine you have to at least hire a business development manager, costing 50.000GBP our profit already melts to 120.000GBP add a dedicated quality engineer and you are down a further 30.000 to 40.000GBP plus a little bit of engineering overtime and our profit has nicely melted down to just 70.000GBP. This is just on paper, in reality profit margins of 10% are a rarity in the automotive industry.

You might then argue to change the industry, this would essentially mean starting from scratch.

So what do you do you cut the target profit down from 10 to just 5% and with luck you will get the business.

And this is just the start of the freak-show which is the automotive supplier industry from the perspective of a small or medium sized company. If you think that the customer guarantees you he volume of 100.000 parts per year you are mistaken! NO CHANCE that they will commit to a volume within the contract. What they will set in stone is the price but with another caveat. Each year you will have to agree to price-steps downs because it is assumed that you will become more efficient each year and therefore be able to afford it! By the way this is no joke! However as a token of generosity they will reimburse should inflation cause increases in material costs, but this is purely limited to raw material only not tooling or any other production input such as wages!

Translated: You have no safety over volume paired with fixed and decreasing pricing with limited ability to pass any cost increases on!

I am not making this up, look a study performed by Lazard and Roland Berger:

Even before Covid EBITDA margins were falling despite rising revenues, You tell me how!

It is not unusal that volume plans do not work out the way as it was initially portrayed by the customer. In our case we are 30% behind in terms of volume which was initally quoted to us and on which we based our investment plan and costing model.

What would mean 30% less volume for our fuel pump manufacturer which just signed a contract for a price of 17,85GBP per part.

  • Sales revenue: 700.000parts sold (30% less than initially promised) resulting in 12.495.000GBP

  • Raw material cost (also 30% less as it it fluctuates with demand) equates to 4.200.000

  • Staffing stays roughly the same as you can not easily hire and fire so lets discount it by 15% overall, making it: 3.400.000GBP.

  • Investments in plant and machinery stay the same as they were committed right from the start with the expectation to produce 100% of quoted volume, so: 5.000.000GBP

  • Last but not least overheads, the are mostly a fixed cost as well such as rent, etc... so lets say we were able to cut them by 10% which leaves us with: 1.800.000GBP

Now the really important question, what has happened to our profit?

A 30% reduction in volume will result in a loss of 1.905.000GBP over a 10 year period! This is the craziness of this constrained system and explains the high debt levels and financial strain within the automotive supplier industry. If you are so susceptible to fluctuations in demand and chained to your external credit providers such as banks who financed all the machines it makes perfect sense why there is so little chance for the many smaller suppliers linked to the traditional combustion engine to change their business models which would require new investments and a lot of patience before they would actually return back some profit and cash!

The difficulty in responding to volume cuts

As exemplified, the worst nightmare for a supplier is when the volume drops. So much effort is put in this one topic in order to anticipate demand, not a surprise to me when you can't increase prices. I want to give you a few examples what can go wrong and piles on financial pressure:

  1. Calculation risk: It is one thing to plan costs on paper but as the saying goes, every plan goes down the drains once it hits battle. There are so many ways you can get things wrong in a budget:

    1. Did you calculate the time it takes to produce a part in real-time conditions correctly

    2. How long does it take for your tooling to wear off.

    3. How is it easy to recruit workforce

Calculation risk becomes even trickier if you have to set up a whole new factory in a foreign country, because of local content requirements.

Todays mentality is only making things works

The word shortage is often used these but mostly associated with material goods such as toilet paper. However there is one thing that increasingly becomes a rarity and that is patience and long-term thinking. It starts with the short-term thinking applied by investors jumping from one quarterly result to the next and ends with the ill-designed performance based remuneration packages of purchasing executives working for the "big boys", cementing a cut-throat culture in the search for the biggest bargain.

I could become a bit philosophical arguing that this is the course of modern capitalism always in search for cheaper stuff, whether is material or labour, but I think this is just an excuse and to easy of a scapegoat.

All it needs is a fairer playing field: One suggestion would be to share the market mutually between the buyer and the seller. No one can predict the market over a 10 years period but if you are wrong by a huge percentage why not allow the seller to apply a price premium to partially compensate for the losses suffer which if significant enough can drive them into bankruptcy.


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