Auto Labour Costs and Auto Industry Recovery

I was recently invited to speak to the annual management briefing conference sponsored in Michigan by the Center for Automotive Research, a fine outfit which does the best research work in the continent on auto employment, workers, and skills.  My slides are available here.

My panel was addressing the current UAW negotiations with the Detroit Three automakers – the first big contract talks since the meltdown and bailouts of 2009.  I was diplomatic enough as a visitor to the US not to make any direct comment on the UAW talks (the “host” union), but rather addressed the broader economic issue about the North American auto industry’s painful recovery, and what role — if any — labour costs have played.

Most of the media hype about these talks so far has focused on whether the union and the companies will be able to turn over a “new leaf” in their relationship.  They warn against the two sides going back to their “bad old ways,” driving up labour costs and bankrupting the companies in the process.  To try to combat this “frame,” UAW President Bob King and the lead company negotiators have gone to great lengths to stress a “new way of working,” their new sense of partnership, and their shared recognition that bargaining can’t add to labour costs or else the North American companies won’t be competitive anymore.

Implicit in both the dominant frame, and this response to it, is the assumption that high labour costs were indeed the reason why the Detroit Three got into trouble in the first place.  The flip side is the corollary claim that the reason the companies have recovered so impressively since 2009 must be because they dramatically reduced their labour costs.

Both assumptions are wrong.  Labour costs were not the key problem in the Detroit Three’s crisis.  And cuts in labour costs have not been the key reason, or even a major reason, for the subsequent improvement in their performance.

Direct labour costs account for about 7% of the total costs of designing, manufacturing, transporting, and selling a new vehicle in North America.  Yet labour costs (and labour negotiations) seem to get 99% of the attention.

In my presentation I conducted a back-of-the-envelope financial analysis to consider the relative importance of labour cost reductions in the overall profit recovery of the Detroit 3.

Between 2006 and 2010, the combined net income of the Detroit 3 improved by almost $30 billion – from a $17 billion combined loss to a $12.5 billion combined profit.

There were many different economic factors driving the change in profitability, some of them moving positively (reduced labour costs, downsizing, stronger unit revenues, reduced management expenses, lower interest costs), but some of them moving negatively (especially the impact of the recession and the painfully slow recovery on auto sales).

Here is one way to estimate the upper bound of potential labour cost savings in recent years: take the average reported reduction in the UAW’s all-in hourly rate (from low 70s in 2006 to mid-50s in 2010 – for an hourly saving of about $18-19 U.S. per hour), and multiply that by ALL the Detroit Three’s workforce in North America.  This is a huge overestimation, because not all employees suffered that size of labour cost reduction (Mexican workers, for example).  A more accurate estimate would require access to unreported data on employment and labour costs by type and country.  So this should be considered very much as an upper bound for the potential labour cost savings which the companies have enjoyed.

But then, we also have to consider the impact of the funding for the VEBA health care trusts in the U.S., which was a major part of the labour cost reduction at all three companies.  These trusts imposed certainty on the company’s retiree health costs, and allowed the companies to use some equity not cash.  But the VEBAs were certainly not “free.”  While the cost of funding the VEBAs does not appear on the labour cost tally, it is still a major cost to the company while the VEBA is being funded.  Ford in particular has publicly noted that most of its labour cost savings were the outcome of the VEBA.  After deducting the VEBA expenses (even if amortized over a long period of time – say 15 years), the net labour cost savings to the 3 companies (combined) is just $4-5 billion per year in total for the three companies.  That is about 2% of their total North American revenues. 

Compared to the reduced expenses that resulted from downsizing and plant closures, these labour cost reductions are very small.  I estimate the three companies saved much more — almost $20 billion per year — from downsizing its North American workforces.

The companies also saved many billions from other measures – such as reductions in General and Administrative expenses and interest costs.  This data is publicly available from the income statements of GM and Ford, but not for Chrysler (which was a subsidiary of Daimler in 2006, and of Fiat in 2010, and hence did not report full financial statements in either year).  For just GM and Ford, the reduction in G&A spending was worth $25 billion per year, and the decline in interest costs (mostly at GM, a happy outcome of its 2009 restructuring) worth $18 billion.

Also, compared to the improved unit revenues that companies have attained as a result of better quality product and a noted relaxation of import pressure since 2008, the labour cost savings are small.  The 3 companies together in 2010 took in over $32 billion in additional revenue as a result of the increase in the average selling price of their vehicles since 2006.  This reflects more discipline on their part regarding incentives and fleet sales, higher quality vehicles, and a relaxation of competition from offshore.  (The yen has risen 60% against the $US since 2007; that plus the quality and tsunami-related problems of Japanese producers has contributed to a substantial decline in import penetration to the U.S. market.)  Together, the companies captured about 8 times as much benefit from higher selling prices, as they did from lower hourly labour costs.  So in this regard, they had a “revenue problem,” not a “cost problem” – a point which a few free-thinking auto analysts made for years.

In short, the reduction in compensation and other labour costs was at most a small secondary factor in the recent rebound in auto industry finances.

My conclusion is that far too much attention is paid to labour negotiations in the context of the continuing struggle to recover in the industry.  Simply cutting labour costs does not address the true competitive challenges facing the Detroit Three – most of which comes from offshore, and most of which has no direct relationship to labour costs (but is driven by other factors, like product quality & innovation, exchange rates, imports, and the macroeconomic problems which continue to hamper the recovery of North American auto sales).

Misdiagnosing the problem is likely to lead to a misidentification of solutions.  If we’re concerned about the future prosperity of this industry (and there’s ample reason we should be, even before the current round of financial instability), then we should be looking at more fundamental issues like product quality and appeal, import competition, and selling prices – rather than the knee-jerk focus on trying to squeeze a little more out of labour.

In that regard, the misplaced public emphasis on the need to continue to suppress hourly labour costs (an emphasis which is being reinforced by current coverage of the UAW negotiations), is diverting us away from recognizing and addressing the true problems which continue to afflict the sector.

If we want to worry about returning to the “bad old days,” perhaps we should worry less about unions and management conspiring to fatten compensation.  And worry more about a state of affairs in which an individual CEO can make $100 million or more, and the newly-hired workers in U.S. plants (who make half the wage of other workers) can’t afford to buy a new car.  After all, here’s how Henry Ford himself put it way back in 1914:

 “The commonest laborer who sweeps the floor shall receive his $5 per day… We believe in making 20,000 men prosperous and contented rather than follow the plan of making a few slave drivers in our establishment millionaires.”