Shall we start by looking at the relationship between OEMs and Tier 1s?

That's the beginning of all of it. The three first principles: quality, price and delivery. These are a given that are not debated about. Either you can fulfil the quality requirement, either you can fulfil the price range and you can make sure that you can deliver in time, as expected, or else you're out of the business. So this is not a differentiation factor.

Quality is a given. In the end, you have to consider that when we're talking about, for instance, the seat frame structure and the mechanisms, we're talking about a security part. We're also talking about ppm [parts-per-million] rates in the range of 10 to a maximum of 15 ppm. So either you're in this ballpark or you're not considered.

And with regards to the price, of course the OEMs try to push the suppliers as much as possible to get to the "right price." Most of the time, there's a certain bandwidth. If you are in the range of 5-8% plus/minus then you're still considered. If you're shooting too high, then you're out again.

And delivery, here we're talking about two elements. If you're a complete seat suppliers, we're talking about the just-in-time supply, which consequently means the JIT (just-in-time) factory has to be relatively close to the customer, I would say within a radius of 50-80 miles of the customer site. Otherwise logistics costs and delivery on time become just about impossible. Or you have to have an interim warehouse, which is not beneficial because in order to build the variations as late as possible a warehouse doesn't make sense.

Let's compare Adient to Faurecia, let's assume that they both have the same quality, does is just come down to operational ability in terms of manufacturing at slightly better cost?

No, actually the difference between Adient and Faurecia when it comes to seats is that they have the rework stations included in the just-in-time lines, while Faurecia has taken it out. So, if there's rework to be done on a seat, it's done outside the regular production line. Outside of this, Faurecia is following rigidly and strictly the Toyota manufacturing principle, which in Faurecia has called the Faurecia excellence system. I see it as a beefed up Toyota manufacturing system, which they have continued to improve over a period of time. In order to make the Faurecia excellence system happen all over the globe in each of the Faurecia plants, they have recruited a couple of Japanese manufacturing experts to teach, and also monitor and audit the excellence system to ensure it's being utilised to the maximum.

They have rework stations, but they have excluded it from the regular production line, while Lear and Adient have it as part of the production line. If you look at the standard seat manufacturing line, Faurecia is using between 15-18 employees per shift, while Lear and Adient are using approximately 2 more.

And that's down to the the rework part of the line?

Yes. The philosophy of Faurecia is rework is not part of the standard operation process. It happens, yes, but if it happens it has to be separate from all the other operation systems and processes.

What's the difference typically in the cost and duties of these extra two people?

Actually, from a pure cost standpoint, Faurecia is a bit lower than Adient for a typical seating line, which is mainly due to the fact that rework is part of the standard operating process. In Faurecia, if there's rework to be done, they hide it under the SG&A costs. It's divided through all the different processes so in the end it doesn't have too much of an impact on the cost price per seat.

It does show up in the bottom line though right?

Yes, it does. But, if you can spread it over all the different operational processes, it's a micropercentage that you have to add.

Why would the EBIT margin for Faurecia be higher than Adient, for example?

There are a couple of elements to it. They were the first company to fully standardise; first of all, they standardised the seat mechanisms, but then they also standardised the production of seat mechanisms. Consequently, if they are quoting for a new seat, they can just duplicate the designs of the existing mechanism lines, so they don't have the R&D costs again and again. They have standardised the seat frames as well, which is also a cost benefit. Furthermore, Faurecia is strongly focused on using the Toyota production system to create permanently continuous improvement. And, if they quote a tool for the price of x, they also have ideas in mind to bring the cost price down x minus 5 or x minus 6 or whatever.

Don't Lear and Adient also have this standardisation?

Lear and Adient are lagging behind. They have started to go in the direction of standards, but they are not as advanced as Faurecia is for the time being. Aa a matter of fact, Lear is partially buying seat mechanisms from Faurecia, and Magna is also partially buying mechanisms from Faurecia. So when it comes to economy of skills, Faurecia is certainly seeing a big benefit through this standardisation.

Is the seat mechanism the core structure of the seat?

It's a mechanism that helps to adjust the seat in height. Helps to adjust the backrest and so on. So, it's an add on to the seat structure.

Let's look at how the pricing is structured. If you've got Faurecia versus Adient or Lear for example, two slightly different models and propositions - how do the OEMs approach pricing with Tier 1s?

Actually, the way the product is priced is the same everywhere. The big difference is how much of the components you need for a complete seat: are you buying externally and how much are you vertically integrated? This much can make a big difference. For instance, Lear is a company that says, "When we talk about vertical integration, we are looking at the visible part of the seat," meaning leather, fabric and all this stuff. Whereas Faurecia are looking at the non-visible parts like the seat frames, the mechanisms and also the foam of the seat.

Lear has an installation in China to produce electric motors for seats. Faurecia said, "We won't do that. There are companies around that do motors on a big scale, they are validated and verified by the automotive industry already. Why should we do it ourselves, we'll buy them."

If I'm an OEM, and I've got a new model that I'm rolling out, I'm producing 100,000 model Ts, for example, how do I purchase the seat mechanisms? What is the structure in the contract between Faurecia, for example, and the OEM?

We have to differentiate because in the majority of cases Faurecia is a full service supplier for a full seat. And this means there's a requirements contract from the OEM, where everything is specified. Then, in the courting process, Faurecia reviews the specifications of the customer for every element of the seat, and they either confirm or propose alternatives. Then when the RfQ is being reviewed by the OEMs, all this stuff is being ticked off, meaning, yes, Faurecia can fulfill this, Faurecia proposes alternatives here, and Faurecia is 8% more expensive in whatever component. But then they look at the full process cost and the full cost of ownership and they make the decision.

So is the cost of ownership the full delivered cost?

Actually, we're talking about two prices, it's the A price, which is basically the price for the manufacturing of the seat, then we have the B price, which is everything that we can subsume under logistics costs.

So the Tier 1s will provide a unit cost for manufacturing and a full delivered cost of ownership?

And is the contract typically for a set volume for 3 to 5 years?

First of all, it's a contract for a period of 5 to 7 years, depending on the product life cycle of the customer car. Let's say, you need to produce seats for 100,000 cars for a Volkswagen Polo for instance, you need to have the flexibility to cover plus or minus 20%. So if it's below 80,000, the supplier, in this case Faurecia, has the right to start renegotiating the price, if it's above 120,000 the OEM has the right to request renegotiation of the price.

So if the demand increases with the OEM, they can demand a lower unit cost with the supplier?

Does the OEM look at the total profitability that the Tier 1 earns and then manages that?

In the end, it depends on how much innovation you have in the seat. Faurecia is trying to stabilise the profit margin and improve the profit margin by bringing in innovation. For instance, they installed pneumatics in order to have more rigid seatrests or to improve the side protection of the seat with pneumatics. Therefore, they can ask for a premium price. If you don't have a premium price, you can say that the OEMs accept an EBIT margin of between 4.2 to 4.8, maximum 5%.

And if you have a premium price, Faurecia can get 5-6% maximum?

If you have superior technology, you can end up - but this is really extremely rare - with a profit margin of between 6.5% to 7.5%.

If you look at Faurecia today, the EBIT margin is just over 5.6, 5.7%.

Which is good. In 2012/2013, we were having an average profit margin in seating of 3.3 to 3.4%.

Because of the standardisation and also the rationalization in the factories. And rationalization is a standard process in the Faurecia culture.

So that's just a part of the Toyota manufacturing process, in terms of lean manufacturing?

Was the standardisation just a set R&D platform spend for a mechanism that you can roll that out across different models for OEMs?

No, it was more. It was  a combined effort from R&D, coupled with quality, coupled also with project management. So there was a bunch of people working on it, and then they involved potential suppliers of equipment and that's how it came into existence. But we were also monitoring business units. I know this as I was part of the team. For instance, there was a business unit in Northern Europe and Southern Europe, and we merged these two units into one, which got rid of lots of overhead structures that you didn't need any more.

Turning back to pricing, how does it work in terms of the raw material pricing, if we saw inflation in the materials of the Tier 1s, could this be passed on to the OEMs?

It depends on the contract, because the tricky thing with pass-through is it also works the other way  around. Sometimes you're lucky as a supplier and the material prices are reducing, and if you do not have a pass-through clause, you don't have the need to reduce prices due to lower material prices. If you have a pass-through clause, that's a kind of hedging in the end, if the material prices increase, the customer has to participate, but if the material prices should decrease, the customer has to participate as well. So it's a risk mitigation thing that you need to evaluate very carefully. Faurecia is having contracts with pass-through clauses and having contracts with no pass-through clauses.

So it depends on the contract but it can work in both ways?

I can tell you that, with the pass-through clauses, the OEMs always find a means to approach the supplier for reductions. They say, "You're the specialist for this kind of production, you have gained the efficiency, we want to participate in efficiency." So whatever reason they can find, I can assure you they will find it.

I'm curious about the cash flow profile of one of these contracts. Let's go back to the 100,000 Polos example, how does the cash flow profile work between the OEM and the Tier 1? When does the Tier 1 have to lay out cash for manufacturing versus the OEM actually paying upfront for some of this stuff?

You can more or less say that the Tier 1 is a kind of bank for the OEM. Normally, you can say as soon as business is awarded, 30% of the needed investment is paid in advance. Then, when the first prototypes are available, another 20 or 30% is paid. Then, when the first serial parts are delivered, another 20% is paid. Last but not least, all the testing and validation is done by the Tier 1 and by the OEM, and the remaining 20% is paid. Here, we're talking about an intensive stretch payment scheme. You do need to have a certain financial power, if you want to play in this business.

That's 30% upfront, 20% staggered based on volume, and then 30% test and validation at the end?

To begin to produce seat mechanisms or complete seats for these models - if you receive 30% up front then I guess you have to pay out another 30% yourself right?

Let's focus on the potential tools you need. When we talk about seats, we're talking about stamping, cutting tools and welding tools. So, depending on the quantity, and depending on the re-usage of existing tools, we're easily talking about an advance in the range over $4.5 to $6 million. This is only tools and not equipment, which consequently means, let's say $5 million, 30% advance, you get $1.5 million.

But the Tier 1s need to pay the suppliers in full, because most of the time the suppliers don't have the same strength as a Tier 1 supplier, and they can't cope with the request to pre-finance all this stuff. This means the Tier 1 supplier, who has to pay in advance, gets the shorter end of the stick.

What's the break-even on a cash basis that you look for in one of these contracts with an OEM?

If you do it right, meaning you have no quality issues, you have no ramp up issues, you should be in a break-even range in a period of 18 to 24 months.

That's the interesting thing actually, the entry barrier in this kind of business is relatively high because you need to have the power to spend big cash.

You touched on how, if the volume decreases, then there needs to be that flexibility for the OEM and the Tier 1 to add back-pricing or take back some margin.  How can the OEM use its power against the Tier 1? Can the Tier 1 be in serious trouble if the volumes fall materially?

The OEMS can always put pressure on Tier 1s, that's a fact of life. We're also talking about relationship management. If the relationship is okay and there are no major issues, then, yes, the OEM will still put pressure on you. But, they will not put it to the max, because the max would be saying they are going to change the supplier. First and foremost, changing supplier costs money for the OEM. Of course, the OEM will then try to get this money back from the Tier 1 that they want to get rid of. But it's a very complicated process and there used to be some legal claims. And when this business gets legal, it's not a very happy marriage.

How hard is it to switch then for OEMS? What is actually required?

First of all, it takes time and it takes money. Let's assume a Mercedes product for instance. Most of the time you have a complete JIT factory for Mercedes. If the OEM wants to switch, there needs to be a supplier who either has a factory available or who is willing to set up a factory. And setting up a factory (infrastructure, equipment, and everything) is not trivial. The alternative source will want something in reward from the OEM, it's not going to be for nothing.

So it's very unlikely for an OEM to switch Tier 1s?

Yes. In the end, you can say that in the seating environment, it's more or less 100% supplier. So it's not dual sourcing, it's mostly single sourcing, because it's too capex intensive.

So the relationship between the OEM and the Tier 1 is very important in this case?

Is there any material difference between the seat mechanisms and the complete seat business?

Actually, due to the fact that the material in a complete seat is specified by the OEM, you can't say that the same material is used everywhere.

So the OEM would demand which kind of material would go into the complete seat?

Yes, it's a matter of liability and warranty because, to the end customer, the OEM is liable and has to guarantee warranty. This would bring a bad reputation, so the OEM will do whatever is needed from their perspective to keep the risk at the lowest possible level.

How does the integration between the OEM and the Tier 1 work?

It's relatively simple. There's a direct IT connection between the OEM and the Tier 1 supplier. Due to the fact that it's just-in-time supply, the Tier 1 receives the information two hours before the call off. Then they can assemble the seats in the sequence needed.

So the Tier 1 has their facilities where the sourced product they've manufactured - the mechanisms and all the products - are there ready and they can assemble when they have the information from the OEM?

Yes, you have a window of 2 hours before you have to ship them. You get, the colour, the material and all the specifications and then you do the assembly just in time.

Is the manufacturing for the seat mechanism more of a typical manufacturing line?

This is independent. It's a typical metal production, which is decoupled from the just-in-time factory. The seat mechanism factories can be anywhere, because a seat mechanism is relatively small so the logistics costs are not an issue. Variations are also not an issue. You ship it in batches to the just-in-time factory.

How does Faurecia manage the utilisation of a large facility, like you said it cost so much money to get it up and running, but you only have a few customers that drive most of the volume?

That's the tricky part about it. Companies like Faurecia will always try to have more than one customer, which for a JIT factory is just about impossible. So the only thing that they can do is keep the factory as flexible as possible, keep the overheads as lean as possible. And in Faurecia factories, they make sure that workers on the shop floor are as flexible as possible, which means that they can be used in 6, 8, 10, 12 workstations without additional training. So that's also a Faurecia philosophy.

You mentioned that the just-in-time facilities are predominantly one customer only.

It's for the benefit of the customer. They have the factory for their products right on the doorstep of their own factories.

What happens if their volume falls lower than expected and the utilisation for the Tier 1 is lower?

Then you have to discuss that with the customer again. That's a standard procedure in this kind of business.

You mentioned how the Faurecia way is different to the traditional production process, in terms of its lean manufacturing. How does the organisational structure differ between Faurecia and other Tier 1s?

Faurecia is very rigid when it comes to the shop floor organisation. They have defined a very clear span of controls. You have team leaders who manage 6 to 7 people. The team leader doesn't only manage the team, he also takes turns, if somebody has to take a break or whatever. Then they say a shift manager can manage a maximum of 6 to 8 teams. And the production manager manages a maximum of 100 to 120 people.

Adient does not have the team structure as rigid as Faurecia has it. but they have group leaders, a group of people is between 10 to 16  people. And then they have shift managers.

Is there anything else specifically about the manufacturing process that Faurecia  has leveraged from the Toyota machine, that others haven't?

They try to have a relatively high rate of re-usage of machines and equipment, but they are also investing heavily in order to have the latest state of the art equipment. In the end, you can use equipment for two production cycles, which means between 10 to 12 years, maximum 14 years. But to do that, you have to have re-usage.

By ensuring that you have standard equipment, as well as standard products. Equipment that is not necessarily focused on one product and one customer, but equipment that through relatively small changes can be used for another product.

Could you elaborate slightly on the point around the modular approach to seating that Faurecia have by comparison to competitors? How is it or why is it that Faurecia seem to have this platform the others don't?

For Faurecia, it was just of a matter of cost optimisation. They reviewed their complete product portfolio for seats and they found out that they have batches of 50,000 seats with different seat mechanisms, different seat frames, and batches of seats with 200,000 seats per year with different mechanisms and seat structures. That's when they came up with the idea, if we really want to make a step forward, we need to standardise the basic components of the seat.

So when looking more broadly at the Tier 1 supplier business - maybe specific to seats so that you can touch on your experience of interiors in general - what is key to managing the EBIT margin in these companies?

First of all, it's material consumption. That means reducing the scraps from cut-offs, be that fabric, or be it from the tubes for the seat structure. You really need to be very focused on improving and standardising the pre-processes. Second to this, you need to manage the scrap because scrap can really kill the complete result. Last but not least, you also need to manage the customer because the customer made it a source of income to initialise customer quality debits. Let me give you an example. For instance, you deliver a component or a complete seat and you have to put on a barcode. This barcode has to be in a certain position. If this barcode is slightly - meaning 2, 3, 4 mms - out of the expected range, then they charge you $50 for this single barcode. If your seat arrives too early, they charge you. If it arrives a bit late, they charge you. So you really need to manage your processes in order to get the EBIT margin you're looking for. It's all about scrap and the pre-production of the components for the assembly.

What are processes in place to manage scrap?

First of all, it's in the training. In the end, you can't inspect quality into the products, you need to produce it, which means each and every employee in the production line needs to have a clear focus on quality and needs to understand the level of quality that is required. Those individuals need to clearly understand the quality requirement and how to produce it. And they need to understand how to use the inspection devices. So it's training, training, training.

Auto OEM and Tier-1 Dynamics

Former President and CEO of Interior Systems at Faurecia

inpractise.com/articles/OEM-and-Tier1

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Manfred Kwade

Former President and CEO of Interior Systems at Faurecia

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Auto OEM and Tier-1 Dynamics(October 15, 2019)

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