overcapacity – The OM Blog by Heizer, Render, & Munson

OM in the News: Overcapacity Hits China’s Auto Industry

Workers at SAIC-GM-Wuling Automobile in Qingdao

“For much of the past decade, China’s auto industry seemed to be a perpetual growth machine,” writes BusinessWeek (Nov. 9, 2015). Annual vehicle sales surged to 23 million units in 2014 from 5 million in 2004. That provided a welcome bounce to Western carmakers such as VW and GM and fueled the rapid expansion of local manufacturers including BYD and Great Wall Motor. No more. Automakers in China have gone from adding extra factory shifts 6 years ago to running some plants at half-pace today—even as they continue to spend billions of dollars to bring online even more plants that were started during the good times. The construction spree has added 17 million units of annual production capacity since 2009, compared with an increase of 10.6 million units in annual sales.

“The Chinese market is hypercompetitive, so many automakers are afraid of losing market share. The players tend to build more capacity in hopes of maintaining or gaining market share,” says a Bloomberg analyst. Worse, the combination of too many new factories and slowing demand has dragged down the industry’s average plant utilization rate, a measure of profitability and efficiency. The industrywide average plunged from more than 100% six years ago (the result of adding work hours or shifts) to about 70% today, leaving it below the 80% level generally considered healthy. Some carmakers are averaging 50% utilization.

Excess capacity is raising the pressure on carmakers to step up discounts to push sales and keep production lines busy. The markdowns can be huge. Motorists can buy an Anhui Jianghuai car for $9,642, 60% off its sticker price. The offering price of Audi’s A1 is being cut by up to 35%. And with capacity growth expected to continue outpacing demand, the industry’s return on invested capital in China will decline from 19% in 2014 to 10.5% by 2018.

Classroom discussion questions:

Why is overcapacity an operations problem?
What is causing overcapacity in the industry today?

OM in the News: It’s Raining Cars in China

Three years ago, China’s Chery Automobile announced plans to expand its factories to make as many as 1 million vehicles a year. But demand didn’t grow as planned. So Chery today has the capacity to make 900,000 vehicles annually—twice the number of cars it sold last year. Sales have slumped by 1/3 since their 2010 peak. “Chery is a classic case” of overcapacity, says a Shanghai-based consultant.

Domestic and foreign-based carmakers are building more factories in China than anywhere else, a construction binge that risks hurting margins, writes BusinessWeek (Feb.16-22, 2015). By 2017, there will be 140 car production plants in China, vs. 123 at the end of 2014. Factories across the mainland in 2015 will be able to build 10.8 million more vehicles than will be sold in Greater China. In North America, however, plants will churn out about 3.2 million more cars this year than the factories were intended to produce when they were built.

Overcapacity is only expected to get worse for Chinese carmakers. China will have about 11.4 million vehicles’ worth of idle capacity by 2017, more than double that of European automakers. Some carmakers already are regretting plans for Chinese plants that will open in the next few years. But that decision has been made and they cannot backtrack.

Foreign carmakers have been among the most enthusiastic factory builders in China, with Hyundai, Renault, and Fiat Chrysler among those that have announced plans or are already building in China. GM will soon sell Buicks made at a plant that opened last month, with plans to open a Cadillac factory later this year. GM has 22 factories on the mainland. Volkswagen, which is vying with Toyota and GM for the global auto sales crown, has 28 plants in China and will open 3 more within the next few years.

Classroom discussion questions:
1. What are some tactics for matching capacity to demand (see Supp.7)?

2. Why are auto makers flocking to China?

OM in the News: Trying to Close French Factories Can Lead to “Boss-napping”

Workers set tires on fire at this French Goodyear plant where 2 execs were held hostage

Negotiations broke down last week at a Goodyear tire factory scheduled for closing in northern France, so employees kidnapped the bosses. Hundreds of employees held two senior executives captive, threatening to detain them until the company agreed to pay out “huge amounts of money” to nearly 1,200 workers about to lose their jobs. The revival of the French unions’ “boss-napping” tactic clearly causes concerns of multinationals about France as a place to locate, reports The New York Times (Jan. 8, 2014). “This happened because workers were desperate,” said a French prof. “But it is still an act that will underline the perception that it’s difficult to do business in France.”

Tension at the Goodyear plant flared last year after Maurice Taylor, CEO of an American tire company, Titan International, rejected a government appeal to step in and buy the plant. Taylor described French workers as loafers of minimal productivity. “In the U.S., we call this kidnapping,” he stated. “These people would be arrested and prosecuted. But in France, your government does nothing — it’s crazy.”

France’s rigid labor market and the influence of labor unions has long been a source of aggravation to employers. The country’s 3,200-page labor code embodied what the government acknowledged was a “cult of regulation” that choked business. Procedures for shedding workers when economic conditions deteriorate are lengthy and expensive, and businesses pay high taxes to help fund France’s social welfare system. For an employee earning 1,200 euros a month, employers pay an additional €1,000 in tax and pension costs. Unions at the Goodyear plant had been demanding severance packages of €80,000 ($110,000) plus €2,500 for each year worked.

In recent years, French employees took executives of Caterpillar hostage when talks over revamping the company’s operation broke down, trapped the CEO of the group that owns Gucci, while bosses at 3M and Sony were held in an attempt to get bigger severance packages.

Classroom discussion questions:

1. How else can companies in France deal with overcapacity?

2. Why does the French government seem to favor unions?

OM in the News: The Rise and Fall of Rare Earths

Manufacturers of high-tech products rely on a steady stream of metals–some of them scarce–to make their goods. These “rare earths” are light-weight, malleable metals that are essential to hybrid cars, cell phones, and hard disk drives. (Toyota Prius batteries use neodymium to power the car.) Rare earth metals, a collective name for 17 minerals used in products like these, had skyrocketed in price in the past 2 years as China (which controls 90% of global production) slashed exports to tighten control over the sector. Lanthanum, for example, jumped from $10/kg in 2009 to $160/kg last year. Neodymium surged from $20/kg to $455/kg. Prices of many other rare earth elements rose more than 10-fold in a little more than a year.

But The Wall Street Journal (Nov.13, 2012) reports that companies– like Australia’s Kimberly Rare Earths, Black Fire Minerals, and Sable Minerals– that bet on rare earths as a hot commodity play are canceling investments after being caught by a sharp fall in prices this year. Fears of overinvestment and a supply glut are the driving forces. Lanthanum—used in oil refining and hybrid vehicles—now fetches just $13/kg. Cerium, which is used in catalytic converters and plasma televisions, is now down to $16 a kilo, from $102 a kilo last year. Neodymium, used in wind turbines and music players as well as in batteries, has fallen to $85 a kilo from $234 a kilo.

Sentiment in the wider mining industry is souring on concerns over the slow pace of the global economic recovery. “All of a sudden we have 400 years of rare earths being drilled out,” said Kimberly’s director. “Smaller projects just aren’t viable anymore.” Although demand for rare earths will more than double to nearly 250,000 tons over the next decade, the growth in supply will outstrip demand between 2014 and 2019 as new mines start operations.

Discussion questions:

1. Why are rare earths so important in manufacturing?

2. What lessons do OM managers learn from these price fluctuations?

OM in the News: Europe’s Turn to Face Auto Plant Overcapacity

While Europe has been preoccupied with the euro crisis, another storm has been gathering that could also take a huge toll on jobs. Just as it has too much debt, Europe has more auto factories than the economy can support. With new car sales down 21% in France and 17% in Italy, “the overcapacity is not exactly a secret,” writes The New York Times (March 7, 2012).

“All of the car manufacturers have capacity problems–all of them,” says Carlos Ghosn, head of Nissan-Renault. Government scrap programs, which promoted the replacement of older cars with new ones through the 2009-2010 downturn, are not likely to be repeated. Nations are simply not in a financial position to subsidize unproductive plants as they may have in the past. But in Europe, any attempt to cut costs will deteriorate into a political struggle among the countries that stand to lose jobs.

Sergio Marchionne, the CEO of Chrysler-Fiat, estimates the industry needs to cut capacity by 20% in Europe, a huge number when considering the 2.3 million employees making cars and parts. Unused capacity, as we saw in the US, is ruinous for automakers because idle factories cost money to maintain and unproductive workers to pay. Production capacity in Europe fell only a little after the 2009 downturn. Fiat closed a plant in Italy, Saab went bankrupt in Sweden, and Opel shut a plant in Belgium. Some companies have become better at managing fluctuations in demand. BMW, for example, makes use of temporary labor. Porsche outsources production of some models. Still, a large production overhang remains.

Discussion questions:

1. How is the US auto industry different from that in the EU?

2. In what ways can European car makers cut capacity?