Nate Sez: It’s about Legacy Costs

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Nate, who is more of a Michigander than I am, drew this not-pretty picture of GM’s operating margin over the last half century. He explains that this picture shows that GM has been using health care and pension promises to put off the time it registers these real costs on its balance sheet as a way to get the benefit of labor but put off paying the true costs of it.

GM was willing to cut its employees some very attractive deals in the 1950s through the 1980s — provided that they took them in the form of retirement benefits rather than salary, which wouldn’t hit GM’s books until much later and which until 1992 weren’t even required to be carried on its balance sheets all, making its financial statements (superficially) more appealing to its shareholders. That health care costs have risen so substantially in the United States have made a bad matter worse.

Nate’s absolutely right about the systemic issue underlying GM’s woes.

But I’d add another point. While his not-pretty picture doesn’t show when this happened, we know that sometime around the time when GM’s operating margin first hit zero, GM began to face stronger competitors domestically: the Japanese. And for the first decade and more after the Japanese started competing in the US, GM was competing against companies the bulk of the labor for which received cheaper health care and pensions in Japan. And even as Japanese companies opened factories in the US, it took decades before their first employees retired, meaning the Big 2.5 were paying pensions for two generations of retirees, while Japanse transplants were paying nothing, yet, in pension costs. All other factors being equal (they weren’t, but just pretend they were), that meant it has always been a lot easier for Japan to make a profit off its cars, partly because Japan pays for health care differently than we do, and partly because they entered the US market relatively recently.

In addition to making it easier to make a profit on a car, this makes it a lot easier for Japanese companies to make investments in their cars pay off.

That means that the Japanese–who in the early years were competitive with the US on hybrid technology–could forecast the profitability of the technology and decide it made sense, whereas the US companies would make the same calculations and decide it didn’t make sense. They were both making the same kind of business calculation, but the underlying numbers were different. A lot of the decisions that outsiders attack–particularly the technological ones–made sense from a business perspective when you factor in these legacy costs. The US couldn’t invest in these technologies because they had to spend money for legacy costs instead.

Here’s how the Administration’s assessment of GM’s viability described this:

As GM moves through its forecast period, its cash needs associated with legacy liabilities grow, reaching approximately $6 billion per year in 2013 and 2014. To meet this cash outflow, GM needs to sell 900,000 additional cars per year, creating a difficult burden that leaves it fighting to maximize volume rather than return on investment.

The entire current annualized volume of cars in the US right now is 9 million. The Administration is saying that one tenth of all cars sold in the US this year will go to pay for GM’s legacy costs. (This is why GM and Ford’s expansion in overseas, more profitable markets is so important, because without those profits, these numbers would have already doomed these companies.)

A lot of people (like Bob Corker) like to pretend this is only a problem the auto industry has experienced. But that’s not true. We’ve already seen the airline and the steel industry go through this, among others. 

Sadly, though, aside from the mention of GM’s legacy costs, yesterday’s announcements ignored this systemic problem for what it was–one of the key underlying causes of the "bad" decisions the auto industry has made for the last two decades. Yes, Obama is pushing for health care. But the reason we need health care (and need to retain social security, among other things) is because it is killing our businesses.

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16 replies
  1. earlofhuntingdon says:

    Your and Nate’s takes on GM are thoughtful and well-grounded. GM certainly expected that paying the piper could be put off almost indefinitely. It was a largely successful strategy in deferring EPA mileage requirements, for example.

    There was no lack of hubris in Roger Smith’s day, but by Jack Smith’s tenure, it was clear that the piper wouldn’t go away no matter how good their treasury operations or Andy Card’s lobbying were. You are also right that international growth, especially in East and South Asia was not just for profits, but for survival.

  2. klynn says:

    Sadly, though, aside from the mention of GM’s legacy costs, yesterday’s announcements ignored this systemic problem for what it was–one of the key underlying causes of the “bad” decisions the auto industry has made for the last two decades. Yes, Obama is pushing for health care. But the reason we need health care (and need to retain social security, among other things) is because it is killing our businesses.

    (my bold)

    Yep.

    Should we link to Jane’s post in terms of your Social Security note?

  3. Synoia says:

    It was massive fraud in non-funded pension and retiree health care, that goes back to the 50’s. The whole system was a massive fraud and now the bils are coming due.

  4. Leen says:

    As someone asked on another FDL post if you are going to force an auto industry “shot gun wedding” what would be a good gift? I vote a National health care plan. Take that cost off the backs of that industry.

    Hell I think Corker knows if the Obama administration allows the U.s. auto industry to fail it will pave the way for an Obama failure in 2012.

  5. earlofhuntingdon says:

    GM and the Japanese manufacturers also had very different ideas about process quality and improvements. The Japanese, meeting stiff domestic competition and playing catch up in their most desirable overseas market, also had a greater incentive to create a niche Detroit ignored or thought it could spend its way out of (a tactic that worked for Detroit for decades).

    You are absolutely right that a credible nationalized health care system is essential not just for Americans’ health and social stability, but for the economic survival of their employers. GM’s vulnerability should make them argue that. But it also makes them less persuasive inside what is now a Wall Street dominated Beltway, a loss of leverage that will bring crocodile tears to current and former chairmen of Goldman Sachs.

    • emptywheel says:

      True. GM did learn a lot about business management from the Japanese. (Though I’m not ruling out the possibility that Japan, bc it shows more chauvinism in its sourcing, may end up losing competitive edge on that over time).

  6. earlofhuntingdon says:

    I don’t know that adopting GM or Wal-Mart’s standards for managing suppliers is the way to go, either. Price is important, but unlike jeans or sports bras or shoes, automotive systems require considerable time to design and produce, and they need to be supported for years in the field. Engineering quality and financial viability are also important traits in a supplier, but too often respected in the breach.

    • emptywheel says:

      I think you’re misunderstanding my point about suppliers. GM’s supply chain looks absolutely nothing like Wal-Marts, nothing. And they do respect engineering quality.

      My point is that there are times when the Japanese will stick with a Japanese supplier EVEN IF that supplier’s quality has declined and EVEN IF there’s someone who does it better from another country.

      • earlofhuntingdon says:

        I understand your point well and have spent some time negotiating such contracts from both buyer and supplier’s perspectives. Like pigs, among “price, quality, service and delivery”, price is more equal than others.

        • emptywheel says:

          Agree they’re buying on price. But if you think they’re not buying long-term engineering relationships (albeit at the cheapest cost), then you’re not looking at the engineering.

          And trust me, the Japanese lowball their contracts in other ways, largely by screwing suppliers. They’re definitely NOT paying more, and in a number of cases I’ve heard of, suppliers charge higher prices to the Big 2.5 to make up for the fact that the Japanese clients aren’t paying them.

          • earlofhuntingdon says:

            I agree with you that engineering is a significant factor in choosing suppliers, and on the differential pricing Japanese OE’s use with those in or outside their keiretsu and in or outside of Japan. A lot of sake, soju and Maotai went into that statement.

            I am saying that long term relationships are becoming fragile or dispensable when they are needed the most, whether they are automotive company IT systems or product drivelines.

            • Rayne says:

              The long-term relationships and chauvinism EW mentioned are tightly linked.

              GM did learn much about management from the Japanese, but the most important part of those learnings — including kereitsu development of preferred vendor relationships where engineering and quality was best — went out the door with GM’s fanboi fanaticism for all things Jose Ignacio Lopez de Arriortua.

              Lopez did irreparable damage not only to GM but to the rest of the Big Three, encouraging them to look to price over the short-term instead of quality over the long-term, and to do so in highly unethical fashion. I really wish Nate had supplied dates on his chart because if Lopez’ impact appears on the chart where I believe it might, it could explain why GM believed that they were doing the right thing in an environment where their marketshare was increasingly threatened.

              Unfortunately, the situation playing out before our eyes is not going to improve the automaker-supplier relationship. With Fiat and Chrysler appearing on the verge of a shotgun wedding, some suppliers will automatically be on the verge of failure — those which Chrysler relied on heavily will be forced to take a backseat to Fiat’s suppliers, in some of which Fiat owns a stake. Ford is known across the industry as a less-than-ethical player, demanding “rebates” well after awarding contracts, just before or during delivery of material or equipment. Their current situation will only reinforce this behavior. And GM’s bankruptcy will likely force a number of other suppliers regardless of quality to wither and die, having operated for too long with too tight margins and carrying paper and risk for GM. Those that remain will not trust any of the Big Three and will continue to model their production around this lack of faith.

              The other factor which doesn’t appear in Nate’s chart is the direct loss of margin attributable to shift in marketshare due to technology transfers. The foreign automakers used many of the same suppliers as the Big Three and benefited greatly from the sunk costs in engineering paid out by the Big Three; they leapfrogged to equal status and then with nominal additional costs improved on quality over the Big Three (I’m thinking specifically of the Koreans here). It’s happening now in China, and it’s happened in the Japanese-owned plants here in the U.S.

              Somehow this Shock Doctrine fire sale approach to rebuilding the industry has got to stop and give American automakers the breathing room needed to do a real assessment of what works and what doesn’t — but I don’t know how that’s ever going to happen.

      • justbetty says:

        You raise a good point about the Japanese tendency to protect Japanese industry. You mention suppliers, but another aspect that has surprised me is the Japanese law that imposes such high taxes on cars that after a few years people sell cars that are in excellent condition and buy new ones in order to avoid the tax. Many of these second-hand cars end up here in the Caribbean, sold to people who wouldn’t have been able to afford new cars – a situation that has wreaked havoc on the relatively undeveloped road infrastructure in the islands.

  7. rosalind says:

    somewhat related: kevin roderick at laobserved links to a good article in the Whittier Daily News titled “Millions Owed On Retired Employee Benefits” –

    Public agencies nationwide in 2008 started to publish for the first time how much they will owe in retiree medical costs, which differ from city to city, based on population, number of retirees, and the generosity of medical packages. What governments are finding in many cases is that the cost estimates are far bigger than they expected.

  8. foothillsmike says:

    The concept of the unfunded liabilities was not one that was done only by the auto companies. It was something that everyone has done. Where are the future liabilities of our government funded?

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