Manufacturers in Europe have a choice of three strategic directions. What they have in common is a need to fix the way cars are sold.
The McKinsey Quarterly, 2003 Number 1
Sweeping new EU legislation meant to increase competition in sales of new cars and in markets for services and parts will probably be good news for consumers, independent service shops, spare-parts suppliers, and many dealers.1But as manufacturers lose some of their control over the way dealers market and sell their brands, they could face increasing price pressure on the 15 million cars they sell annually in Europe and in the highly profitable after-sales market. Nevertheless, they have a huge and long-neglected opportunity to compensate for falling revenues by improving the performance of their inefficient distribution networks. Europe’s car-retailing system was built decades ago, when dense and integrated sales and service networks were needed to satisfy demand in growing markets and to offer qualified repair service for cars whose quality and performance were generally worse and more varied than they are now.
To stimulate the large investments that were necessary, regulators allowed the automakers to grant their franchised dealers sales areas in which nobody else could sell their cars – an arrangement known as the exclusivity rule. Meanwhile, the selectivity rule allowed automakers to establish certain standards and performance criteria for their franchises in matters such as showroom design, the size and training of the sales force, service offerings, and sales targets. These two regulations in effect made it difficult for dealers to sell cars from a variety of manufacturers or to use resellers, such as supermarkets, that the manufacturers hadn’t approved.
The result has been limited competition both among dealers and between dealers and other sales channels. In the after-sales market, manufacturers were allowed not only to support their own dealerships’ service centers with original parts, full technical information, training, and the official stamp of authorization but also to exclude all others from such benefits. Taken together, these rules have created an integrated automotive value chain with limited competition for dealers and automakers alike (Exhibit 1). In fact, net profits from spare parts, service contracts, financing, and insurance subsidize sales of new cars.
There has long been a need to consolidate overly dense European networks – Germany alone has mor e car sales points than does the entire United States – and to expand the range of retail channels to reduce distribution costs in a market suffering from overcapacity. But the old order favored manufacturers, and the after-sales market compensated them for low margins on car sales, so they had no pressing need to tackle the complex proposition of reforming distribution. Instead, they strengthened their brands, widened their range of car models, and increased their manufacturing efficiency. As for dealers, the regulatory system prevented them from initiating change. Europe’s automotive-distribution system has thus ossified.
New rules of the game
All this is about to change as a result of new regulations, adopted in July 2002, that for the most part will be fully implemented by October 2003. In essence, the highly complex revised block exemption will force the distribution system to become more competitive and confront manufacturers with a huge challenge, for price pressure on cars, spare parts, and services will surely increase.
Under the new rules, manufacturers will have to choose between revised versions of the exclusivity and selectivity rules. If they opt for exclusivity, they can continue to grant and dictate exclusive sales territories for their distributors, thus limiting competition among dealers selling the same brand. In the new system, however, the dealer has the right to sell cars to nonauthorized resellers, which can in turn sell them anywhere in the European Union.
Using a reseller that isn’t a direct competitor is a way for the dealership to sell additional cars with minimal effort: it makes a profit on the difference between the wholesale price it gives the manufacturer and whatever higher price the reseller is willing to pay. The reseller can still make a profit when it sells the cars to customers if its distribution costs are very low thanks to expedients such as the use of no-frills showrooms (which may not offer test drives) and to a relatively small (and perhaps less qualified) sales staff. Many carmakers fear that this option will dilute their brands and the associated price premiums.
So most manufacturers will probably choose selectivity, which allows them to ban nonauthorized resellers, such as supermarkets. The downside for the manufacturer is that dealers will then be allowed to market and sell cars directly to consumers anywhere in the European Union and also, from October 2005 onward, to open new outlets anywhere in it. The result, inevitably, will be more competition among dealers selling the same brand.
Regardless of whether a manufacturer opts for exclusivity or for selectivity, additional price pressures are bound to come from two other regulatory changes. First, restrictions on multibrand dealerships are being eased, so competition among brands will heat up as dealers sell cars from different manufacturers in the same showrooms. Each carmaker may demand a separate area within them and – upon payment of the incremental cost – a separate sales force as well. The other major change is that manufacturers will no longer be allowed to limit the share of a dealer’s cars that are sold through intermediaries, often Internet brokers.2This rule is intended to spur cross-border trade and thus to accelerate the harmonization of car prices, which now differ substantially across the European Union.
Even more important, the new rules threaten the share and margins of the car manufacturers in the after-sales market, in which they currently make most of their profits, by breaking down the car b usiness value chain. Dealers will have the choice of providing service themselves, either at their sales points or elsewhere, or of outsourcing service altogether. Furthermore, the carmakers will be forced to give independent service providers full technical information and to authorize those capable of meeting certain criteria. More competition will be the result. In the spare-parts business, suppliers will no longer have to sell through the manufacturer – which typically marks up the price of the goods and then resells them to service shops – for the parts to qualify as “original.”
Consumers should benefit from all these changes in the form of lower prices. Spare-parts providers too are likely winners, since they will be able to sell original parts directly to service shops, without sharing their margins with car manufacturers. To do so, however, the providers will have to build new skills to handle a wider customer base and more complex relations with the carmakers, which will still be their biggest customers. Dealers face threats as well as opportunities: some will be able to grow, though weaker ones may not withstand the competition. But it is undoubtedly manufacturers that face by far the biggest challenge, given a prospective cut in car prices, a shrinking share of the vital after-sales market, and lower prices on spare parts and service.
Three strategic directions
Manufacturers have a choice of three strategic directions, each emphasizing one or more of the industry’s value drivers – selling more cars, finding ways to keep margins as high as possible, and protecting share and margins in the lucrative after-sales market – to maintain their profitability in Europe. What these three alternatives have in common is the need to improve the performance of the distribution system. Each manufacturer must assess its brand strategy, growth aspirations, starting position, and capabilities in its different markets and decide on the right strategy for each of them.
The first option for manufacturers is to become product specialists, concentrating on volume by making cars widely available at competitive prices while maintaining reasonable margins. To pull off that trick, companies will need to have a low-cost structure for both manufacturing and distribution. In distribution, this strategy calls for the use of a wide range of channels, with a significant share of sales going through new, low-cost formats such as multibrand superstores (volume outlets, often located outside cities, with lower service levels), supermarkets and other mass retailers, and the Internet.
This arrangement is quite usual in most other industries where consumers can choose from a variety of distribution channels. Durable consumer goods such as kitchen equipment and home electronics, for instance, are sold not only in single-brand stores owned or franchised by the manufacturers but also through low-cost channels such as discount outlets (for stock overruns and older models), supermarkets, multibrand superstores, and the Internet. Such a mix permits manufacturers to make their products widely available while keeping average distribution costs down by tailoring shop locations, showroom designs, service levels, and product offerings to the needs of each customer segment.
There have been isolated European initiatives to sell cars in supermarket – Germany’s Edeka has sold the Fiat Punto, and cars have been offered, in cooperation with one or more dealers, in the El Corte InglÃ©s and Alcampo hypermarkets in Spain. But no manufacturer has made a concerted effort to develop sales through low-cost channels, despite latent demand: a McKinsey automotive-consumer survey showed that 41 percent of respondents in Germany could imagine buying a car from a supermarket, while 17 percent could imagine buying one directly from the manufacturer over the Internet, without a test drive.
The disadvantage for the product specialist is that by cooperating with new retail formats, it will have to accept less direct involvement in retail operations and thus an accelerating loss of control over the brand experience and a lower share of the after-sales business. This strategy is therefore attractive mostly for weaker or unestablished brands – perhaps new entrants hoping to break into European markets – that wish to grow aggressively. It could also be an option for established but troubled mass-market companies struggling to maintain volumes and for strong and successful carmakers introducing low-cost brands that can be manufactured relatively cheaply.
Making the transition to the product specialist strategy is a bold move posing some likely difficulties. For one thing, manufacturers would have to give careful consideration to the possibility that using this approach in one market might damage their brands in another. There is also a chance that the shift will at first encounter internal resistance – the pride of employees might suffer, and some jobs may be lost in the reorganization – while dealers could find their positions diminished. And early movers will have to take the risk of betting on new types of retail partnerships. Nonetheless, the strategy has obvious benefits if successful: significant mass-media coverage (in effect, free advertising) will attract the attention of price-sensitive car buyers, and there is a real prospect of cornering a new, low-price market.
Another response to the new regulatory environment would be to become a downstream integrator. In this strategy, the manufacturer moves aggressively to acquire dealers, to take control of its retail network in selected markets, to maximize margins on its cars, and to protect its share of the service and spare-parts market. The advantage is that the manufacturer ensures control over its brand experience and has a better chance of protecting its price premium from dilution in multifranchise and mass-market outlets.
Ownership of a distribution network secures a 100 percent share of its retail margins and a profitable service business, in which manufacturers can insist on the use of their own original spare parts. (Of course, competing service networks and the availability of alternative parts will still reduce margins in the after-sales market.) Direct control also puts manufacturers in a good position to restructure and improve the performance of distribution networks. The biggest potential lies in the consolidation of dealerships, as significant scale advantages can be won by spreading the cost of premises, advertising, IT systems, and administration over a larger volume of sales. Integration across the network would, for example, allow such a manufacturer to establish a pool of test cars that could be shared among dealerships in a metropolitan area. The potential gains are suggested by the sizable gap in the number of cars sold per outlet and per salesperson in Europe as compared with the United States (Exhibit 2), where dealerships tend to be larger.
Nevertheless, ownership too entails major risks. Dealerships owned by manufacturers have difficulty matching the retail skills of independent operators, which evince much greater entrepreneurial drive. Overcoming this problem by developing structures and incentive systems will be one of the biggest challenges for the downstream integrator. And to avoid conflicts that could damage the loyalty and performance of the remai ning franchised dealers, the manufacturer would have to guarantee them equal treatment with its own network in such matters as wholesale prices and sales support. Unlike product specialists, downstream integrators will maintain a strong focus on the traditional dealer channel, but they will improve the mix of formats in each region. Integrated sales and service dealerships that offer large demonstration and test-drive fleets, for instance, can be located in suburban areas where real estate is relatively cheap. Such showrooms can be complemented by smaller, centrally located ones with a more limited service offering.
This strategy will probably be most attractive to premium-brand manufacturers, which regard the brand experience as vital and tend to have higher retail margins for their products. However, these companies must take into account the fact that the purchase of dealers involves a large capital investment – one estimate puts it as high as 5 million euros ($5 million) for each dealership – as well as the creation of permanent M&A and postpurchase-integration units. The manufacturers best suited to the downstream integration model not only boast financially strong brands but also already own much of their dealer networks. Such partial ownership is relatively common in Europe; French carmakers, for instance, handle around 30 percent of their domestic sales through dealerships that they own.
To compensate for the investments and risks involved, this strategy will probably be used primarily in markets where a brand has both a strong position and high volumes and where margins ensure healthy returns. Franchising agreements will be more favored in less attractive markets.
World-class franchise partner
Finally, there is a less aggressive but equally challenging strategy, which is likely to be chosen in most markets by a majority of car manufacturers that have a brand price premium to defend but are unwilling or unable to buy and run their own dealer networks. It will be crucial for these companies to maintain or improve their margins by focusing more strongly on distribution in order to reduce their costs and thus maintain their competitiveness and to compensate for the aftermarket profits that will be lost as a result of the new regulatory framework. Such companies may avoid the financial strain of acquiring their dealerships, but they will have to push through the same efficiency improvements that downstream integrators must implement, without having direct control through ownership.
Success will require a new attitude, including a greater overall focus on distribution and the adoption and management of new retail channels consistent with the brand image of the manufacturers. (In small towns, for instance, they may strive to be the preferred partner of multibrand dealerships rather than try to retain unprofitable single-brand outlets.) Manufacturers choosing this strategy will have to reduce the overall number of dealerships and, at the same time, to make sure that the right owners stay in business in the right places. The performance of dealerships will have to be improved through measures such as the networkwide centralization and standardization of training and marketing programs as well as the development of collaborative programs with individual distributors.
Manufacturers choosing this strategy will still depend heavily on their franchised dealers, over which they will have less power. They must now act decisively to improve the way their cars are sold, by cooperating more closely with dealers. “
Making the most of US auto distribution– the other article in this package – shows how US manufacturers, with no leeway to change the existing market structure radically, might try to accomplish this goal. Much of the advice there is relevant to European manufacturers as well.
Erik Bohman and Peter Stenbrink are consultants in McKinsey’s Stockholm office, and Joachim Rosenberg is an associate principal in the Gothenburg office.
1The authors wish to thank JosÃ© Maria del Aguila and Lars Wilsby for their contributions to this article.
2The revised selectivity rule wouldn’t end this practice, because the brokers are intermediaries between seller and buyer rather than resellers.
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