There has been a lot of froth and bubble recently about the dumb decisions, particularly about model choice, that Ford management in Australia has made that has resulted in the decision to close manufacturing operations in 2016. I recently saw a YouTube video of a Clayton Christensen (http://www.youtube.com/watch?v=35z03U3wugs ) lecture that might justify the opposite being true! Christensen believes that some of our current problems with fighting our way out of the GFC cam be slated home to the overly sophisticated way that we measure a firms’ performance. In particular, he questions the use of measures such as ‘Return on Capital Employed’ in a world where the cost of capital is approaching zero.
Christensen tells the story of the decline of the Integrated Steel Mills in the USA where the ‘mini mills’, who remelted scrap, had a 20% cost advantage over the traditional integrated mills. At first the only product that the mini mills could produce was reinforcing bar for concrete construction. With a cost advantage, the mini mills took market share which the integrated mills were glad to give up. Their sophisticated analysis told them that they were better off exiting the reo bar business because it made their company performance look better. Once the market for reo bar was only made up of mini mills there was an immediate drop of about 20% in the price for reo bar. Christensen points out that for a ‘low cost’ strategy to work you need a ‘high cost’ competitor! The mini mills were obviously looking for the next steel commodity to target to improve margins. This required a step up in quality which was achieved with an approximate 20% cost advantage. The integrated mills gladly gave up this next category because their sophisticated performance measurements showed they were better off exiting. Once the category was only supplied by mini mills there was an immediate 20% drop in prices, which provided the incentive for the mini mills to target the next steel category. This pattern continued until the integrated mills became unviable and exited steel production entirely.
So how does this relate to Ford in Australia? Firstly some points about the direct costs of producing large cars and small cars, direct costs being the assembly, labour, components and raw materials. It may surprise some but the direct cost to product a large car versus a small car of similar specifications may be measured in the hundreds of dollars, not thousands. Yet the large car can be sold for $10,000 to $15,000 more – a welcome contribution to margin!
Faced with making a decision on where to apply their capital, Ford would find it hard to go past a decision to build the large car. Their sophisticated measures would have made it clear that this was the ‘smartest’ decision (making a decision that flew in the face of the sophisticated measures was unlikely, they probably used up all their favours just to be allowed to continue building cars in Australia).
Ford, like the integrated steel mills, was also trapped by their specific investments in this market. Based on my experience at Nissan Australia when we closed down manufacturing, I would estimate that this move will cost Ford in the order of $1.5 billion to their bottom line in direct costs and write-offs. Again, based on the Nissan Australia experience, market share is likely to drop to around 4% to 5%. This of course is very bad news for dealerships and Ford back office people.
So, using Christensen’s theory, Ford was not making dumb decisions, but rather being too sophisticated in their analysis. Perhaps an old fashioned bottom line profit analysis might have led them to a different decision!