Incentives

Can't live with 'em. Can't kill 'em.

Incentives are the nagging contradiction of today's auto industry. Whether you view them as carrots or crack, they are credited with bolstering sales to keep assembly plants humming and cash flowing — but condemned for draining bottom lines, eroding brand equity and feeding a consumer addiction to discount pricing.

Consciously or not, this new reality is prompting seismic shifts in how auto makers conduct business today, and long term, changing everything from the way new cars and trucks are designed and built to how they are marketed and perceived.

By some accounts they've taken on superhero qualities. General Motors Corp. was credited with “saving the U.S. economy” when it rolled out 0% financing post-Sept. 11.

But incentives also have toppled the mighty. DaimlerChrysler AG canceled plans for a greenfield plant to build the Dodge M80 pickup in Windsor, Ont., Canada, and tabled approval of a plant in Pooler, GA, to assemble the Sprinter cargo van — due to “marketplace conditions.”

Incentives also are blamed for knocking Chrysler Group financially off track in 2003. After two years of layoffs, pay cuts, plant closures and pressure on suppliers, incentives have dealt a devastating blow in the third and final year of a turnaround plan that previously had reached all milestones.

Incentives forced Chrysler to revalue half a million vehicles in inventory — and some key executives. Former President James P. Holden was shown the door in 2000, and ex-marketing head James Schroer abruptly resigned in May — scapegoats for incentive-related losses.

The latest incentive fighter is former Stuttgarter Joe Eberhardt, charged with weaning Chrysler off inducements to build Mercedes-like value around new, “gotta-have” product.

That won't happen overnight, he says, noting Audi AG spent 10-15 years moving upmarket.

Brand-building is on hold during a summer incentive drive, but Chrysler insists it is not abandoning that long-term strategy. “It will work, it will happen, it will just take longer than expected,” says Eberhardt.

Without incentives, Eberhardt suspects U.S. sales would be 2 million to 3 million units less.

Industry insiders admit, ultimately, there is no way out.

“We are struggling with (this),” Eberhardt says. “We're having brainstorming sessions (but) not coming up with too many things at this point.”

Rick Wagoner, GM chairman and CEO, says: “We'll probably never get zero incentives.” “When you have an old product in its lifecycle vs. competitors, then you need incentives.”

But such admissions may be the first step to recovery — or at least dealing with the addiction.

“It's the crack cocaine of the auto industry,” sums up Dennis DesRosiers, president-DesRosiers Automotive Consultants in Richmond Hill, Ont., Canada. He says incentives are the drug of choice because the cost is predictable, unlike leasing, which requires too much guesswork in calculating residual values.

“Manufacturers and dealers together created the monster that got consumers hooked,” confesses a Chevy dealer.

Incentives date back to 1912 when Henry Ford promised rebates on Model Ts. They matured in the 1950s with end-of-year clearouts. After the 1973 oil embargo, auto makers offered money back in the formerly taboo winter and spring selling seasons. GM reached new heights with 0% financing on popular and all-new vehicles.

The nature of the beast has changed over the years, switching between dealer and consumer incentives, lease and cash. Today it has become the 800-lb. gorilla everyone is afraid to stop feeding.

“Inducements have always been part of the industry, but they are past the point of rationality,” says Jim Padilla, president-Ford Motor Co. North America. “When it was an 18-million market, there still were some products that needed some juice. We've always had (incentives) to some degree. Now we have them to a large degree.”

Today the Big Three shell out on average $3,389 per unit, discounts needed, in part because higher quality is tempering the replacement cycle.

“I don't know how you go back to a level of incentive that is just a moderately competitive leasing deal and normal dealer spiffs,” agrees Joe Phillippi, AutoTrends Consulting in Short Hills, NJ. “The customer is so conditioned to expect a deal 365 days a year.”

GM marketing head John Middlebrook says he hopes sales inducements will moderate, “but we're certainly not looking at them going away. When you pull back, you get killed really quick.”

GM, which sets the pace in spiffs, remains unapologetic. “Nobody else has to follow,” says Wagoner. But the reality is, they must — and do.

As the low-cost producer among the Big Three, GM can afford to call the shots. It spends 62% of revenues on labor, parts and distribution, compared with rival Chrysler, for example, which must allocate 68% of its take to variable costs.

“A smaller player can't lead the pullout,” says Tom Gorman, general sales manager-Ford Div. “GM or Ford has to do it. Chrysler is too small to do it.”

Although GM Chief Financial Officer John Devine says “the sky is not falling,” the financial hit auto makers are taking in the U.S. is hard to ignore.

Besides DC's unexpected $1.2 billion second-quarter loss, neither Ford nor GM's earnings are close to pre-Sept. 11 heights.

“Profit and loss statements show (the OEMs) are in bad shape (because of incentives),” notes DesRosiers. “GM makes all of its money selling mortgages.”

Ford used to set aside 7% of revenue to pay for sales. “Today it's double that, and that's irrational, especially since profit margins emphasize the need for back to basics,” says Padilla.

The big threat on the horizon is deflation, though some observers say that curse already plagues the industry, which has been wringing out costs as it struggles to hold the line on car prices. “It's as close to deflation as it can get,” says DesRosiers.

On the bright side, the stock market has rallied recently, and indications are corporate capital spending is loosening up. The Federal Reserve's latest interest-rate rollback may not spur sales as sharply as in the past, but should join the Bush tax cuts in goosing new-car demand.

Ward's forecasts a 16.6 million seasonally adjusted annual rate during the second half of 2003, up from 16.0 million in the first half. The year is forecast at 16.3 million, and continued improvement is expected into 2004.

“It's certainly a good time for consumers to come to market, and we hope there will be less (incentive)pressure as they do,” says Gary Dilts, Chrysler senior vice president-sales.

A little easing actually could pay off for some buyers. While today's market represents a buying bonanza for most, some customers are caught in what Schroer has dubbed the “incentives doom-loop,” whereby incentives cut resale values of used cars, giving buyers a smaller trade-in against a new vehicle.

“Without incentives, consumers will keep driving current vehicles,” says DesRosiers.

And selling cars in today's deal-of-the-week environment isn't quite like shooting fish in a barrel for dealers. Incentives move metal, but some dealers say they are feeling more like warehousers than retailers, operating holding pens for inventory until the next round brings buyers back.

“We're becoming order-takers in the front and trying to make money in the back end and with used-vehicle sales,” says Lee Kemp, owner of Forest Lake Ford in Forest Lake, MN.

The discounts also are taking cash out of the register, according to Kemp, who says profit margins for Ford dealers in his region have slipped to $1,200 for trucks and $962 for cars, with a big chunk of that diverted to financing vehicle inventory.

Customers, conditioned to seek better deals, are willing to play the waiting game. “You get customers every day who say, ‘Maybe if I wait another two weeks, I'll get something better yet,’” says Rich Douglas, general sales manager at DeFouw Chevrolet BMW in Lafayette, IN. “And normally they do.”

When dealers reel them in with 0%/60-month financing, it means buyers aren't due back for five years.

Still, dealers agree they'd rather put up with the incentive baggage than go without. “I guarantee you, if they took off incentive programs, business would stop,” says Douglas.

Suppliers also profess a love-hate relationship. Spiffs maintain demand for parts but take their toll on the bottom line, especially when suppliers are forced to compete on price with producers in low-wage countries such as China.

“How do you find $3,000-$5,000 to put into each glove-box? You beat up on suppliers,” says DesRosiers. “You start seeing plants closing, companies going under.”

But the incentive debate has an upside. The deep discounts often are enabling buyers to order more car or truck for their money and move into higher-line vehicles they otherwise could not afford.

On an apples-to-apples basis, Edmunds.com says new vehicle prices dropped 0.3% between April and May, but its research also shows many consumers are spending their savings on better-equipped, more luxurious vehicles. Edmunds says average transaction prices are up $1,290 from a year ago to $26,442.

“Clearly the mix has been getting richer,” says GM's Middlebrook.

Plus, OEMs have snuck in price increases to make up some of the rising cost of sales, but few can count on that solution.

Edmunds says GM is getting 14.5% more for its GMC Sierra 2500 pickup than it was a year ago, for example. “Wherever we (can), we look for the opportunity of raising and retaining price,” John Smith, GM group vice president-sales, service and marketing, tells analysts.

But few suggest sticker prices are making up the full difference — especially for the Big Three, which are being squeezed by overcapacity and high retirement and health care costs that add as much as $1,200 to the price of a Big Three vehicle.

GM's retired U.S. workers now outnumber actives 2.5:1, and its worldwide global pension obligation reportedly totaled $92.2 billion at the end of 2002. By contrast, Toyota Motor Corp.'s tab is $13 billion.

To pay the legacy costs, the Big Three need to keep plants running and cash flowing. “They don't have a choice,” says Philippi. “They've got to throw money at the market or cut capacity — but (either way) they would still have all the people and all the legacy costs.”

Says Wagoner, “In the old days you could lay off people. Today we can't — we carry the cost with (us). It makes more sense to lower the price and try to keep the volume going.”

Foreign OEMs have avoided many of the ill effects of the incentive-charged U.S. market. But no auto maker is immune.

Today, Japanese OEMs are spending an average $1,062 per vehicle while Korean brands are doling out $1,371 and the Europeans $1,945.

Nissan North America Inc. held off pricing its new Titan pickup to better gauge the market, and Mitsubishi Motors North America was badly bitten by the incentive frenzy. It now is dealing with $304 million in bad loans and bulging inventories that are forcing it to turn to fleet sales — the “superincentive.”

“Most manufacturers have the gloves off,” including the foreign nameplates, says GM's Paul Ballew, general director-sales and industry analysis. “We're going to see more of the same in the second half.”

Driving incentives is overcapacity. Many manufacturers are building too much of what consumers don't want. Ward's estimates by 2005, when a new Hyundai Motor Co. Ltd. plant is running, North America will have the ability to produce 19.1 million vehicles — about 10 plants more than needed to hit the sales sweet spot of 16.5 million. That takes into account likely plant closings by Ford and GM. Chrysler already has closed seven plants as part of its restructuring program: three vehicle assembly, two engine and one transmission facility.

Already there is at least one vehicle for every person in the U.S. of driving age, says DesRosiers. “The market is fully absorbed with affordable, quality vehicles. In the next two to five years, 6-10 assembly plants have to disappear. All will be Big Three and unionized.”

Harbour Report data highlights the problem: Chrysler's profit per vehicle fell to $226 last year from an industry-leading $1,497 in 1999. GM makes just $701 compared with Nissan's $2,069 and Toyota's $1,214.

“More capacity than demand suggests what we're seeing in terms of negative net pricing,” points out Mark Hogan, GM group vice president-Advanced Vehicle Development.

But the solution won't come solely from closing plants, executives say. Out-of-the-box thinking is required. More efficient engineering, flexible manufacturing, compelling products and better branding will play a role in the industry's effort to wean itself away from incentives.

Simple as it sounds, the manufacturer with the best products and lowest costs wins — today more than ever.

On the engineering side, auto makers are working to reduce development time to 24 months or less to respond quickly to market trends.

And they're trying to reduce cost up front during design.

“Profits equal revenue minus cost,” points out Mike Donoughe, Chrysler vice president-family vehicle product team. “If revenue on a transaction is decreased, the only way for corresponding profits to be viable is to address the cost base.”

Incentive costs are showing up as new line items in budgets and contracts, executives admit.

Hogan says GM now weaves in expected incentive costs that must be offset when building a business case for a new model. The auto maker already has cut its product development budget 47% over the last six years and is aggressively cutting its number of component sets. The goal is to eliminate much of the re-engineering that goes into creating a new model — the forté of Toyota and Honda Motor Co. Ltd.

GM's 2006-2007 target is to be able to pull 75% of a new vehicle's components off the shelf, up from about 50% today. “We do an exhaustive teardown and set the budget at what we need to be competitive and work backwards,” says Hogan.

The auto maker's global architectures also give it the kind of money-saving volume few competitors can match, says Jim Queen, vice president-GM North America Engineering.

Recent financial difficulties have increased focus on the cost side at Chrysler, as well. “Now, it's like having your head shoved under water and if it doesn't work on the cost side, the head doesn't come out,” says Donoughe.

At Chrysler, engineers aim for about 80% carryover parts for a “top hat” (an existing underbody, chassis, electric system but new interior and sheet metal), while all-new vehicles shoot for 40%-50% of its parts from the bin, says Donoughe.

Ford's motto is simple: No cost gains on new products from '07 to '08 to '09. “It's a tough way to run a business, but we have to do it that way,” says Mathew Demars, executive director-Ford Tough Trucks. “Our jobs are to get the cost out of the products. The low-cost producer wins.”

The battle also must be waged in the factory. It starts with flexibility. Ford hopes to save $1.5 billion-$2 billion by turning 12 assembly plants into fully flexible operations each capable of producing up to eight models on at least two different platforms. And others are following suit.

“The days of a 500,000- to 1 million-unit run for one body style are over,” declares GM's Hogan. Except for pickup trucks, “50,000 to 100,000 units is the new norm.”

That's a wrenching change for OEMs that have built an industry on massive single-platform plants. Making profits in a run of 50,000 units is one thing, doing it with 10 or 20 models at once in order to burn up that 500,000- to 1 million-unit capacity is no small task.

And it's tough without a crystal ball to accurately predict which vehicles at 50,000 units will be hits, which will be duds and which will need more capacity, says Thomas LaSorda, Chrysler executive vice-president-manufacturing.

Even with a flexible plant, changeovers take time. Dies, underbody and powertrain may be turned around in nine months, but suppliers likely need more lead time.

LaSorda points to the Chrysler PT Cruiser as a prime example. “It was a bigger hit than we expected and when we got more capacity, it was too late.”

Chrysler also increasingly will rely on “business flexibility,” with suppliers as partners owning and operating assembly plant paint and body shops.

“I believe it is truly going to be our long-term strategy for most parts of the world,” LaSorda says of the manufacturing concept that was to be used for the scuttled M80 project and remains “fundamentally solid.”

Competitors aren't buying into such a radical concept.

“I'm not willing to jump off that ship,” says Ford's Padilla. “Let them do it. I'll watch.”

GM's Hogan, who once tried to pioneer a similar approach under the guise of the Yellowstone Project, doesn't advocate the Chrysler plan because of concerns about quality. “The core of our business is (to build) dimensionally excellent bodies and paint them flawlessly. It's the area we're least likely to outsource.”

Hogan advocates eliminating the costly infrastructure altogether. “Ultimately, our vision is to build assembly plants that don't require body or paint shops,” he says, picturing a future of molded-in color plastic body panels and racing-car-like hydroformed and bent-tube space frames.

But all the cost cutting in the world means nothing without an exciting portfolio for which customers will pay full price.

“It all comes down to product, product, product,” says DesRosiers. “Product drives problems and provides the solution. The unfortunate thing is product takes years to work.”

The proof is in the marketplace where, despite huge incentives, the U.S. Big Three have failed to prevent their combined share from eroding.

More than a full point of penetration has slipped away so far in 2003 — mostly at the expense of GM, the one calling the shots on incentives.

“It's hard to claw share back,” notes Philippi. And the consensus is that incentives are losing some of their draw.

“Everyone is shouting a deal, even the imports. How do you stand out?” asks Ford's Gorman, mindful of how much incentives are eating into limited marketing dollars.

“When everybody has $3,000, $4,000, it becomes the norm,” says Chrysler's Eberhardt. “It doesn't move anything.”

The ultimate answer is to cultivate a high-quality, “aspirational” image that will encourage consumers to pay top dollar, executives say. “The product's what's going to have the reputation,” says Toyota Div. General Manager Don Esmond. “The product's what's going to last in the long run.”

“If you are a market-driven company and are more intelligent on your production, you don't get forced into (incentives),” contends Volkswagen of America Inc. marketing head Frank Maguire.

The long-term threat of incentives to brand equity is real, analysts say. The question for the Big Three is, how much damage already has been done?

“They're overwhelming the brand image with a distressed-merchandise image,” says one multi-franchised dealer.

“If somebody's buying on price and not on brand, they're more likely to do so again in the future,” says Lincoln Merrihew, practice leader-Automotive Group for Compete Inc. “You might have to spend a lot of money to get them again.”

Domestics, in particular, need a more consistent brand and marketing philosophy to fight back. Bouncing between incentives and trying to establish brand equity confuses customers and won't work in the long run, says Merrihew.

“It's tough to build brand today,” admits Tom Marinelli, head of Chrysler marketing.

The importance of new product means auto makers must guard against cuts in new vehicle programs as part of the solution, LaSorda cautions.

Toyota can afford more content “by not spending on incentives,” says Esmond. “When you spend huge incentive dollars, those dollars go (right) out of the tailpipe.”

Solutions include better cycle planning to phase in new body styles and exclusive features at critical junctures, helping keep demand closer to peak levels.

Better long-term quality also is key. J.D. Power moved up its Vehicle Dependability Index survey to three years of ownership from five because OEs are eager to match Honda's ability to parlay its durability record into an additional $1,500 per vehicle at resale.

Among steps taken so far, each of the Big Three has joined upscale competitors in forming performance divisions to elevate their marques. These low-volume, higher-profit vehicles are designed to rev up revenue by adding higher-output engines and sporty effects to mainstream models.

Auto makers also are aggressively chasing a bigger share of the $25 billion accessories market to make up profit shortfalls.

Toyota expects to sell $1,000-$3,000 in accessories with each spartanly priced Scion-brand vehicle.

GM is hoping to turn every model into a Hummer H2, where the average transaction includes $2,000 in accessories.

“It's viewed as an important revenue stream,” says Nancy Philippart, GM accessories.

In the end, success stems from a “fantastically complex” formula of supply, demand, product and marketing, notes Merrihew. There always will be weak players and underperforming vehicles that need the push incentives can provide.

Encouraging is the way every facet of the industry is starting to assume ownership of the problem. The economy may help, but won't address fundamental weaknesses incentives have made glaringly apparent.

A cure won't happen overnight. Some stakeholders will be forced to swallow more medicine than others, and not all may survive. But the will to live is growing with each quarter and few believe the current madness can continue.

“Somewhere the insanity has to stop or something will give,” concludes DesRosiers. “The industry will either choose to deal with it, or be forced to. Adam Smith's ‘invisible hand’ is more powerful than any auto company and, at the end of the day, he'll have his way.”
— with Brian Corbett, Steve Finlay, Kevin Kelly and Katherine Zachary

Highest Incentives:

Lowest Incentives:

Source: Edmunds.com

Europe Has Its Own Incentive War

European auto makers refusing to join the U.S. incentives war on claims it will dilute the value of their brands obviously are not taking cues from their home markets, where there is intense pressure to pump up sales.

Sagging sales are forcing European makers to study how U.S. counterparts are keeping their plants running and metal moving on showroom floors through the use of incentives.

But unlike the U.S. market, where 0% financing has been the rage, the European market lacks the means for such tantalizing new-car deals.

That's because offering 0% financing across the board is more costly in Europe than in the U.S.

Up until June 6, when it dropped to 2%, the European Central Bank's key refinancing rate was stuck at 2.5%, roughly double what the U.S. Federal Reserve was charging on its Fed Funds rate, discouraging many European auto makers from selling 0% financing on a widespread basis.

Instead, the manufacturers are turning to a popular U.S. vehicle-buying method: leasing, a relatively new retail phenomenon in Europe that seems to be catching on. But auto makers also are exploring other creative ways to lure potential customers, as well.

BMW AG is offering three years of complimentary service on its aging 3-Series and 5-Series cars in certain Western European markets. Similar programs are in place for some Daihatsu, Mitsubishi, Saab and Volvo vehicles.

European consumers also can receive one or two years of free service on select Honda Motor Co. Ltd. vehicles. Those looking to save money on their auto insurance costs can opt for one year of free insurance in certain countries, and some brands are adding optional equipment as standard features to entice buyers.

All of these inducements are having a lasting effect on the European auto industry. Plants must become more flexible to produce a number of vehicles off the same platform to meet rapidly changing consumer tastes.

In Douai, France, for example, Renault SA is embarking on a plan to turn its factory into a niche-vehicle builder with maximum flexibility.

The plant currently is producing the new Megane II and Megane coupe/cabriolet and is poised to add the Megane Scenic II MPV (multipurpose vehicle), as well as the long-wheelbase, 7-seat version of the Megane Scenic II, in the coming months.
— Kevin Kelly

INCENTIVES SPECIAL REPORT

For more coverage on incentives and additional stories and statistics, go to WardsAuto.com and click on the “Incentives Special Report” button.