by Donald V. Potter

After nearly eight years in the doldrums of overcapacity, the American Rust Belt has revived. Machine tool order books are expanding. Chrysler is talking about exporting cars, and many industries are at peak utilization levels. Even that perennial invalid, the integrated steel industry, is showing signs of health.

The question now is whether this upturn will only be a short-lived illusion – or whether American companies can use this breathing spell to fundamentally improve their global competitive position. The current upturn is the first decent chance in several years for U.S. firms to gain ground on their foreign competitors. It could be their last chance until well into the 1990s.

The Rust Belt Revival owes much to the weak dollar, whose effect has been to make American companies more cost competitive, probably temporarily. The high cost structure, and resulting high prices, of much of American industry encouraged a wave of new foreign competition, which began in the late 1970s and grew steadily with the strengthening dollar.

Now the dollar is weak again, as it was in the late seventies and early eighties. In 1981 it began to gain strength and peaked in 1985. The current cheap dollar will not last indefinitely, since there is a limit to how much unemployment Europe and the Far East will allow us to export to them through exchange rate manipulation. In fact, the dollar has strengthened steadily throughout 1988.

Meanwhile, the basic economics of many industries have been changing. Companies achieve a low cost position differently, because there are new economics of scale. It used to be that low cost resulted from the possession of the largest manufacturing plants and highest throughput – traditional economics of scale. But now, in industries such as autos, steel, airlines, and copiers, the company with the greatest capacity no longer has the low cost position. Today, low cost results from a reputation with customers as a reliable and convenient supplier.

Scale counts. But owning share of the customer’s mind is more important than sheer scale. Traditional economies of scale may give a company a cost advantage of as much as five percent of revenues. But every year most companies spend between fifteen and twenty percent of revenues to market and sell their products. A company that establishes a reputation for high quality and convenience has invested far more in gaining that reputation than it has in achieving low manufacturing costs.

In large markets, quality and convenience are more important than new products and innovative pricing. Differences in product features and prices are less marked than they once were in today’s global economy. Successful new features and low prices are cheaply and rapidly imitated. It is much more costly today to win a superb customer relationship than it is to develop innovative products or new pricing schemes. The very best competitors in tough markets – McDonalds in fast food, Yellow Freight in trucking, Honda in motorcycles, American in airlines, Anheuser-Busch in beer, Matsushita in color televisions and John Deere in farm equipment, among others – win consistently by offering the highest quality products at prices their competitors and customers view as low.

Surprisingly, some U.S. industries seem more intent on counting profits from the upturn than on forging strong ties with customers. Automobile manufacturers – even those with plenty of capacity – are raising prices right along with foreign producers in order to benefit from high profit margins. The problem is that raising prices allows the foreign companies to survive and expand, whether here or abroad. The result: zero net improvement in global overcapacity. In the case of autos, chronic overcapacity will likely get worse in the 1990’s. Instead of raising prices during the upturn, U.S. industries should be lowering prices in order to build strong customer relationships and simultaneously discourage, rather than encourage, foreign competition. If U.S. industries like automobiles persist in raising prices, perhaps the bulk of the additional margin should be invested in extraordinary efforts to close the quality gap between themselves and foreign competition.

Other U.S. industries, such as chemicals, are running out of capacity. These industries need more capacity, not lower prices. Fearful of overcapacity’s return, and the low prices it brings, domestic competitors in these industries have been reluctant to expand during the upturn.

Recent history, however, argues otherwise. In the early 1970s, the U.S. semiconductor makers encountered a bout of overcapacity. They stopped adding capacity while the Japanese plunged ahead. As the market turned upwards, the Japanese had capacity and the U.S. did not. The Japanese got much of the new business, a foothold in the U.S. market, and a strong share of the customer’s mind – a position they have since built on relentlessly. In the long run, the U.S. semiconductor industry suffered lower returns from a failure to expand than if they had expanded.

Aggressive expansion, rather than passive profit-taking, is needed when demand outpaces capacity. A company cannot keep its profits high by delaying expansion unless it can stop all its other competitors from expanding under the price umbrella it holds over them. A company that declines to expand in a capacity-short industry is surrendering its most important cost advantage, a satisfied customer relationship, to another company. Someone will meet the customer’s demand.

The weak dollar will strengthen our foreign competition. It has already driven the Japanese and Germans to streamline, outsource, and otherwise lower their cost structures. Despite a nearly fifty percent appreciation in the yen, Japanese firms have lost little U.S. market share; they say they can profitably withstand another 20% fall by the dollar. The Germans have lost less volume than expected, and the Koreans don’t seem to have noticed that much has changed at all. The exchange rates of just three years ago, when the dollar was strong, left America with a very high relative cost structure. When the dollar strengthens again and our temporary cost advantage fades, some American firms will be in a worse relative cost position than before – unless they make good use of this window of opportunity.

Even high cost U.S. firms benefit from this respite. The long-term outlook for these companies is bleak. Many of them have tried to reduce costs, but in most cases, they were so far behind offshore competition to begin with, even stringent cost-reduction efforts will prove futile. No matter what they do to their cost structure now, their competition can and will match their moves. For these firms, the current upturn is the time to sell the business or merge it with a stronger competitor, since market conditions are good and they can get a premium for their shareholders. If they hold on until the dollar strengthens again, this premium is likely to disappear.

Most U.S. firms, of course, will decide to stay the course. During the next twelve months these companies should 1) discourage production by competitors by dropping prices, 2) make greater efforts to improve quality and convenience, and if needed, 3) enhance a reputation with customers for reliability and convenience by adding capacity and assuring supply. The companies that accomplish these steps will be the ones most able to compete effectively against the reinvigorated foreign competition when the dollar regains its strength.

(Note: This Perspective was written in the context of the economy in 1988. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

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