Automotive Renaissance-Can Suppliers Measure Up?

 

I remember attending the CAR (Center for Automotive Research) conference in the fall of 2009 like it was yesterday.  The overall atmosphere was of grave concern, like we were sitting in a hospital waiting room, listening to every word the Doctor (speaker) said, hoping to hear a sign of recovery.  Grave concern was certainly the case, as the U.S. was in the midst of the greatest threat to American automobile manufacturing that our country had ever experienced.  Millions of existing jobs were on the line along with the unfortunate realization that hundreds of thousands of jobs had already been lost during the recession.    

 

By the end of the second day of the conference I started to get the feeling that the auto industry's state of turmoil was about to undergo a positive transformation.  Even though the American OEM's had been struggling for years prior to the recession for what should have seemed an obvious contributor to their downfall "building products customers did not like."  Discussions by the OEM's were more focused than ever on what went wrong and how they were implementing change to build higher quality, more attractive vehicles. The new product designs being presented made me realize that real change was about to take place.  In addition, several presentations focused on a renewed collaboration between OEM's and suppliers, as the supply base had been decimated due to "give back" programs.       

 

Now, just two years later, 2012 CAR conference proved there is an abundance of renewed optimism.  The U.S. auto industry has bounced from a low of around 10.6 million units in 2009 to a 2012 projection in excess of 14 million units.  U.S. sales are on track for double-digit growth for the third year in a row.  Demand is expected to reach 16 million units by 2016.  As a result, for the first time in many decades, manufacturing is one of the leaders for new job growth due in big part to the automotive rebound.  Key short term economic indicators are driving the rebound in the U.S. including historically low interest rates, decreasing unemployment, rising consumer confidence, reduction in delinquent loans and housing stabilization.  Along with these positive economic indicators, the OEM's are building products that are being well received by the public, which is also a major contributor to their recovery.                                

 

With all the positive news surrounding the accelerating growth in U.S. automotive production, there is an abundance of discussions regarding the next set of industry challenges. Will the supply base be able to meet the forecasted demand?  Where did all the skilled labor go?  With many suppliers gone or in financial distress because of the downturn, the industry is now faced with uncertainty and challenges related to a financially viable supply base.  However, suppliers can take action to help address many of these key challenges.

 

Is there enough supply chain capacity to support forecasted production levels?

Based on U.S. Federal Reserve Board of Governors data, suppliers are running at 78 percent capacity utilization as of August 2012.  To meet production demand of approximately 14 million units many suppliers are running overtime, incurring shortages of materials and expedited freight costs.  Although this sounds like a recipe for disaster-it really is an opportunity for the supply base to become more efficient with the capacity constraints they face instead of going back to the old model of bloated overhead cost structures.  Although there is risk due to capacity constraints in certain sectors, in the end when there is monetary opportunity, capitalism will prevail and supply will step up quickly to meet demand.

 

Suppliers are also seeing a return of certain parts from overseas creating additional production demand.  You may have read articles using the term "backshoring" as there has been a push for several years by OEM's and Tier 1's towards "build where you sell" initiatives.  Many factors are driving these initiatives: including currency exchange risk mitigation, supply chain risk mitigation, county regulations, politics and the development of foreign markets that are support themselves.  These forces are creating additional opportunities for U.S. suppliers.  So, what can U.S. suppliers do to ensure they can grow in a way that does not lead them down the path of past unsuccessful suppliers and meet the growing demand?

 

Supplier Action Plan

If auto sales grow at around 5% the supply base should be able to support demand but some will certainly encounter issues including expedited freight, overtime, and perhaps certain material shortages.  The call we have been receiving lately is "we are out of space and need to move into a larger facility."  In certain cases this is very true but in a majority of cases, especially for Tier 1 and 2 suppliers, the available production capacity is within their current facilities.  UHY's operational team has assisted many companies with addressing expansion plans and squeezing capacity out of current operations where possible.  There are several key focus areas where we find opportunities to increase current capacity and address common issues.

 

Attack shortcomings in planning and production scheduling. Much of the overtime and expedited fright can be directly traced back to planning and scheduling.  This is probably the number one area in which we assist companies in smoothing production flow and number of setups.  We have seen dramatic improvements in reduced expedited freight and overtime, just by driving down to the root causes in planning and scheduling.  Prepare process flow diagrams in this area and you will identify that planning and scheduling is the root of overtime and expedited fright.

 

Implement operational accountability systems.  Implementing daily accountability operational systems can also contribute to reducing the issues we noted.  We have all heard about "lean manufacturing" and the positive impact these initiatives can have on an organization but sometimes these implementations are too costly to fully implement for smaller suppliers.  UHY has developed a best practices operational improvement scorecard called "OPMS" (Optimal Performance Management System)which is a daily accountability operational scorecard of key manufacturing metrics so you can know at the end of the day if you "won" or "lost."  OPMS incorporates several different disciplines that are cost effective to implement and solves issues at their root cause(s).   

 

Review part profitability.  With a continued competitive market, companies need to know what each part costs.   Often we see companies where a handful of parts are profitable and a majority is only marginally profitable.  When capacity is tight there is an opportunity to shed or outsource certain lower margin parts to make room for higher margin parts, but you really need to understand your cost structure to undertake this action item.  Begin by building contribution margin analysis (revenue less direct material and labor) for your top 25 or 50 volume or revenue parts to understand what parts are contributing the most in not only a percentage but in dollars.      

 

Assess facility processes layout.  Many companies we visit appear to be good operators but when you look under the "hood" and identify areas of operational improvement, the number one response is "but that's how we've always done it."  Now is the time to take a step back and really look at operational processes and stop accepting the status quo as an answer.  Prepare process flow diagrams for key operational processes and you will be amazed at what you find out. There is potential to unlock additional capacity just by making a few changes to your plant floor.  Based on experiences, we have seen return on investments greater than 3:1 with a very low monetary investment. 

 

Add scale and diversification through strategic acquisitions.  With OEM's continued efforts to reduce the number of direct suppliers OEM's work with, suppliers need to focus on scale and diversification to mitigate risk.  Just by adding production capacity to add more automotive business may pose a risk as many suppliers have learned.  Look to add capacity through strategic acquisitions that can add more customer or industry diversification; technical resources like engineering that will increase competitiveness.  We are seeing a lot of Tier 1 and Tier 2 suppliers looking to do address these risks so they can move away from being a commodity suppliers that can resourced at any time.              

 

If the supply base implemented these action items, production capacity concerns would be greatly dampened. 

 

Is there a potential skilled labor shortage amongst the supply base that will stall production supply?

With the abrupt rebound in the automotive industry-it has left not only the OEM's looking for skilled labor but the supply base in an even more risky situation since they are completing for labor from with same labor pool.  Based on automotive research, demand for automotive workers could increase from approximately 600,000 in 2011 to more than 800,000 by 2016.  However, will the labor supply be able to meet the demand?  Based on the U.S. labor participation rate, the participation percentage has decreased from a high of 67% in 1999 to a current rate of less than 64%.  Additionally, more than 25% of the population is older than 59, up from 19% in 2000.  Hence, a smaller labor pool to attract to the industry.  More importantly, the industry has been in the bottom for wage and employment growth from 2006 to 2011.  Therefore, since the start of the decline in the auto sector in 2006, demand for automotive skilled labor has fallen dramatically and thus the supply of skilled labor has found employment in other sectors.  Community colleges stopped offing classes relating to tool and die, machinists and other related skilled labor due to decline in demand during this period of time.             

 

A key statistic by the U.S. Department of Labor in 1979 was that young workers received an average of 2.5 weeks of training each year.  In 2011, only 21% of employees received any training from employers in the last five years. In addition, non-employer sources of training directed toward the auto industry have been disappearing.  As we enter a knowledge based economy, the demand for skilled workers will only increase. 

 

Supplier Action Plan

I remember the days when tool and die shops offered numerous apprenticeship programs. There was also an abundance of training classes at local community colleges for this job and other auto related skilled jobs.  However, when the U.S. automakers stated to decline around 2005 the demand for newly skilled workers declined.  Due to the slack labor market there was abundance of skilled labor and less new training required to be provided by employers.  Today, too often we hear that companies cannot find skilled labor with industry experience.  However, there is little evidence that a skills gap or labor shortage exists.  The perception of a labor shortage is driven by reduced employer commitment to training, over specification of job qualifications, the recent slack labor markets encouraged over searching for the right person at the right price.  So what needs to happen to dampen what is perceived as a lack of available labor? From a macro level two things need to take place; wages and employment growth need to grow faster than the national average.  Today employment in manufacturing is growing faster than the national average; now we need wage growth in certain key sectors to uptick to attract more supply.  Some of the key skilled labor jobs that are in top need are machinists, tool/die/mold makers, electricians and machine repairers.  There are numerous steps suppliers can immediately implement to attract labor to the industry.

 

More in house training programs. This will open up recruiting to a broader audience that may not have all the exact skill sets.

 

Sharing training costs with other employers and employees.  As stated above, there has been a decline in industry related skilled labor training.  Employers will need to step it up in the short term to cover the gap in training.

 

Communicate and interact with local community colleges and private/public partnership training programs.  Community colleges will bring these training classes back as long as they hear from employers that there is a demand.  We're already seeing a pickup in activity at local community colleges here in Michigan. 

 

Consider a shared workforce model that utilizes apprentice programs. By offering apprentice programs employers will once again begin to position their workforce for the future. 

 

Specific skill sets.  As skill sets have become more specific and technical, your company will need to fill the void. Don't just expect public institutions to provide specific technical needs that your company is searching for.

 

Search and utilize staffing companies in your specific industry to locate skilled labor.  Many offer temp or perm positions that allow you on a contract basis to have a trial period with a skilled laborer.     

 

Is the supply base financially viability coming out of the recession?

Based on a UHY study, even after the cleansing of suppliers in 2008-2010, there still remains more than 20 percent of the supply base that remains distressed.  We've been consulting with more companies than ever before as OEM's and Tier 1 suppliers are making almost all suppliers complete financial risk assessments to retain and quote new business.  In many cases, a pure financial risk assessment does not fit all privately held suppliers, since most Tiers 2-5 suppliers are tax focused, have related party entities, and/or retain little equity in their businesses.  However, the mere reliance on these scores to be on the bid lists for new business will in itself promote more financial stability for the supply base which is good for the future viability of the supply base.  Suppliers need more education on what they can do to improve their balance sheet and operating metrics.  In addition, many private companies do not want to divulge their financial information to their customers. If presented correctly suppliers will not have to expose themselves completely if they present their financial information in percentages instead of values.  We have seen this work successfully among several Tier 2 suppliers.           

 

Supplier Action Plan

With so much risk associated with the supply chain today, OEM's and Tier 1's are more focused than ever on the financial health of their suppliers. It's critical to understand the financial performance metrics your customer is asking for.   We often see these financial analyses go to accounting departments and they get filled out and submitted without much review by the management team.  It's very important to understand the results before sending, as these financial scorecards are getting much more attention by OEM's than ever before.  There is a variety of metrics used by OEM's and Tier 1's but some of the key metrics you should manage to in order to continue to be a preferred supplier include:

 

Liquidity

Current Ratio: at a minimum maintain current assets over current liabilities in excess of 2:1; need to stay above 1:1 to remain viable

Operating Cash Flow: at a minimum maintain a positive operating cash flow

Accounts Payable Days: less than 45 days is optimal, greater than 60 is viewed more negatively

Accounts Receivable: less than 50 is optimal, greater than 60 is viewed more negatively

 

Leverage

Funded Debt to EBITDA: at a minimum maintain third party funded debt to earnings before interest, taxes, depreciation and amortization less than 4:1 

Total Debt to Equity: at a minimum maintain total debt to equity not to exceed 4:1; in some cases 3:1 is the threshold  

 

Profitability

Year-to-Year Sales Trend: at a minimum maintain a positive sales growth; more than 5% is optimal

Gross Profit %: at a minimum maintain a gross profit in excess of 10%

EBITDA % of Sales: minimum is greater than 5%, optimal is greater than 10%

Net Income %: minimum is greater than 2%, optimal greater than 5%

Return on Assets: minimum is greater than 5%

 

Please note these are ranges we have seen based on supplier scores.  Your customer benchmarks may vary depending on a number of factors. 

 

As you can tell, some of these ratios are difficult to achieve for smaller suppliers that maintain little equity in their businesses due to a variety of reasons.  If results are suspect, you will need to give your customer factual information as to why results are not where they should be.  If your results are only slightly greater than the minimums noted above, you still could be deemed a marginal supplier, and ultimately place you on your customers watch list.  For more information on supplier benchmarking and how the results impact your company, please contact a UHY professional.

        

Lease vs. Purchase.  One way to improve your balance sheet if your debt to equity ratio is not where it should be is to lease equipment under operating leases.  In addition, tying up capital in real property can also be detrimental to your financial ratios.  FASB is considering changing the rules around operating leases which could put all operating leases on the balance sheet, thus negating this opportunity, but we are years away from the FASB implementing this standard.

 

"Don't let the tail wag the dog".  Although much effort is put into maximizing deductions and reducing taxes, if your balance sheet is borderline it may be prudent to pay taxes in order to shore up the company's equity.  The risk of not being able to quote new business or being resourced is not worth the tax savings.  Owners should also be conscious of how much compensation they are taking out so as not to strip the operating cash flow from the business.    

 

How to manage natural disaster risk all the way down the supply base given tight production capacity?

With all the natural disasters that have impacted automotive production in the last several years, it was only a matter of time that OEM's would put in place action plans to decrease or eliminate supply chain risk all the way to the bottom.  In some cases, a corporate role has been emerging in importance called the "Supply Chain Risk Officer."  These corporate officers are focused on understanding risk through the supply all the way down to the Tier 5 supply base.  Many OEM's will admit they have an understanding of supply chain risk at the Tier 1 or 2 levels but beyond that there was little visibility in key components.  The realty of this was most felt by Toyota during the Tsunami that hit Japan.  Supply chain risk mitigation has become a very important focus for all automakers not only due to natural disasters but also the tight production supply in certain sectors.  The supply base needs to be ready to address potential risks-or risk having their parts resourced.         

 

Supplier Action Plan

Many suppliers we talk with have little or no disaster recovery plan.  We recommend that companies work with other suppliers in their industry to collaborate with each other in the event of a disaster.  Develop a plan to address as many disasters as possible.  If you remember the fire that Magna endured in 2011 they were able to react and work with their other plants and suppliers to help them get up and running in a short period of time.  Many OEM's are requiring suppliers to provide a disaster recovery plan to the best of their knowledge.  Obviously you cannot protect against all disasters but fires, death of key owners or employees, supply shortages, etc. can be mitigated with the right planning. 

 

A key planning opportunity that many companies do not address is a succession plan in the event of a key employee or owner death.  Without proper planning the future of the organization and its employees is in jeopardy.  We recommend key man insurance on key employees in the untimely death of a key employee. This will give the organization some funding to pay for a replacement search and may also be needed to fund a signing bonus to attract a highly qualified candidate.      

 

Although there are some key challenges facing the supply base there is also preemptive actions that your company can immediately start to implement.  By being proactive, your company will be positioned to take advantage of the bright automotive future.

 

For more information please contact a member of our UHY's Manufacturing team in Farmington Hills (248) 355-1040 or Sterling Heights (586) 254-1040 or visit us on the Web at uhy-us.com.