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Trust may reduce the cost of making a car by as much as 10 or 15 percent, study suggests

July 1, 2002

For more information, contact: Benjamin Haimowitz, HHaimowitz@aol.com

"[Foreign-based manufacturers] squeeze you, but they're fair…[U.S. companies] want to beat you to death. If somebody comes in one penny cheaper, they'll replace you in a minute." (Tommie Burns, U.S. auto supplier, quoted in Business Week, July 2002

What is that penny worth next to the loss of trust it brings? Although gaining the trust of suppliers or customers intuitively seems important to a company's success, significant bottom-line benefits have been hard to document.

Now new research focusing on the automobile industry suggests that trust amounts to a lot more than a feel-good approach that brings marginal gains. A study presented at the 2002 annual meeting at the Academy of Management (Denver, Aug. 11-14) suggests that it may reduce the cost of making a car by as much as 10 or 15 percent.

"It's not surprising that trust makes a difference. What's startling is how much of a difference," comments Jeffrey Dyer a professor at Brigham Young University, who will present the study he carried out with Wujin Chu of Korea's Seoul National University.

Drawing comparisons among eight automobile manufacturers in the United States, Korea, and Japan, Dyer and Chu find that the least-trusted automaker incurred procurement costs that were more than five times higher than that of the most-trusted manufacturer.

In other words, writing contracts, haggling and assigning blame was so much more extensive in the least-trusted firm that the dollar value of parts purchased per procurement employee was less than one-fifth what it is was in the most-trusted firm.

In the least-trusted manufacturer about 47 percent of face-to-face interaction with suppliers was spent negotiating contracts and assigning blame for problems, essentially nonproductive activities. That is more than double the 21 percent devoted to these functions in the most-trusted automaker.

Such nonproductive activities greatly inflate what scholars call transaction costs, that is, costs associated with conducting exchanges between firms. Dyer notes that transaction costs take many forms -- management meetings, conferences, phone conversations, sales calls, bidding rituals, reports, and memos -- but their underlying economic purpose is always to enable the exchange of goods, services, and ideas. A 1997 study by the management consultant McKinsey & Co. estimated that such endeavors amount to more than one third of economic activity in the U.S.

And in auto manufacturing and many other industries, Dyer points out, that proportion is growing, as manufacturers increasingly outsource work to outside suppliers.

Dyer and Chu obtained their data through eight auto manufacturers in three countries -- Ford, GM, and Chrysler in the U.S., Toyota and Nissan in Japan, and Hyundai, Daewoo, and Kia in Korea. They visited each company's purchasing department and gathered from the procurement head a representative sample of suppliers, as well as the total number of employees involved in procurement of production parts and the total value of goods they procured. This enabled them to get a measure of automaker transaction costs, expressed as the dollar value of good purchased per procurement employee.

They then surveyed suppliers identified by the automakers, obtaining responses from 135 companies in the U.S., 101 in Japan, and 108 in Korea. A measure of trust was determined through questions that gauged the automakers' fairness and their reliability in honoring promises and commitments. To measure transaction costs, the researchers asked suppliers to estimate the number of person-days of contact between their organization and the automaker during the previous year and what percentage of their face-to-face time involved negotiating a price or contract or haggling over who was to blame for problems. The authors note that, "according to suppliers, face-to-face communication represents the most important, and expensive, form of communication between suppliers and automakers."

The researchers found that at the least-trusted of the eight companies, an American firm, the parts purchased per procurement employee amounted to somewhat over $2 million a year compared to about $12 million per year at the most-trusted automaker.

They also found a strong correlation between trust and suppliers' willingness to share confidential/proprietary information. As they observe, "the sharing of sensitive information, such as costs and proprietary technology, has been demonstrated to be a critical factor for the successful implementation of automaker and suppliers' joint efforts to minimize costs."

But isn't it possible that haggling and hard-nosed dealing pay off in terms of lower costs for parts? Two findings suggest otherwise: transaction cost (the percentage of face time spent negotiating prices, haggling, and assigning blame) proved to be inversely related to firms' overall profitability (measured in return on assets over 10 years), while trustworthiness was positively related to profitability.

Comments Dyer: "If the effect of trust on transaction costs were only marginal, there might be some reason to believe that all that extra haggling and negotiating and hard-nosed dealing pay off in terms of getting parts at a cheaper price. But the effect is so large that it seems unlikely."

He adds: "The arms-length, hard-nosed approach has historically been most associated with General Motors, which has seen its market-share in the United States drop during the past 40 years from over 50 percent to about 28 percent. Of course, there have been many factors in that. But, based on our findings, it's hard to believe that trust hasn't been an important one."

The Academy of Management, founded in 1936, is an international organization that works to foster the advancement of research, learning, teaching, and practice in management disciplines. It has over 12,000 members in 90 countries, including some 8,000 in the United States. The academy's 2002 annual meeting, August 11-14, drew 6,000 scholars and practitioners to Denver for more than 1,000 presentations on a host of issues relating to corporate organization, the workplace, technology development, and other management-related subjects.

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