Entering the ultra-low-cost car segment, as India’s Tata Group intends to do with its $2,500 Nano car, is fraught with rewards and risks, an A.T. Kearney study finds.

While the profit margins are razor thin on ultra-low-cost cars (ULLCs), which the consultancy defines as those costing $5,000 or less, the volume potential is great, especially in emerging markets such as India.

“Literally the (profit) margins are 2%-3% on ULCCs,” Dan Oxyer, vice president, A.T. Kearney, tells Ward’s in an interview. “That’s amazing and alarming, because the smallest misstep in the launch process, or commodity indexes continuing to increase, will further erode those margins.”

Today, there are only 10 vehicles in the low-cost car (LCC) segment, defined as those vehicles priced at $6,000 or less. But the sector is growing at an incredible rate, with volumes expected to reach 17.5 million units globally by 2020, largely driven by India and Asia, with the exception of China, which has experienced a 5% decrease in the segment over the past five years due to increasing consumer wealth.

India has seen the world’s largest growth in the LCC segment, with an 85% jump in the last five years. LCCs now represent 82% of all vehicles in the country, the study finds. While the LCC sector is fairly well established, the ULLC segment is in its infancy, making volume growth difficult to determine.

But when Tata surprised the world earlier this year with its plans to launch the Nano this fall, it set off a “flurry of excitement in the (ULLC) segment,” Oxyer says, noting both Hyundai Motor Co. Ltd. and the Renault SA-Nissan Motor Co. Ltd. alliance have since announced they are developing their own entries.

Shortly following Tata’s announcement, A.T. Kearney began the first part of its study by interviewing three global auto makers and three suppliers, with most of the questions focusing on what it takes to succeed in the blossoming segment, as well as how to avoid possible pitfalls.

Perhaps the greatest benefit of entering the ULCC segment is the opportunity to learn a new way to manufacture a car that focuses on cost reductions across the board.

Oxyer says Tata took a unique approach in the development of Nano, beginning with a clean slate and disregarding the past.

“The traditional approach you take in product development – engineering, manufacturing and distribution – won’t work,” he says. “You will not make the (price) entry point to compete in this segment if you use traditional approaches. The paradigm needs to shift.”

German supplier Robert Bosch GmbH, which played a significant role in the development of the Nano, provides a prime example of how to enter the ULCC segment successfully, the study says.

Bosch took a “no thrill” engineering approach in the development of the Nano by concentrating on the essentials and avoiding non-functional parts.

Rather than utilizing its extensive European product-development expertise, Bosch turned to Indian engineers, most of whom develop motorcycles.

In fact, some of the components used in the Nano are modified motorcycle parts, such as the starter engine. Bosch also took cost out of the program by stripping down the engine-control unit and redesigning sensors for size and weight.

Key to the success was early collaboration between Tata, Bosch and other suppliers, says Shiv Shivaraman, a principal with A.T. Kearney.

“Tata had very aggressive cost targets,” he says. “Most (suppliers) that participated and were successful said it was challenging and difficult, but it allowed them to do something different. They said, ‘(Tata) didn’t give us a hard set of specs and say you have to do only this.’ It was a collaborative effort with aggressive cost targets.”

While the ULCC segment can be risky, those auto makers that choose to enter it can learn new and lean manufacturing techniques and gain an advantage over their competitors, the study finds.

Additionally, start-up suppliers that were formed specifically to serve auto makers in the segment eventually may adapt and grow their capabilities and pose a threat to established part makers, Oxyer says.

“Established suppliers could potentially fall into a low-cost trap,” he says. “OEMs set target prices for the suppliers for their commodities, and it’s very well known what the build-up of a unit price would be.”

However, if a new supplier “with an ultra low-cost clean-sheet approach develops a new product to meet those specifications, it could drive new standards and new target prices from the OEM to the supplier,” Oxyer says.

While there are opportunities for those choosing to enter the ULCC segment, there also are obstacles.

“You need to have a very clear market-entry development strategy, not just for India and Asia, but also for export to the Middle East, Africa and other emerging markets,” Shivaraman says. “So you need to look at how you are going to enter the market and how you’re going to grow out from there, because you need to have volume (to turn a profit).”

Developing a distribution channel is another challenge, Shivaraman says, because traditional methods are too expensive. “So you need to have alternate distribution approaches and to think about how it’s going to impact your branding.”

Additionally, with the segment’s slim 2%-3% profit margin, any significant fluctuation in the cost of steel or another essential commodity could quickly lead to a sea of red ink, Shivaraman says.

“The Nano is $2,500, so even at a 3% profit margin you’re making $75 a car,” he says. “If your material costs are increasing by 19% or 20%, suddenly it starts eating away any profit you have.”

To avoid this potential financial disaster, A.T. Kearney suggests three possible solutions: raise prices, increase volume so that fixed costs are spread more evenly or further reduce costs.

The latter solution could prove the most difficult, Shivaraman warns.

“(Further cost reduction is) going to be a little more challenging, because you’re doing a clean-sheet design here,” he says. “You started with the best possible approach, the cheapest avenue, so it’s going to be more challenging.”

More established auto makers may enter the segment by de-contenting pre-existing vehicles or reintroducing a vehicle that has been discontinued in developed markets, Oxyer says.

However, even this approach poses potential dangers, including an auto maker cannibalizing sales of other vehicles in its lineup.

A.T. Kearney’s study represents phase one of a 3-part project. The second phase entails speaking to more auto makers and suppliers about the market, while phase three, which launches this fall, involves securing a Nano to disassemble and study or test drive.

Ultimately, the ULCC segment is promising, Shivaraman says.

“It’s a good place to be because we believe the market is real and we believe it’s growing and is going to grow even more,” he says. “As discretionary income (in emerging markets) increases, consumers will move up in segments. We believe those (auto makers) in the (ULCC) market early can capture consumer loyalty and will have a better opportunity long-term.”