These are perilous times for North America’s auto suppliers. Many are struggling for survival, squeezed by rising materials costs, blistering competition from low-cost countries, declining production volumes across many vehicle platforms, and relentless downward pricing pressures from automotive OEMs, which themselves face very difficult business conditions. Since 2001, about one-third of the region’s 25 largest auto suppliers (by revenues) have filed for bankruptcy protection, and many others are struggling to create shareholder value. Moreover, although suppliers have scope for further operational improvements—indeed, many are attempting to raise their efficiency—the majority find it difficult to capture the full value of such efforts. At the root of the suppliers’ woes is their weakness in pricing and their inability to maintain an equal balance of power with OEMs.
To see how suppliers might create sustainable value1 in such difficult circumstances, we studied the product characteristics and market economics of a typical passenger car at the level of individual product segments. We found that over the next five years, North American suppliers could potentially create value across 60 percent of a vehicle’s content and perhaps an additional 10 percent, though that will probably be hard to sustain. These opportunities lie in three kinds of product segments: those that provide opportunities for significant innovation; those that are consolidated, with high barriers to entry; or those that give suppliers early-mover cost advantages that competitors can’t easily replicate.
Creating value in the remaining 30 percent of a vehicle’s content will be extraordinarily difficult (and probably impossible) for suppliers in North America—or elsewhere— because these product segments offer suppliers few opportunities to differentiate themselves. Indeed, we expect that capital will flee these segments and that suppliers will be forced to leave them. To ensure supply in such circumstances, OEMs will have to rethink their current sourcing strategies and contract structures and, in some cases, even consider backward integration to ensure supply.
Our findings, which have strategic implications for suppliers and OEMs alike, paint a picture of a none-too-distant time when North America’s auto suppliers may have to exit large swaths of their existing businesses and product lines, restructure their portfolios significantly, and ultimately consolidate along tightly defined product segments.
Opportunities to create value
An analysis of 115 component segments in a typical passenger car and the value categories that auto suppliers can target to create value
Road to nowhere?
Auto suppliers in North America face daunting challenges. Demand for automotive components has declined in recent years, along with OEM sales: the North American production volumes of Detroit’s Big Three automakers have dropped by 2 percent a year, on average, over the past decade. Such declines have amplified the negative effect of the suppliers’ existing operational shortcomings. Meanwhile, stiffening competition from suppliers in China and other low-cost countries is pressuring the margins of their North American counterparts at a time when prices for key inputs, such as steel and aluminum, have reached historical highs. Worse, even large suppliers typically lack the pricing power to pass the full extent of these cost increases along to automakers.
But North America’s OEMs—threatened by increasing competition, decreasing demand, excess capacity, and rising materials prices—also face challenging times. These circumstances lead the automakers to leverage their pricing clout and use aggressive sourcing practices, such as switching suppliers during the life cycle of a program and cost-modeling subcomponents aggressively to estimate costs and thereby identify what they view as excess margins. As a result, auto suppliers must typically slash prices throughout the life of a contract just to retain the business. Few suppliers have the power to receive truly defensible guaranteed volumes in their contracts. It’s little surprise that North American suppliers suffer from declining margins and shareholder returns (Exhibit 1).
Not that the suppliers have stood by idly: although there are still significant untapped operational-improvement opportunities available to them, many suppliers we’ve studied have raised their performance with respect to capital, inventory, and purchasing; in fact, several are actually more productive than their high-performing counterparts in other manufacturing subsectors. Some have gone further still—for instance, by broadening their customer base2 or widening their product offerings—in hopes of gaining more pricing leverage with the automakers. Although such moves may have helped in the short run, the rewards from them have been unsustainable because they failed to alter the structural disadvantages suppliers face in dealing with OEMs.
To see how North American auto suppliers might create value in such a difficult environment, we conducted a bottom-up analysis of the 115 component segments (such as weather strips, batteries, seats, and wiring) that North American automakers use when they make purchasing decisions for typical passenger cars. We then analyzed each segment across more than 30 quantitative and qualitative dimensions, including its cost structure, demand characteristics, market share, capital-investment requirements, and minimum efficient scale, as well as the suppliers’ level of design control. These findings allowed us to assess the suppliers’ ability to create—and retain—value in individual product areas.
Mapping the value
Three areas of opportunity, representing 70 percent of a vehicle’s content, emerged from the research (Exhibit 2). Tellingly, when we looked at the product portfolios of top global suppliers, we found that companies enjoying above-average margins over the past two economic cycles were more likely than average suppliers to have products in these very categories.3 In the remaining 30 percent of a vehicle’s content, however, we see very little basis for sustained value creation.
Product innovation headroom
Products in the first category we identified—those with headroom for innovation, such as audio and navigation systems, turbochargers, and electronic braking systems—represent about one-quarter of a typical passenger vehicle’s content. The potential for innovation stems largely from regulation, consumer demand, or a supplier’s ability to unlock latent demand by significantly reducing the cost structure. These innovations tend to be introduced in premium and higher-end mass-market vehicles and typically require considerably more spending on R&D4 and engineering than products in other categories do. Moreover, such products tend to have strong proprietary design elements allowing suppliers to retain greater pricing control.
The product segments with innovation headroom are located primarily in a vehicle’s power train, electrical and electronic components, and chassis, where consumer interest, regulation, or both encourage innovation. For power trains, it is the influence of consumers (particularly around fuel consumption) and pressure from regulators (for emission controls) that will spur innovation over the next several years. The importance consumers attach to monitoring safety has emerged recently as a key factor in electrical and electronic products' candidacy for innovation. In the case of electronic braking systems, for example, considerations include the emphasis consumers place on stability control5 and forthcoming safety regulations requiring US automakers to upgrade the braking systems in all of their vehicles by 2012.
Suppliers looking to create and sustain value in these and other product segments in this category should pursue targeted internal R&D efforts or explore opportunities to gain or maintain access to cutting-edge technologies and increase speed to market through niche acquisitions focused on potentially disruptive technologies. (In our experience, few suppliers base their R&D spending on the likelihood that it will enable them to charge price premiums for specific products.) What’s more, suppliers with products in this category should actively look for opportunities to shift their customer mix toward OEMs serving premium consumer segments. These automakers tend to be more willing to pay for the privilege of introducing new technologies and may consider coinvestment opportunities with suppliers. Finally, suppliers should also think about broadening their R&D footprint to benefit from lower-cost global engineering talent in emerging markets. In fact, by making selected products in this category significantly less expensive, our research suggests, suppliers could unlock considerable latent demand among consumers.
Consolidating segments with high entry barriers
High entry barriers might help suppliers truly unlock the benefits of scale at the product-segment level, thus giving them the prospect of commanding higher margins. Entry barriers in this context include key engineering capabilities, high investment costs, and OEM relationships strong enough to reduce the threat that automakers might switch. Products in this category, representing about one-third of a typical vehicle’s content, are found throughout the vehicle. They include axles, batteries, fuel systems, and seats, and wipers.
A closer look at the market for seat components illustrates this category’s value creation dynamics. The manufacture of seats, which is quite capital intensive, requires considerable engineering, design, and development capabilities because of OEM design requirements and safety regulations. Further, seats are expensive, so OEMs would rather get them on a just-in-time basis than hold them in inventory. To provide these services, one global seat maker we studied operates more than 40 production facilities in upward of a dozen countries to ensure speedy deliveries. Such service requirements are costly for suppliers but may generate higher margins—in our experience, just-in-time deliveries of seats can account for up to 20 percent of their total cost to the OEM. Finally, the extensive validation requirements that regulators mandate have the effect of forcing seat makers to work closely with various parts of an OEM’s organization. If a seat fails during testing, only the supplier has the subcomponents and engineering know-how to address the problem and reengineer the product.
Suppliers attempting to create value in seats or other products in this category should explore ways to gain structural advantages, and margins, through consolidation. Crucially, suppliers must avoid the temptation to pursue size for its own sake, an approach that has failed to deliver value in the past. Instead, they should focus consolidation efforts on specific products that would allow them to optimize their cost structure—for example, segments whose entry barriers give them the prospect of gaining scale and leverage for a product or portfolio. This approach could include the pursuit of vertical-integration opportunities in subcomponents.6 Suppliers (as well as external investors, such as private-equity firms) should explore consolidation opportunities carefully and take pains not to squander capital on products that may currently seem attractive from a margin perspective but in reality have low barriers to entry and are thus less likely to retain long-term value.
Companies that make products in this category should also look for opportunities in low-cost countries—for example, targeted sourcing from new subsuppliers or the expansion of R&D. At the same time, they ought to beef up their ability to assemble and test time-critical components near OEM assembly facilities. Finally, to increase the potential value from innovation, suppliers should seek opportunities to exert greater proprietary design control over these products.
Cost structure advantages
Product segments that allow suppliers to create value by dramatically improving their cost structure relative to that of competitors represent about 10 percent of the content of a typical vehicle. Such products are found throughout its electrical and electronic systems, chassis, exterior, and power train areas, and the competitive advantage stems primarily from significant investments in production efficiency, an optimized global footprint for manufacturing, or the aggressive sourcing of high-cost components in low-cost countries. In the case of high-precision bearings, for example, innovative or automated processes that other suppliers can’t easily replicate provide the advantage. By contrast, in segments such as wiring, major suppliers have aggressively developed manufacturing operations in Mexico and Puerto Rico to offset higher commodity prices for copper with lower costs for labor (about one-quarter of total costs). Yet these suppliers can stay close to the OEMs and optimize transportation expenses.
Although suppliers with products in this category will probably succeed in creating value in the near term, retaining it will be increasingly difficult as the OEMs go on investigating opportunities to reduce their costs. In segments such as wiring and mechanical brakes, where safety, warranty, and liability concerns predominate, OEMs may remain reluctant to source directly from suppliers in low-cost countries, although that is far from clear. To prevent the erosion of value, suppliers will need to reduce their costs aggressively and continually in these segments. Although further consolidation remains possible in some of them, its value is unclear if it doesn’t provide clear barriers to entry.
Difficult to create value
Creating value across the final 30 percent of a vehicle’s content will prove exceedingly difficult for suppliers anywhere, but particularly for those in North America. Indeed, though we expect that in the coming five years or so continued price pressures from North American OEMs that restructure operations will affect the region’s suppliers more than their counterparts elsewhere, such pressures could trigger a broader exodus of suppliers and capital in some of these segments. Products in this category use mature technologies requiring labor-intensive production processes (for instance, manual transmissions), have low entry barriers (weather strips) or minimal capital expenditure requirements (functional plastics), or can be shipped long distances without adversely affecting an OEM’s assembly schedules (antennas). Such products’ cost structures tend to be well understood by OEMs, and this has historically allowed them to reduce prices significantly—for example, by routinely switching to lower-cost suppliers to increase competition.
Although proximity requirements or high shipping costs may allow some North American suppliers to compete in a few such markets (for example, suspension modules), they too will be challenging. Given the current situation, we believe that North American suppliers should actively consider their exit options in these segments. If suppliers and capital leave selected segments, OEMs would face severe supply risks and be forced to consider restructuring their contracts to include “take or pay” arrangements, which guarantee volume to ensure supply. In other cases, North American automakers may consider taking advantage of new labor contracts and pursue vertical integration. Therefore, North American suppliers with products in this category too should actively consider their exit options. Some, such as Delphi and Visteon, appear to be doing so already. Suppliers elsewhere ought to keep a close eye on the category, because comparable dynamics apply.
Our analysis suggests that suppliers could benefit from a “shrink to grow” strategy: divesting their portfolios of products in which it will be hard to create value and focusing capital elsewhere. Of course, such moves won’t improve the operational efficiency of suppliers. Nevertheless, the analysis indicates that having the right product portfolio is a required (though not a sufficient) condition for success in the marketplace. The magnitude of such a restructuring could be significant. We’ve observed that fully one-quarter of the product portfolios of average-performing suppliers, for example, are in difficult-to-create-value segments. OEMs will almost certainly continue to source aggressively to drive down costs. But to ensure supply in some of these segments, they may need to rethink their current sourcing practices and contract structures—or prepare themselves for the significant costs and challenges of vertical integration, supplier bankruptcies, or both. 
About the Authors
Srikant Inampudi is an associate principal in McKinsey’s Detroit office; Aurobind Satpathy is a director in the Chicago office, where Anant Singh is a consultant.
The authors wish to thank their colleague Holger Klein for his contributions to this article and to acknowledge the work of team members Romain de Dion, Tom Pepin, Sze-Meng Soon, and Marwa Zohdy on the underlying analysis.
Notes