## University of Michigan Report Finds Focus on Fuel Economy Would Be Very Profitable for Detroit 3; Says Rapid, Wide-Reaching Change in Business Models Required for Turnaround

##### 23 June 2009
 According to the study, higher fuel economy standards would benefit the Detroit 3 automakers the most. Source: McManus and Kleinbaum. Click to enlarge.

A new report released by the University of Michigan Transportation Research Institute (UMTRI) analyzes critical choices faced by automakers and finds that broad, deep, fast change is necessary for success in the context of the worst financial crisis in the history of the domestic automobile industry.

According to the report, “Fixing Detroit: How Far, How Fast, How Fuel Efficient?” successful turnarounds hinge on rapid cultural transformation, which requires replacement of management teams. Further, the report finds that the existing culture within the domestic auto companies systematically underestimates the value of fuel economy, which has crippled profitability.

Modeling the impact of increased fuel economy standards, the study finds that an industry-wide mandated increase in fuel economy of 30% to 50% (35 miles per gallon to 40.4 mpg) would increase Detroit automakers’ gross profits by roughly $3 billion per year and increase sales by the equivalent of two large assembly plans. The chance that increased profits could exceed$6 billion is 18% if fuel economy standards were increased to 40.4 mpg, but only 6% if standards remain at the mandated 35 mpg.

Our findings support rapid, wide-reaching change in business models. The key to a long-term recovery is executing an excellent portfolio of products, and we find that increasing fuel economy standards will lead to a portfolio of products that is more likely to raise the profits of the Detroit 3 automakers than to lower them.

—Walter McManus, director of UMTRI’s Automotive Analysis Division and co-author of the report

Rob Kleinbaum, a former GM employee and consultant and report co-author, said the industry attitude about fuel economy is symptomatic of its current culture.

For years it has discounted consumer research results when calculating the benefits of improving fuel economy, often by as much as two thirds. If GM had followed its own market research results over the last three decades, they would not be in Chapter 11 today.

—Rob Kleinbaum

The authors analyzed extensive literature on the successful turnaround of six international companies of comparable size, diversity and distress to the domestic automobile industry. Research revealed universal approaches critical to success:

• Implement Broad, Deep, Fast Change: All successful efforts addressed the fundamental issues that drove them into crisis and they did it as fast as possible.
• Replace Management Team: In addition to changes in strategy and structure, in all cases there were widespread changes in management.
• Transform Culture: All of the successful companies considered changing culture a critical requirement and made it a top priority for success.
• Build a Portfolio of Excellent Products: The path to long-term financial health of any company rests on having a great product portfolio. Our domestic auto industry, in its modern incarnation, has never been able to execute an excellent portfolio, only isolated successes.

Fuel Economy. The report models the impact of three different fuel economy standard increases—30% (35 mpg), 40% (37.7 mpg) and 50% (40.4 mpg)&madsh;on the profitability and sales of the industry and separately for the Detroit 3, the Japan 3, and all others. The model captures the cost of fuel economy improvement on suppliers, its impact on pricing and the resulting changes in demand. The inputs to the model are the most recent and accepted estimates of all the key parameters, but since there is debate on many of these values, the report conducts an extensive sensitivity analysis on the results.

Modeling results include:

• The Detroit 3 gain profits over base in all scenarios, with the largest profits gained from pursuing more aggressive fuel economy.
• Japanese automakers’ profit gains are smaller than the Detroit 3, with the smallest profits gained from pursuing a 50% increase (40.4 mpg) in fuel economy.
• At a 50% increase, the Japanese industry loses sales while the domestic industry continues to gain in sales and profitability—a result driven by the different starting points.

The value given to fuel economy by automakers has critical impact moving forward. According to the report:

• There is compelling evidence that the Detroit 3 have systematically underestimated the value of fuel economy to customers.
• Because Detroit 3 automakers have long underestimated the consumer value of fuel economy, raising fuel economy standards will not cost more than consumers would be willing to pay.
• In every scenario, the average cost per vehicle (direct plus indirect) is less than what consumers would be willing to pay.

In a sensitivity analysis conducted on inputs to the model, the report finds:

• The chance that increased profits could exceed $6 billion is 18% for a 50% increase (40.4 mpg) in fuel economy, but only 6% for a 30 percent increase (35 mpg). • There is a 7% chance that profits would be less than zero if fuel economy standards were increased to 35 mpg, and a 15% chance of profit loss if standards were increased to 40.4 mpg. • Three of the factors had extreme values capable of generating a drop in Detroit 3 profits: a gasoline price of$1.50 per gallon (a price not seen since 1999); extremely low consumer response to fuel costs relative to vehicle prices; and direct manufacturing costs (materials and labor) that are more than twice the estimates used by McManus and Kleinbaum and three-to-four times National Research Council estimates (adjusted for inflation).

The sensitivity analysis of the impacts on profits showed that only a few factors could reverse our finding that profits of the Detroit 3 automakers would increase under higher fuel economy standards: relative value consumers put on fuel costs compared to vehicle price, the future price of fuel, and the level of direct costs to improve fuel economy. While the three factors could result in losses rather than gains in profits, the potential losses are relatively small, and all three factors have much more upside than downside. The total risk and reward profile of these scenarios is very positive, with only a small chance of losing and a very large probability of gain.

—McManus and Kleinbaum (2009)

The new report builds on studies published by UMTRI beginning in 2005 predicting that the three biggest domestic automakers stood to lose billions in profits and thousands of jobs in the event of an oil spike—a prediction borne out as Hurricane Katrina and tensions around the world sent prices skyward. The studies documented the financial risks to Detroit automakers and the risks to American jobs of higher fuel prices, and predicted that gas prices more than $3 per gallon could lead to combined losses of$7 billion to $11 billion of profits for Detroit automakers. By the time gasoline prices spiked to more than$4 a gallon in July of last year, Ford and GM had already reported combined losses on their automotive operations of more than $57.2 billion. And through the first quarter of this year their cumulative automotive operations losses since 2004 total$83.6 billion. In addition, they have lost 14.2 points of market share since 2004 (GM down 8.8 points and Ford down 5.4 points).

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Surely quick solutions to this would be to produce more European-based models with a wide variety of engines - Vauxhall's Corsa, Astra, Vectra and so on, and Ford's, Ka, Fiesta, Focus and Mondeo etc, whilst Chrysler introduce Fiat models (perhaps rebadged as Chryslers to make them more paletable for the US market).

Some of these, even none Diesel versions can be very efficient by comparison, although transmission is a factor to consider as well. Autos are traditionally less efficient than manuals and often rob 10% or more economy, but then better ratios may alter this.

This report is incredible in almost every point.
The statement “Three of the factors had extreme values capable of generating a drop in Detroit 3 profits: a gasoline price of $1.50 per gallon ..” is only one of the more astounding. They seem to mix the Detroit-3 striving toward better MPG and mandated MPG. And then the verifications of their predictions at the end does not ring true “By the time gasoline prices spiked . . . . . . , Ford and GM had already reported combined losses . . of more than$57.2 billion.”
Did they predict Japanese losses also?
I think the sudden losses were largely due to the economy.
I just cannot see how very much of this could be true.
Maybe they figure this will get coverage and the refutation will be ignored, particularly with the present public attitude.
But I await review by industry experts.

Did they factor in the amount of kickback money from the oil companies that they will be losing.

Before you scoff. Do you really think that the hundreds of millions the car companies have spent fighting CAFE over the last 3 decades didn't come from the oil companies.

I agree the oil companies probably wanted low CAFÉ as badly as anyone.
They would have been fools not to aid the auto companies in opposing higher CAFE and, with cash, when/if the Big-3 needed it.
But because of their lead, investment, profits in large vehicles and inability to make affordable small cars, the Big-3 also desperately wanted low CAFE.
As did the UAW, for the same reasons.
To assume the oil companies DID cooperate illegally or unethically with the auto makers, to some extent at least, just because it was in their best interest, is rational.
But this behavior is true for both political parties, all presidents and – well - all of us.
To assume they are heinously evil, just because they opposed CAFE is NOT rational and is the type of paranoia that diverts us from useful efforts.

JosephT, i'm not scoffing but i don't think you need to go there to explain big-3 fighting CAFE. They just didn't want to spend $on more engineering. Also, Americans never embraced fuel efficient cars in the past. On the contrary, they embraced fuel hogs. - Let's hope they get it now and can start cranking out some EV's quickly. I personally predict that once the option to buy EV is made available, the public will embrace them, as they did dvd's, cd's, vcr's, etc. Yes, the way to go is forward. I don’t have a lot of hope for EVs from the Detriot-3, but that’s the way forward. I do not have time to read the post carefully and would encourage someone to paraphrase or otherwise analyze it. I am still amazed. Even the part about replacing the management team is a little odd. This would be hard to criticize; many believe this goes without saying, except they justify it based on “six international companies of comparable size, diversity and distress . . “ ? Sounds like a simplistic justification for a solution. Sounds more like a bunch of dipwits trying to seem relevant. The us car companies fell the way they did simply because tax deals made years ago to keep high paying jobs in the us combined with red tape to straightjacket the car companies into keeping those workers no matter what combined with not one but TWO generations of people who prefer anything BUT a car made by the big three.. combined with a skyrocketing healthcare and pension cost and finaly combined with the baby boomers retiring/dieing. The result was hopeless from the get go. And they are still hopeless. Who is REALY gona buy a gm or crysler? I sure as hell wouldnt even 3 years ago I bloody well wont now. I only wanted them to bury billions into h2 and ev and the volt so that when they went belly up someone USEFUL would buy that up and.. make a CAR with it. I mean buying a gm is like shopping at kmart and buying a crysler is like shopping at ... radio shack. Only worse.. at least if I shop at kmart I can destroy the bags and act like im not white trash. The mass conversion to electric cars will be fast and ruthless. I predict it will begin in 2012 and be mostly complete 5 years later. Like with digital cameras, the instant someone produces one that is competitive in performance and price, a light bulb will go off in the minds of the consumer. But the transition will be faster than it was to digital photography, because unlike with digital photography when it was emerging, the EV technology is now well advanced and just waiting to be let loose. And we are getting close to having that competitive car. Who will it be first? The Tesla model S? Um, I'm not sure of your shopping preferences, Winter, but I agree that whomsoever wrote this must indeed be dipwits. Or as Dursun and E-P would say; Did we just wake up in some Bizzaro-like parallel universe. I suspect that the Tesla$ will be left high and dry by more practical, lower priced (Asian) EVs.

But who can tell, if low cost batteries become available to others, they will be also to Tesla.

Maybe labor will become less of a factor with with EVs and after the bankruptcies and maybe US makers will be able to compete.
And maybe not.

The University of Michigan's prowess in all things business has collapsed along with the auto industry that for decades it has supplied with graduates. Leaders and Best? Champions of the West? Uhhhhhhh...no.

Aside from the gibberish extrapolations from bad or useless data, the other sin is abject failure to actually look at the source of profits: either very high volume, or very high content cars.

Let's make a blanket assertion: no one is going to be selling a tremendously high volume of cars in the foreseeable future. So no great profit stream there.

As to high content, while Mercedes, BMW, Audi, and Toyota all make wonderful high mpg, high content, and doubtless very high profit cars, I can't think of even a single high content high mpg car in the pipeline at any American car company, let alone actually for sale. We have totally missed the boat on this, and it is a sad example of a fundamental misreading of the market to fail to recognize the importance of this segment -- American can makers still equate small high mpg cars with a 1980 Celica and just can't seem to shake that mental equivalence. So, no profit there.

I know: huge SUVs! Oh, wait...

jzj: good points. I agree with your assertion except if someone comes up with a game-changing vehicle that is super cheap, strong, solid, safe, well built and gets a crazy MPG. A return of the housing market with bring back some demand for cars - but nothing like we saw 2004/05/06.

jzj
What do you perceive as the cause, when you say;

"Mercedes, BMW, Audi, and Toyota all make wonderful high mpg, high content, and doubtless very high profit cars, I can't think of even a single high content high mpg car in the pipeline at any American car company, let alone actually for sale".

Do you conclude that it never occurred to them?
Or because they did not want to?
Or because they cannot, because of ? ? ? ?

All 3 US auto makers were the same here, that's old news.
The cause is all important.

Very interesting article.

One may say that the Big-3 assumed (for much too long) that they knew what vehicles the public needed.

Anyway, if they made a few mistakes here and there, they assumed that their PR could convince the public what they built was exactly what buyers wanted.

Taking us for granted for too long back-fired and the majority switched to other manufacturers.

Changing the Big-3's way of doing their things is a major endeavour and may not be possible short of Chapter 7 for Chrysler and GM and chapter 11 for Ford.

Our last Big-3 car was a 1990 Buick and we are not ready to go back. The last four Toyotas have performed very well and a Prius III is coming soon.

The Big 3 made cars that I would have liked, but they won't sell them in the USA.  Had Cadillac marketed the BTS here, I might not be driving my third Volkswagen.  And it's exactly as UMTRI wrote:  they completely disregarded the value of fuel economy to me.

"One may say that the Big-3 assumed (for much too long) that they knew what vehicles the public needed."

Are you serious?

Industries attempt to provide products the public wants and will buy.
Need may or may not drive what the buyer wants.
What you or I think the buyer needs is obviously immaterial
– well, it used to be.

From granola bars with chocolate chips and marshmallows to surgery for sagging breasts – the buyer is driven by their wants, not our needs.
Has there ever been any auto maker that sold vehicles the public needed but do not want?
Maybe the Trabant factory did.

Maybe the new GM will.

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