Creating Economies of Scale in the Auto Industry

The German automakers are under some pressure. They need to have a small car in their product line-up in order to respond both to consumers’ growing preferences for smaller cars and to government pressures to reduce fuel consumption and carbon emissions. BMW has answered with its One series. Volkswagen has taken a 20% stake in Japan’s Suzuki Motor Corporation, which is a small car specialist. Mercedes Benz has decided to go an alliance route.

Recently, Daimler, the maker of Mercedes Benz automobiles, announced an alliance with Nissan and Renault to create a common line of small cars. The companies will also share engines and work together to create small commercial vans. To do this, Nissan and Renault will invest about $1.6 billion in Daimler who, in turn, will invest about $1.6 billion in Nissan and Renault. These investments will have a good pay-off. The two sides of the alliance estimate that they will each save about $2.7 billion in costs over the coming five years. This alliance creates new economies of scale for each side by increasing their productivity, as measured by units of input costs over units of output product. (See “Audio Tip #187: The Components of Productivity” on StrategyStreet.com.) In this case, they improve productivity by spreading fixed cost activity such as design of new products over more sales output.

In analyzing several thousand cost reduction approaches, which companies have employed over the last twenty-five years, we have seen two basic approaches to the task of increasing the output over which fixed costs investments are used. First, the company may acquire a similar organization to spread fixed costs over more units of sales. Second, the company may form an alliance of some kind to spread these fixed costs over more sales output. This small car alliance is an example of the second approach. In turn, we have identified three ways that companies pursue this second approach of spreading fixed cost. First, the companies may use their fixed cost with competitors who employ outsourcing. Second, the companies may combine fixed cost with competitors into separate businesses. Third, the company may use its fixed cost with new customer segments by turning some of their cost centers into profit centers. This small car alliance is an example of the second of these techniques, combining fixed costs with competitors into separate businesses.

Other examples where companies have employed this cost management approach include Sony and Sharp partnering in the flat panel TV business two years ago. Sony invested in Sharp’s plant to make LCDs. This gave Sony the option of buying the panels for its TVs while Sharp reduced the investment burden for panel production. In another example, General Mills and Land O’Lakes combined their distribution networks, improving their scale economies. In this later case, the companies were not direct competitors as are the companies in the small auto alliance.

You may find many more cost management concepts and examples in StrategyStreet.com/Improve/Costs.

Price Leader Expansion Under Standard Leader Umbrella

Over the last year, private label sales of food and other grocery products in the U.S. have grown at over 10% per annum. These private label products are examples of Price Leaders, companies and products who offer performance less than that of the larger, industry-leading, Standard Leaders for a price substantially less than Standard Leaders.

Standard Leaders are the companies and the products that are most common in an industry. Standard Leader products make up the majority of the industry’s sales. A Camry and an Accord would be Standard Leader products. The Yaris and the Fit are Price Leader products.

Private label products rely in the brand name of the retailer to establish Reliability, while offering the consumer Function benefits that are roughly equivalent to the Standard Leader product. Sometimes industry Standard Leaders will produce private label products which are unrelated to their major branded products. More often, though, private label products are produced by private label company specialists, such as Ralcorp and Cott. The majority of these private label food producers are mid-sized private companies. Most are unknown by the average consumer. They include companies such as Schwann’s, Land O’Lakes, Specialty Foods, Sterm Foods and Pan-O-Gold.

In the food business, private label products can put significant pressure on the industry’s Standard Leaders. That is happening today. While private label products have grown 10% in the last year, many of the branded food companies are growing well below that or are shrinking in their sales. ConAgra Foods saw a sales increase due to price increases, but sales volume actually fell. Kraft Foods, General Mills and H.J. Heinz also saw declines in sales volumes.

The reason for the disparities in growth rates between private label products and branded foods is pricing. Last year the branded food companies had a unique opportunity to raise prices dramatically, on the order of 10%, due to the rising commodity prices at the time. However, these commodity prices have come down and the branded food companies have continued to maintain, or even raise prices. With the fall-off in the economy, and these price umbrellas set by the branded food companies, private labels have jumped in popularity. This is a form of the Leader’s Trap. We just placed many examples of the Leader’s Trap on our StrategyStreet web site (see http://www.strategystreet.com/tools/glossary_of_terms /leaders trap and also the Symptom and Implication, “Leaders Stress Quality to Offset Competitors’ Lower Prices” on StrategyStreet.com).

The problem that private labels are creating for the branded food companies is one of improving Functions and Reliability. The increased volume that the branded food companies are allowing private label products enables these Price Leader companies to improve their products, reducing or erasing the Functional and quality differences their products have compared to the branded products. The private label products then become permanently stronger.

This is a serious challenge. J.D. Power & Associates recently reported that consumer perceptions of private label grocery brands have shifted to the positive. Many consumers no longer consider them to be low quality with bland packaging. These consumers look at private label brands as unique and having quality that equals that of traditional brands. The traditional branded companies are setting up powerful competitors who will always maintain a price advantage over them.

These private label store brands are unlikely to lose all the market share they have gained over the past year, once the industry Standard Leaders reduce their prices, as they inevitably will.