DAF trucks: Avoiding fixed labor costs

By contrast with the United States, it is very difficult for businesses in many Western European countries to lay off workers for economic reasons. Accordingly, labor can become a fixed cost for a very long horizon. As the example of DAF Trucks shows, some European businesses try to reduce fixed costs by substituting temporary workers for permanent employees.

DAF Trucks NV is one of Europe’s largest truck manufacturers. It was established in 1993 to take over production in Belgium and the Netherlands from DAF NV, which had collapsed under pressure from a falling European demand for trucks.

DAF Trucks retained only 2,500 of its predecessor’s 13,300 workforce. Within two years, by late 1995, growth in demand had enabled the new organization to increase daily production to 70 trucks. It expanded employment to a permanent workforce of 3,500 plus 2,200 temporary workers.

Although the company planned to step up production further to 80-85 trucks a day, DAF Trucks chairman Cor Baan cautioned, “Flexibility is the key word for the market. . . . The old levels of employment will never come back.” DAF Trucks gears its permanent workforce of 3,500 to a production rate of 60 trucks, while the company meets additional demand through temporary workers. In this way, it can limit its fixed labor cost and avoid excess labor during economic downturns.

Similarly, Ford Motor Company has closed some manufacturing plants, but it is trying to “coincide” the plant closings with the expiration of the current contracts with the employees. This is because of the fact that these contracts represent fixed costs for the company. If the company discharges a contract, it might result in even higher expenditures. So this is a reasonable thing to produce in short term even at loss until these contracts expire, because breach of the contracts might represent higher losses than the company is currently sustaining.

Sources:“DAF Is Back on the Road,” International Herald Tribune, September 20, 1995, p. 15; www.thecarconnection.com/Auto_News/Auto_News/Ford_GM_Face_Plant_Closings_Again.S175.A9165.html

Fujitsu: Durham vs Gresham

In early 1998, Fujitsu decided to shut its DRAM factory in Durhan, England. Fujitsu had invested $590 million in the Durham factory, which had been producing 2.5 million units of 4 and 16 Megabit DRAMS a month. A further $1 billion investment was needed to enable the plant to produce 64-Megabit DRAMs. By contrast, Fujitsu continued production at its Gresham, Oregon plant which produced 64 Megabit DRAMS. Meanwhile, the industry was already working on 256-Megabit designs. Was Fujitsu consistent in closing the Durham factory while continuing its production at Gresham?

Given the development of technology, the Durham plant was close to being obsolete. The $1 billion investment for production of 64-Megabit chips was a long-run decision. Fujitsu had to ensure that the long-run price would cover its average cost (including the $1 billion investment).

At that time, however, Fujitsu had already equipped Gresham to manufacture 64-Megabit chips, hence the decision to continue production at Gresham was a short-run issue. Fujitsu only had to consider whether the short-run price covered its average variable cost.

The average cost of producing 64-Megabit chips at Durham would definitely have been higher than the average variable cost at Gresham. Further, given the tendency for the prices of semiconductors to fall over time, the long-run price of DRAMs would have been lower than the short-run price. Accordingly, Fujitsu shut the Durham factory while continuing production at Gresham.

Sources: “Fujitsu to Curb Output of DRAMs in Europe,” Asian Wall Street Journal, April 1, 1998, p. 6; “Fujitsu Microelectronics’ Durham Plant to Cease Operations”, M2 Presswire, September 7, 1998; and “Japanese Semiconductors: And Then There were Two,” Economist, January 23, 1999, p. 58.

The Delphi Bankruptcy

In 1999, General Motors Corporation spun off its auto parts business, Delphi Corporation. At the time, Delphi’s prospects seemed good: it was the world’s largest auto parts maker, its top customers were generating large profits selling trucks and SUVs, and it was rapidly increasing orders from fast-growing foreign automakers. But, in 2005 it filed for Chapter 11 bankruptcy protection.

Delphi was dragged under by a combination of GM’s falling US market share and its inhereited legacy costs (the same costs that threaten its former parent company). "We got a tremendous blessing and a tremendous curse at the time of the spin-off," Miller told The Detroit News in an interview Saturday. "The tremendous blessing was all of the technology and capability that came with this company. On the other hand, we also received the OE (automaker's) labor contract package, which is wildly uncompetitive with any other automotive supplier," said CEO Robert S. “Steve” Miller.

An increasing portion of Delphi’s US workforce is in a paid but nonproductive status; i.e., a fixed cost independent of volume and revenue. Under the terms of Delphi’s collective bargaining agreements with its US unions, Delphi is generally not permitted to permanently lay off idled workers. The number of idled hourly workers that receive neraly full pay and benefits has been as high as 4,000. Historically, under the terms of the spin-off from GM, Delphi’s UAW employees were permitted to return to GM’s employment (known as “flowback”), but as a result of GM’s decreased production, flowback has been severely limited. Consequently, although the US hourly workforce was reduced by 15% over the 15-month period ending December 31, 2004, aproximately 12% of Delphi’s June 30, 2005 hourly workforce was in a non-productive status. In 2004, this cost Delphi $170 million.

Sources: “Delphi’s troubles have deep roots,” The Detroit News, October 10, 2005; Delphi Bankruptcy News, Issue Number 1, October 10, 2005, Bankruptcy Creditors’ Service, Inc.

Inotera Memories and the Global DRAM Supply

Founded in 2002, Inotera Memories Incorporated is a joint venture between Nanya Technology Corporation and Infineon Technologies. In June 2004, Inotera commissioned the “world’s largest and most competitive 300mm DRAM production site” in Taoyuan, Taiwan.

Production of semiconductors using 300mm wafers is estimated to reduce costs by up to 30% relative to the previous wafer size. Inotera planned to operate the plant at a rate of 20,000 wafer starts per month by the end of 2004. The Taoyuan production was to be “integrated into Infineon’s international network of DRAM production sites, which includes the 300mm manufacturing sites in Dresden and Richmond.” Besides Inotera, Samsung Electronics and Micron were also producing DRAMs with 300mm technology. Accordingly, the global DRAM supply already included production of 300mm wafers.

Inotera’s new plant would increase (shift to the right) the global DRAM supply by a quantity of 20,000 wafer starts per month at the level of Inotera’s marginal cost of production.

Source: “Inotera Memories Joins the Ranks of 300mm Semiconductor Manufacturing with the World’s Largest DRAM Production Facility,” Press Release, Nanya Technologies Corporation, June 30, 2004.

Profit/price variation: Lihir Gold

One of the world’s 15 largest gold mines is located on Lihir Island, off the northeast coast of Papua New Guinea. In October 1995, the owners of the Lihir gold mine launched an initial public offering of shares. The prospectus for Lihir Gold’s offering projected the mine’s profit in 1999 to be $52 million if the price of gold turned out to be $400 per ounce. The projected profit was $24 million or 46% higher if the price of gold turned out to be $450, or just 12.5%, higher.

These projections are consistent with the general principle that a seller’s profit varies relatively more than the price of its output. Accordingly, Lihir Gold’s prospectus also included a production forecast of 584,000 ounces a year. At this production rate, a $50 increase in the price of gold would change revenues by $50  584,000  $29.2 million. Taking into account increases in production, royalties, and taxes, the company projected that a $50 price increase would actually raise profit by $24 million.

Source: “Lihir Sparks a Gold Rush with Hot Stock Offering,” Asian Wall Street Journal, September 12, 1995, p. 13.

Paying for overtime

Typically, employers must pay workers 50-100% more than the regular wage rate for overtime work. Let us understand why employers must pay such a large premium for overtime work.

A worker’s marginal cost of labor increases with the quantity supplied. The typical employer, however, does not allow its workers to choose any quantity of labor for some specified wage rate. Instead, the employer purchases a bulk order of 40 hours a week. Through the bulk order, the employer can extract some of the worker’s seller surplus.

The regular wage rate reflects the worker’s average cost of labor for 40 hours a week. The average cost of 40 hours of labor will be less than the marginal cost of the 40th hour, to an extent that depends on the steepness of the worker’s marginal cost of labor.

If the employer wants to purchase overtime of an additional 5 hours of labor, it must pay the worker’s marginal cost for the 41st-45th hours. As we have already explained, depending on the steepness of the worker’s marginal cost of labor, the marginal cost of these hours may be substantially more than the regular wage. This explains why overtime rates are 50-100% higher than the regular wage.

Paying for morality

Employers also pay according to the perceived social responsibility attached to either the worker’s profession or the employer’s reputation. One study asked students to rank job titles and firm names according to a subjective social responsibility scale. For example, “stock broker” received the lowest rating while “teacher” received the highest. Among firms, Drexel Burnham Lambert received the lowest rating; Andrus Children’s Home, the highest.

Salary levels are significantly related to these subjective rankings. The difference between the highest and lowest ranked occupations amounts to a 43% difference in annual salary. Among firms, the range equated to a 19% difference in salary. These were actual salaries from recent college graduates.

Other data corroborates these findings. There is a large gap between the average starting salaries for public interest lawyers and first-year associates in private law firms. Expert witnesses for tobacco firms charge significantly higher fees than those representing public interest groups (the latter often do not charge), despite the fact that the latter have better average credentials than the former group.

Labor supply decisions are influenced by ethics, and this gives social (ir)responsibility a price tag.

Source: Robert H. Frank. 2004. What Price the Moral High Ground? Princeton University Press, chapter 5.