The Problem with Relocating Original Equipment Manufacturing?

Market research company IHS Automotive recently released a report indicating that global light vehicle production increased by 25 million units between 2009 and 2013. This is expected to increase by a further 21 million vehicles before 2021.

In an attempt to reduce costs and increase market share, automakers are relocating production facilities from high-cost regions such as North America and the European Union to low-cost regions such as China, India, South America and several developing countries. Following this trend CSM Worldwide believes that the combined production out of China and South America will make up more than 50% of the growth in global light vehicle production by 2015.

However, while China increases production, South Korea and Japan, who adopt a "build where you sell" approach,are expected to reduce manufacturing volume as several local original equipment manufacturers (OEMs) move their manufacturing efforts abroad.

Image Credit: Automotive News

This trend is not confined to Asia, Ford has also stepped up its "One Manufacturing" strategy, which aims at producing multiple models in plants across the globe in order to reduce production costs. The automaker aims to manufacture an average of 4.5 models at each of its plants by 2015.

In this rapidly changing production landscape it would appear that opportunities abound for decentralised global production; but is it really that simple?

Reasons for OEM’s relocating production

Motor car manufacture is driven by volume which in turn drives down unit production costs. This makes high volume, high growth markets such as India and China very attractive to automotive manufacturers and their supplier base.

However it’s not only volume driven markets that attract automotive investment; low cost countries such as Mexico, which is set to overtake Japan for second place in car exports to the United States in 2014, are also attracting OEM attention. A recent study by IHS Automotive predicts that Mexico will surpass Canada for the number one spot by the end of 2015.

The viability of relocated production can also be influenced by currency exchange rates: A country with a weak currency such as South Africa, and previously Australia, can leverage the arbitrage to supply export markets, which the principle OEM may not have been able to access. This is well illustrated by Mercedes Benz and BMW operations in South Africa who have for many years won contracts to produce vehicles for export into America, largely driven by the weaker Rand/ Dollar exchange rate and proximity to the market.

Unfortunately production under these circumstances leaves the manufacturer exposed to exchange rate fluctuation which, as experienced in Australia, can contribute to the demise of the industry.

In Australia Nissan ended production in 1992: Mitsubishi halted output in 2008: Ford said last year that it would shutter its plants there by the end of 2016: GM followed with plans to end production by the end of 2017: and finally Toyota will end Australia's run as an automaking nation when it also pulls the plug on local assembly in 2017.

The reasons for the Australian shutdown

The real question isn't really why automakers are closing shop. But rather; why were they building there in the first place? Not surprisingly, the answer has a lot to do with exchange rates and tariffs.

The low volume Australian market hardly justified local assembly in an industry where economies of scale are so important. However for years, Australia’s auto industry was protected by exorbitant import duties and a weak AUD; so when the tariffs dwindled to an effective 3% and the AUD gained in strength, the industry was forced to review it’s viability.

Even though export volumes have been a key component of the government's plan to sustain local production levels and keep plants open, vehicle production in Australia has nearly halved in the past decade from about 409,000 in 2004. This, largely as a result of falling tariffs and the stronger AUD opening up the market to imports, while severely reducing the competitiveness of cars exported from Australia.

Challenges facing emerging OEMs

In an environment where every relocated manufacturing facility has to compete against the principal OEM and other global facilities for production volume, overseas plants face a myriad of hidden challenges.

In countries with volatile exchange rates, model planning has to predict the exchange rate over the life time of the vehicle. With a model life often exceeding 8 years and currency fluctuation greater than 10% per anum, this in itself can be very difficult.

However, while automakers continue to focus on shifting their production facilities to new regions, driven by cost and demand factors, developing a competitive supplier network in these regions remains one of the greatest challenges.

Because auto parts suppliers are sensitive to technology transfers to local third parties, largely because of the potential of low cost competition adversely affecting home production, sourcing economically viable components is often very challenging.

At the same time, high dependence on automakers leaves (home)suppliers vulnerable to pricing pressure and production cuts. Pricing pressure from automakers confines margins of parts suppliers whilst production cuts, driven by frequent market adjustments and overseas supply, negatively affect their operations.

Furthermore: When the principle OEM negotiates contracts with suppliers for both component development and series production, the series production contract already allocates global production volumes.

This makes it extremely difficult for overseas OEM’s to source components from their local suppliers (even if a license agreement exists with the original supplier), as any local production call-off usually requires a new contract with lower global volumes and an increased piece price to the principal OEM.

The future of overseas automotive production

Driven by cost reduction, proximity to market and production volumes countries such as China, India and Mexico are facing boom times. However other automotive nodes such as South Africa are under threat.

Image credit: LMC Automotive (Jeff Schuster)

According to Rick Hanna, head of global consultancy PwC’s automotive division, South African motor industry’s vision of building 1.2-million vehicles a year by 2020 is almost certainly unachievable.

Just 14 months into the government’s 2013-20 automotive production and development program (APDP), industry officials say production is already 30% off the pace. The APDP offers duty rebates to vehicle manufacturers building at least 50,000 vehicles annually, and also returns up to 30% of investments by vehicle and components companies.

For the target to be achieved, at least one global manufacturer would have to spend at least $1bn on a new car plant. The problem is that the country is competing for investment with faster-growing regions like China and India."

South Africa also struggles with an unstable labour environment, low volumes and a volatile currency. "If I was an overseas investor, I would probably put my new factory in China," Mr Hanna said.

Which is exactly what’s happening!

Sources:

• Global automobile production forecast –Market business news (MBN)
• Auto Industry Stock Outlook Feb 2014 – Zacks.com.
• SA’s thriving car industry ambition ‘set to crash’ – Business Day Live (David Furlonger)
• Why Australia's auto industry is going the way of the dodo - Automotive News (Hans Greimel)
• Transport and environment – report March 2013

Peter Els is a technical writer for Automotive IQ