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Auto Supply Chain Case Study: ICRA The Managing Director of Speed Motors Limited (SML), Mr. Adesh stood in his office and contemplated the decision that he needed to take tonight. SML was an Indian car manufacturer concentrated mainly in the domestic passenger cars segment. It had been experiencing problems with its current supplier of auto component X for the past year and just this evening, SML had received an intimation that the current supplier, Engine Parts Pvt. Ltd. (EPPL) would be unable to meet their scheduled delivery timeline again. This had resulted in the production planning team having to call an emergency meeting and revising their production schedules for the next month. Delays such as this were disastrous for the company as production schedules were planned far in advance and could even result in production stoppage due to the unavailability of parts, which was an expensive proposition for an auto manufacturer. Component suppliers were critical to automobile manufacturing, with as much as 95% of the components of an automobile being supplied by outside vendors. So far SML had gone with a strategy of appointing sole suppliers for its components, though it now seemed like the company would have to review this policy. Background SML had setup business in India in the year 2000. It was a good time to start business, the economy was coming out of a slump and the uptrend was clearly on the horizon. With growing incomes and rising urbanization, people had started investing in privately owned transport two-wheelers and four-wheelers. The automobile industry in India was at an inflexion point, with financing for passenger vehicles increasingly easier to obtain, lowering interest rates and rising disposable income in the hands of the people, which spurred the growth in SMLs sales. The growth in the auto industry was being driven by the following factors: High GDP growth Indias huge geographic spread driving need for public as well as private transport systems Increasing road development, making most places accessible Increasing disposable incomes with the service sector Easier financing schemes Replacement of aging four wheelers Graduating from two-wheelers to four-wheelers Increasing disposable incomes of the rural-agri sector Growing concept of a second vehicle in urban areas The company had been setup by two brothers Mr. Adesh, the current Managing Director and Mr. Videsh, who handled the technical side of the business. The initial designs for their small car were done in-house and achieved instant success in the domestic market. The initial model, a small car, was targeted at the economy segment. Over the next few years, the company captured significant market share by introducing new small car models with better features and technology. To expand its product offering and diversify its segment presence, the company also introduced an executive class car model, which met with modest success. In 2004, SML entered into a technological collaboration with a German car manufacturer and introduced a diesel variant of their small car. Keeping in mind, the high value-for-money mindset of the Indian consumer, SMLs mainstay remained the small car segment in which the company sustained its market position by constantly reinventing its advertising campaign and introducing new models while keeping its prices low. This strategy

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worked very well for SML, with its topline growing robustly and profitability improving with volumes. In short, Speed Motors was a success story, as rosy as they came. Sourcing of Auto Components Component suppliers are integral to a car manufacturing company, not only for its own production but also for the replacement parts market. The entire range of components for car manufacturing are outsourced: - Engine parts - Drive Transmission and Steering parts - Body and Chassis - Suspension and Braking parts - Equipment for cars - Electrical parts Through experience, Mr. Adesh knew that smooth and timely supplies of auto components would help improve productivity, shorten lead times, reduce inventory & carrying costs and help the OEM to maintain production timelines. Delay in critical component supplies could result in production stoppages, and in a competitive market like today, unavailability of the product could affect market share significantly. SMLs sourcing policy in the past had been to procure from various domestic suppliers with whom they had established relationships over the past few years. The only components imported were those that were not indigenously manufactured or those for which Indian companies had not yet adopted the latest technology. Though some of SMLs competitors had started sourcing from Chinese companies because of the lower cost, SML had not adopted this practice yet. They felt that Chinese companies had not yet established a track record in terms of quality and timeliness. Typically, for critical components, SML would designate a particular component manufacturer as sole supplier for after conducting stringent quality and technology checks. Contracts were then signed with them for the supply of components for one whole year, subject to renewal at the end of the year. Prices were usually negotiated at the time of signing of the annual contract, though price escalation clauses were commonly built in. Quality checks were conducted by SML annually to ensure maintenance of quality processes. In addition, at the time of receipt of the components, the in-house quality department conducted random sample tests on each batch. Whenever a new vehicle model was designed, SMLs product engineers would develop component designs in collaboration with the suppliers. Due to the long lead times in approving suppliers for critical and technology-intensive components, the inertia to change component suppliers on account of small pricing differences was quite high. Also given the multiplicity of such suppliers that SML dealt with (on an average 50 such suppliers for various components), and the tremendous time and effort involved, techintensive component suppliers were rarely changed. For more commodity components, which were either not as critical or the technology was not as advanced, SML sourced through a competitive bid system, which ensured that they got the best price at all times.

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Quality and technology were critical parameters during the selection of a critical component supplier. Since the lead-time for supply of most components ranged 1-4 months, the company had to have arrangements in place fairly early as per their own production schedule. Earlier SML had had to maintain upto a months inventory for most components because of the erratic delivery schedules of domestic companies, however, with most auto component manufacturers adopting modern shop-floor practices such as Kaizen and Just in Time, SML now maintained much lower inventory levels. Component X Component X was a critical part of the engine and a technology-intensive component. Technology for the component had advanced significantly over the past few years. EPPL had a technological collaboration with a Japanese company, which supplied the technology for its product. Most other domestic manufacturers of the same component also had similar technological collaborations. While many of the international OEMs in the Indian industry decided on their component supplier on the basis of which technology partner they dealt with in the international markets and sometimes also imported their requirements, SML had no such biases. The relationship they had developed with EPPL had been made after extensive due diligence on technology and cost. However, EPPL had run into capacity constraints due to which its delivery timelines had suffered. EPPL was also suffering financially on account of the high-cost debt on its books taken for their previous expansion and currently could not contemplate taking additional debt for expanding their current capacities. Therefore, the capacity constraints would continue for some time. Though EPPL had committed to meet SMLs current requirements, they would not be able to service the new models that SML was planning to launch within the next year. SMLs requirements would almost double in the next year due to the capacity expansion that was planned. That evening, after the production team meeting, the head of the department had met with Mr. Adesh and laid out the problem. Through the discussion, it had become clear that the current arrangement no longer worked. However, given the criticality of the component, getting another supplier on board quickly was almost impossible. Therefore, Mr. Adesh decided that they would play out the existing arrangement until the end of the current contract and then change suppliers. They had also discussed the various options available to the company: - Backward integration through the setup of another company within the group for Component X - Sourcing of the same from Chinese manufacturers, which had a significant price advantage (price differentials were close to 20%) - Appointing another domestic company for a supply arrangement similar to what they had at present The costing details for Component X have been captured below. As seen in Table 1, the costing for the component as per competitive quotes collected by the production department was significantly lower for Chinese companies. Table 1: Costing for Component X Component X Cost of manufacturing Cost of Component X Percentage of car cost Small Car 200,000 17,000 8.5% Executive Class Car 300,000 24,000 8.0%

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Production for 2006-07 (nos) Projected requirements for 2007-08 Projected requirement after capacity expansion (2008-09) Competitive quotes for Component X: Domestic Component Manufacturer Chinese Component Manufacturer (Landed cost)

175,667 217,800 326,700

35,729 45,000 67,500

16,800 14,112

24,000 20,160

Component X supplied for the executive class car of SML was more expensive on account of the higher technology for the product. Raw material (primarily steel) costs accounted for about 50% of the cost of Component X, with the rest being accounted for largely by labour and power costs. The gross contribution margins for Component X were in the range of 25%-27%. Auto Ancillary Industry The Indian Auto Ancillary industry started sometime in the 1940s. Prior to the entry of Maruti Udyog Limited (MUL), this industry was populated by fragmented players, with small capacities and little or no quality control imposed by the OEMs. However, after the entry of MUL, the industry showed a spurt in growth, with the emergence of various auto component suppliers who were required to meet the stringent quality parameters of Marutis Japanese collaborator, Suzuki. The strong performance demonstrated by Maruti gave a boost to the industry and auto component manufacturers began increasing capacities and exporting to international markets as well. Post the liberalization in 1991, many international OEMs setup business in India, including, Daewoo, Fiat, Ford, General Motors, Hyundai, Honda etc. Auto component manufacturers have grown in size and technology along with the domestic and international auto majors. The fortunes of the auto ancillary industry are inextricably linked with those of the auto industry. Demand swings in the auto industry have an impact on auto ancillary demand, with demand being derived not only from OEMs, but also the replacement market or the aftermarket. Amongst the total production range, engine parts account for over 30% of the total revenues of the industry, with the rest coming from chassis, sheet metal and body parts. ACMA, the Indian Auto Component Manufacturers Association, has estimated the Indian passenger car industry to be the 9th largest in the world. About 19.5% (2006-07) of the industrys entire production is exported, with Indian companies increasingly meeting the stringent quality standards of International markets. Indian component supplies to the OEM/Tier I segment in international markets have also grown in the 1990s, the proportion of aftermarket exports to OEM/Tier I companies was around 65:35, which saw a dramatic shift to about 25:75 by 2006. Global MNCs have also started shifting automotive design centers to India to leverage IT skills of the indigenous population and inherent labor cost advantages. In the last decade, along with the auto industry, the auto ancillary industry has also grown strongly. However, in the past 2-3 years, with the increasing competition in the auto industry not only from the incumbent players, but also new international entrants, profitability had declined with OEMs undercutting margins to maintain market share. This coupled with rising

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cost-side pressures had resulted in shrinking margins for most OEMs. Consequently, OEMs had started squeezing component suppliers to reduce costs, resulting in shrinkage in margins in the auto component industry as a whole. In addition, competition posed by low-cost Chinese imports had intensified over the past few years. Many OEMs had started procuring increasingly from Chinese companies leading to loss of revenues for the domestic companies. Unable to match the lower labor and power costs of Chinese companies, this competitive threat had grown significantly over the past few years. What lay ahead? Mr. Adesh needed to make a decision and quickly. The lead-time for getting any component supplier on board was close to 6-8 months and they didnt have the luxury of time, as the contract with EPPL was due for renewal in the next 6 months. Also, the company was planning to double its capacity for both small cars and executive class cars in the next 2 years to cater to the growing demand. Once the increased capacities were operational, component supplies would also have to keep pace. He had promised the Head of Production that he would have an answer for him in the morning. Questions - Apart from the ones listed within the case, are there any other options available to the company for its current decision? - What are the pros and cons of each of the available options? - What should Mr. Adesh do? Support your choice with necessary analysis and facts.

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