Incentives. Can't live with 'em. Can't kill 'em.
They 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 shown an ability to topple the mighty.
They're blamed for knocking Chrysler Group financially off track in 2003. After two years of layoffs, pay cuts, plant closures and relentless 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.
Industry insiders admit, ultimately, there is no way out of the trap.
“We'll probably never get zero incentives,” says Rick Wagoner, GM chairman and CEO. “When you have an old product in its lifecycle vs. competitors, then you need incentives.”
But admissions like that 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 new drug of choice because the cost is predictable, as opposed to leasing, where calculating residual values involves too much guesswork.
Today the Big Three are shelling out an average of $3,389 per unit, discounts needed, in part, because higher quality product is protracting the replacement cycle.
“Without incentives, consumers will keep driving their current vehicle,” says DesRosiers.
“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 is setting the pace in spiffs, remains unapologetic.
“Nobody else has to follow,” says Wagoner.
But the reality is, they must — and do.
GM, as the low-cost producer among the Big Three, 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 believes “the sky is not falling,” the financial hit auto makers are taking from the competitive environment in the U.S. is hard to ignore.
In addition to DC's sudden, 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 the cost of sales. “Today it's double that, and that's irrational, especially since profit margins emphasize the need for back to basics,” says Jim Padilla, executive vice president and president-Ford North America.
The big threat on the horizon is deflation, though some observers believe that curse already is plaguing the auto industry, which has been wringing costs out of every nook and cranny as it struggles to hold the line on new-car prices. “It's as close to deflation as it can get,” says DesRosiers.
On the bright side, some see signs of a rebound. The stock market has been rallying in recent weeks and indications are corporate capital spending could loosen up in coming months. The Federal Reserve's latest interest-rate rollback may not spur sales as sharply as in the past, but it won't hurt industry profits either. And the Bush tax cuts should help goose new-car demand.
A Ward's forecast calls for a 16.6 million seasonally adjusted annual rate of light-vehicle sales 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 a little less pressure on the incentive front 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.
But the incentive debate is not without 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 Middlebrook. “Without question, people have been buying up.”
In addition, auto makers have been sneaking in price increases to make up some of that rising cost of sales — but that's a solution few can count on.
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 Wall Street analysts.
Few would suggest the sticker price is making up the full difference — especially for the Big Three, which are being squeezed by overcapacity and high legacy (retirement and health care) costs that can 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, thanks to Japan's national health-care system, Toyota Motor Corp.'s tab is a relatively paltry $13 billion.
To pay legacy costs, GM — and Ford and Chrysler — 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. (They're) in the business of funding pensions, legal plans, health and eye care — with no help from the (United Auto Workers union).”
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 auto makers have proven more adept at avoiding many of the ill effects of the incentive-charged U.S. market.
No one selling here is immune.
Today, Japanese auto makers are spending an average $1,062 per vehicle while the 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,” says GM's Paul Ballew, general director-sales and industry analysis. “We do believe we're going to see more of the same in the second half of the year.”
Driving incentives is overcapacity. Many manufacturers have too much of what people don't really want to buy. Ward's estimates by 2005, when a new Hyundai Motor Co. Ltd. plant is up and running, North America will have the ability to produce 19.1 million cars and trucks — about 10 plants more than needed to hit the industry 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.
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 per unit. Contrast that 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.
The solution won't come solely from closing plants, executives say. More efficient engineering, flexible manufacturing, more compelling products and better branding all 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.
Incentive costs are showing up as new line items in budgets and contracts, executives admit.
GM now weaves in expected incentive costs that must be offset elsewhere in the vehicle program when building a business case for a new model.
All the cost cutting in the world means little without an exciting portfolio compelling customers to 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 — and most of that has come 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.
The ultimate answer is to cultivate a high-quality, “aspirational” image that will encourage consumers to pay top dollar, executives say. “The product is what's going to have the reputation,” says Toyota Div. General Manager Don Esmond.
“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 and again.”
In the end, success stems from a “fantastically complex” formula of supply, demand, product and marketing, notes Merrihew. And there always will be weak players and underperforming vehicle lines that need the push incentives can provide.
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.”
— with Brian Corbett, Kevin Kelly and Katherine Zachary
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Incentives: They Are Older Than Many People May Think
Incentives date to 1912 when Henry Ford promised rebate checks to Model T buyers.
They entered the modern era in the 1950s with end-of-model-year clearouts.
The practice escalated following the 1973 oil embargo, as auto makers offered money back in the formerly taboo winter and spring selling seasons. It was taken to new heights with GM's 0% program that covered even 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, Ford Motor Co. executive vice president and president-Ford 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.”