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Volkswagen And Its Hidden Debts

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Last week, Volkswagen was well on its way to displacing Toyota as the biggest and most successful auto maker in the world. Now with the revelation over the weekend of its actions to use a software device to defeat environmental regulations on some 11 million cars, Volkswagen has not only had to make a $7.3 billion provision against earnings to cover the costs of fixing the vehicles. It is facing financial consequences that may be far worse. Some analysts argue that Volkswagen’s very survival is in peril, as a result of massive undisclosed technical, regulatory and brand debt that never appeared on Volkswagen’s balance sheet.

What are these strange kinds of hidden debts that don’t appear on any balance sheets?

Technical Debt

I was talking recently with a senior manager about some software problems and he revealed that he didn’t know the meaning of the term, "technical debt." He is not alone. Many otherwise competent managers are totally ignorant of the importance of “technical debt,” which starts to accumulate when managers insist on making repeated “minor tweaks” in an interdependent system that are needed “urgently” without taking the time to reconcile the changes with the system’s architecture.

Top management often become aware of the issue only when there is an abrupt system outage. That happens because when one piece of the system goes down, it can cause breakdowns in other sub-systems, because of tight dependencies. The eventual result can be a total system outage and the whole business can suddenly grind to a halt.

These disasters can be important opportunities to educate the top management on the implications of continuing to make tweaks in an interdependent system without in effect paying to do them properly. Cutting corners to achieve a performance goal while cutting legal corners is a fool's game. The firm can pay as it goes, or it can pay much more later.

When these disasters emerge, they can be a time for top management to set aside its short-term perspective and learn the long term costs of not doing things right in the first place. Management can learn how the accumulation of technical debt leads to increased support costs, difficulty in adding new features, unwanted complexity, and ultimately complete system outages.

Regulatory Debt

Taking short-cuts with software can also have massive regulatory implications. In some countries, system failure can involve penalties, even criminal liability and jail time for those responsible. In the case of Volkswagen, the regulatory penalties for deliberately flouting environmental regulations could be as high as $18 billion. But that’s not all.

Brand Debt

The cost of fixing the system and paying any fines may be only small pieces of the eventual damage suffered by Volkswagen. Market Watch reports on a study in 2008 by Professors, Jonathan Karpoff, D. Scott Lee and Gerald S. Martin in the Journal of Financial and Quantitative Analysis, showing that the cost in terms of loss of customer confidence can be many times higher. The study of 585 firms, which had all been subject to enforcement action, showed that the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs was over 7.5 times the sum of all penalties imposed through the legal and regulatory system.

A consideration of the Volkswagen case shows why. Volkswagen admits that a software switch was used to detect when the car was being tested. When it detected a test, it activated environmental controls. Under normal driving conditions, the switch activated a different engine calibration, which resulted in 10 to 40 times the pollution allowed under U.S. law.

Now Volkswagen wasn’t doing this because it hated the environment. The engine calibration for normal driving dramatically increased performance and fuel efficiency. In effect, Volkswagen’s ads which trumpeted the combination of environmental friendly and powerful engines were a fraud. The engines could do one or the other but not both. If the cars had been sold to operate in normal conditions with the environmentally-sound calibration, the cars would have had much less driving oomph and they would have been much more costly to run.

So what is Volkswagen going to do now? Volkswagen is talking about recalling the 11 million lemons and bringing them in compliance with government rules.But things are not that simple.

Such a fix will likely cost several thousand dollars per vehicle, reduce performance and increase carbon emissions. But which drivers will be willing to bring in their cars to be “fixed” to meet environmental regulations when it means that the car’s driving performance will be seriously affected and its operating cost will increase significantly?

As a result, merely "fixing" the cars by removing the defeat switch from the car’s system will not solve the problem. Volkswagen will either have to offer incentives to owners to have their cars “fixed” or come up with a dramatic engineering innovation that meets the environmental requirements without affecting driving or fuel performance. In the absence of such solutions, Volkswagen may be forced to accept the return of the vehicles and offer replacement vehicles. And which driver is going to trust anything Volkswagen says in future about car performance and its effect on the environment?

In this way, it is easy to see how technical, regulatory and brand debt in Volkswagen’s case could combine to reach 7.5 times of the possible fines of $18 billion just in the US. For a firm with a market capitalization of some $88 billion prior to last weekend’s revelations, such costs could put the future of the firm in jeopardy.

Firms and investors thus need to be aware that hidden are technical, regulatory and brand debts may be more important than the financial debts disclosed on the firm’s balance sheets.

The Underlying Cause: Shareholder Value

If Volkswagen's tale sounds eerily familiar, that's because it shares some features with the story of Toyota, when around 2000, under the influence of MBA-trained managers with a short-term perspective, set aside its goal of being "the best" auto manufacturer and set out instead to become "the biggest."

In 2010, it transpired that Toyota had learned as early as 2004 that its vehicles had an above average level of incidents of unintended acceleration. It took Toyota five years before it issued recalls for two root causes—one, wandering floor mats that jammed the accelerator and, two, accelerator pedals that stuck. The NHTSA associated over 50 deaths with incidents of unintended acceleration.

What caused Toyota, with its legendary attention to quality, to fail get to grips with this issue? Akio Toyoda, now Toyota's CEO, concluded that Toyota's managers had become “confused” about its traditional priorities of safety first, then quality and only then, volume.  Toyota had begun to espouse the traditional management goals of growth at any cost, and drastic cost reductions even at the expense of quality.

When Akio Toyoda returned to Japan in February 2010 after a grilling by US Congress on these issues, he held a rally for Toyota employees. He wore a gray workman's jacket and, in a voice racked with emotion, he told 2,000 assembled workers and a far-greater audience that was gathered in front of live television monitors around the world, "Let's go with high spirits, have fun, and be confident while staying humble. We are making a new start today."

Toyota has survived by returning to its goal of being "the best" and setting aside its short-term perspective of making money to focus on true quality for customers.  Time will tell whether Volkswagen will be so fortunate.

We are thus learning that maximizing shareholder value as reflected in the stock prices is not just an American disease. Even a German firm with a long history of engineering excellence can become a victim.

And read also:

The Dumbest Idea In The World

Follow Steve Denning on Twitter @stevedenning