The Curse of Embedded Costs

The lessons learned from Detroit about costs and assets carry important implications for supply chain professionals

By Bud La Londe -- Supply Chain Management Review, 11/1/2005

In early October of this year, Delphi, the world's largest auto parts maker, slid into bankruptcy. Since that event, every business newspaper, magazine, and news channel has offered opinions on Delphi and General Motors—and the relationship between the two. The odds makers have even established a betting line on the likelihood of GM following Delphi down the slippery slope of bankruptcy.

How can it be that companies like GM, AT&T, Marshall Fields, and Delta—all once considered solid "widows and orphans stock investments"—are now gone as identifiable business entities, in bankruptcy, or the subject of bookmaker odds on their very future? The answer, we believe, can be found in Darwin's message in The Origin of the Species—not the popular notion about the survival of the fittest but the real message of the survival of the most adaptable.

So why did these iconic firms have so much difficulty adapting? There are many reasons why firms cannot adapt and eventually disappear. Sometimes it relates to market conditions, competition, or more recently globalization. Globalization, in particular, has facilitated the flow of commodities, labor, capital, and knowledge. Free trade allows companies to source manufacturing and distribution in the most efficient global site or combination of sites. Free trade should also open up both home and global markets. It follows, then, that if a firm cannot develop an adaptive global strategy, it runs a serious risk of losing market share.

But enough arm waving about globalization. What about GM and its current problems? They followed all the rules. They built large plants in central locations to obtain scale economies in production. They had a large, loyal workforce that they took care of pretty much from the cradle to the grave. The problem for GM (and Ford, too, for that matter) is that the rules they followed were written during the first two decades of the 20th century. Henry Ford's concept of the "moving production line" required embedded assets to make it happen. Embedded assets, in turn, translate to fixed costs that are allocated to a specific purpose. Such assets cannot easily be converted to other uses. Witness the closed and shuttered automotive facilities around the Untied States.

Somewhere along the line, labor costs for GM became a fixed cost. Company employees were being paid almost as much for not working as they were for working. According to a recent issue of Forbes, GM has some 5,000 workers in job banks across the country. Some of these workers do community service, but others go to a room near their closed plant and get paid to play cards or watch TV. With full wages and benefits, this program costs GM $750 million a year. So when GM shuts down a plant, their costs do not go down because their labor costs are fixed costs, not variable costs.

The problem for GM is further complicated by legacy obligations in health care of more than $77.5 billion as of Dec. 31, 2004. Even if the automaker were wildly successful in its health care negotiations with the United Auto Workers (UAW), the automaker's problems would not be solved. It appears that the recent UAW agreement to give back $15 billion of the $77.5 billion in health care costs will save GM only $1 billion in cash each year. This is a long way from fixing GM's operating or financial problems.

What are the lessons that can be learned from the crisis at GM and Detroit? No doubt there are many, but four prominent lessons stand out:

1. Don't let your labor costs become fixed costs. Executives manage three big bundles of assets: traditional fixed assets, labor, and inventory. If the supply chain executive is to have flexibility and adaptability, labor and inventory will have to be largely variable cots.
2. Plan to shift and/or share risks with supply chain partners. Shifting or sharing risks, particularly those risks associated with traditional asset investment, can reduce supply chain risks for all partners. This strategy is especially important when it comes to the "stranded assets" we mentioned earlier.
3. Synchronize contract cycles with investment cycles. Collaboration techniques like CPFR (collaborative planning, forecasting, and replenishment) are typically based on closer communication between partners in the supply chain. The "planning" and "forecasting" parts of CPFR are particularly important for achieving adequate returns on fixed investments. If partners have a realistic time line for customer orders, they can then give realistic time lines to their suppliers. Assume that an important customer approaches you and requests that your firm invest in a special-purpose fixed investment. And assume that the fixed investment has a depreciation life of 10 years. Economists call this an "asset specific investment." Now further assume that the customer agrees to utilize this investment for two years. This leaves the supplier with eight years of risk in the channel. This is one example of using power to shift risk in the channel. Contractually, this type of risk can be covered by the customer agreeing to pick up the unused eight years of risk. The objective of the supply chain partners is to match fixed investment life with the life of the contract. This will spread out risk in the supply chain and reduce the cost of doing business for all of the partners.
4. Throw out the book on contracting. This suggestion probably pains the purchasing group and the traffic managers. I know of a firm that receives deliveries of tires at its manufacturing site every hour. Now why would a supplier agree to such a difficult just-in-time process? The answer lies in the nontraditional contract that was developed. The supplier gets paid by the manufacturer through an electronic funds transfer at the end of the day. The supplier's cash-to-cash cycle is reduced, and both its working capital and profit increases. Similar innovative approaches can be applied to other supply chain challenges, such as getting drivers. You need to figure out what the new drivers want and then create a contract that responds to their needs while providing you with dependable capacity. Creative contracting can solve a lot of problems.