“Tesla Possesses a Growth Formula, But Does It Also Possess Agility?”

Image collected from — CNBC

Tesla, now a well-known car manufacturer, was not thought to have much potential when it first launched in 2003. Specifically because of their exclusive focus on fully electric vehicles, moving toward an energy-efficient electricity base was simply not on many people’s radars at the time. In 2008, the company faced numerous financial difficulties and nearly went bankrupt. However, they have astounded everyone with their remarkable growth rate, skyrocketing stock prices, and a massive market cap of $526.87 billion USD, surpassing more mature companies such as Toyota, Ford, and others. Tesla’s success is built on a one-of-a-kind growth formula: vertical integration. In the auto industry, vertical integration is an uncommon concept because companies frequently outsource 80% of the component manufacturing to suppliers and concentrate on engine production and final product assembly. Vertical integration, however, comes at the expense of losing Tesla’s business agility in the face of uncertain times and the future.

Vertical integration is when a company owns and operates multiple, consecutive stages of production, and the outputs of those stages serve as inputs to other stages in whole or in part. Simply put, it is the decision of a company to become its own supplier and/or distributor of its own goods. Manufacturing firms benefit the most out of this business model.

Tesla invested heavily in R&D in its early years to develop the production system required to manufacture its own components. As a result, this resulted in a competitive advantage that others will find difficult to replicate. Tesla wanted to set its products apart from the competition. The only way to do so was to design each component with the final car in mind. They have widely implemented this strategy with their vertically integrated production system to produce their own powertrain, seats, FSD chips, superchargers, batteries, and user software that runs on their fully electric vehicles. On the other hand, as a frontrunner in the EV market, it was critical for them to keep costs as low as possible in order to persuade more customers to switch from conventional fuel-engine vehicles to fully electric vehicles. This strategy has enabled Tesla to avoid the “middleman” costs and incentives associated with sourcing supplies from third-party manufacturers. Tesla has used both forward and backward integration to achieve as many cost advantages as possible, as well as product differentiation, which distinguishes them in the EV market. According to the public, the features and efficiencies that they provide with each EV car are years ahead of their competitors, and in that manner, they became the first choice for any consumer who wanted to go electric with their daily driver.

According to researchers at Boise & Washington State University, firms that engage in backward vertical integration have lower production costs and in addition, firms with forward vertical integration will have a lower marketing intensity. Although it is expensive to achieve vertical forward and backward integration, Tesla has chosen to combine the best of both worlds. Tesla established itself as the firm that invested the most in R&D and the least in marketing for each vehicle sold. This allowed the business to focus more resources on becoming truly product-oriented with manageable production costs, which is essential in a market where consumers want to get the most for their money while still purchasing cutting-edge innovative products. It’s something that businesses like Toyota, Ford, and Volkswagen have struggled with because they have to spend millions of dollars every year on marketing campaigns to advertise their gasoline cars, taking money away from their R&D departments. It almost seems as though Tesla is betting everything on the fact that the future will be electric.

With the help of their vertically integrated business model, Tesla has worked hard to develop sustainable competitive advantages that are valuable, uncommon, and unmatched by the competition. For instance, Tesla has empowered customers by simplifying the buying process. Instead of the conventional advertising strategy of placing advertisements in top newspapers, on television, or on the radio, Tesla uses the traditional software “inbound” sales strategy. They think that if a need is sufficiently created, customers are smart and will seek out the products themselves. They understand the buyer’s journey inside and out. However, they create this “need” for their products through massive innovation, which would not be possible without this vertically integrated production model. This has saved Tesla a massive amount of marketing expenses.

Any business must work to expand its economies of scale and scope in order to reduce production costs as much as possible. It was even more important for a company like Tesla to lower the high production costs of EV cars because it is challenging to establish a leading position in the automotive industry with skyrocketing prices. As a result, Tesla increases lifetime value of their cars by using better battery technology, which also lowers overall production costs. Tesla also concentrated on making electric cars much simpler to operate than internal combustion vehicles. Compared to 2,000 in internal combustion engines, they only have about 20 components per car, according to some estimates. Because of this straightforward design, the total cost of ownership and production is significantly decreased. Without having complete control over their production process through vertical integration, this level of engineering would not have been possible.

Accelerating the world’s transition to sustainable energy is Tesla’s main mission, and it never changes. They’ve been making adjustments to all of their projects in order to accomplish this, which is why they made all of their patents available to be used in good faith. The distinction between what should never change and what should be flexible is one that great businesses are aware of. Tesla, however, is not feared by new entrants; in fact, Tesla has been inviting them. The same challenges that General Motors, Ford, Toyota, and Tesla faced will be faced by any likely new market entrant. Because the current market players have not yet created solutions to these issues, it could be argued that until they do, new market entrants will face the same issues, making it difficult for any new entrant to surpass Tesla in the EV car market. And in this way, Tesla is still sticking to its core mission without compromising its market share.

It almost looks like vertical integration, a magical formula for growth for a company in the automotive industry. So why aren’t other companies doing the same? The core reason is that it makes the firm lose its agility, making it prone to economic uncertainties. Even though a vertically integrated production model can make the final product simplistic from a design perspective, it makes the firm more complex. For starters, it incurs significant administrative costs that are unrelated to production levels. It increases the possibility of having sunk costs if things go wrong due to any external factor. During a time when the external environment is becoming more of a concern for any business, Tesla’s future is questionable.

The war between Russia and Ukraine was one of the most significant external factors that impacted numerous businesses worldwide, including Tesla. Companies with more agile business models were least affected, unlike Tesla. Tesla officials stated in January that the company is unable to develop the car for $2 5,000 that was promised for the 2020 battery day. Many of which have strong ties to the Russia-Ukraine conflict.

Even though Tesla has the manufacturing setup to create their own components, they still have to source their raw materials from elsewhere. Inorder to create the highly efficient batteries of Tesla cars, the company needs high purity class 1 nickel & palladium. Due to the war, the costs of palladium have increased by 26% as Russia produces around 33 percent of the world’s palladium. Rising prices of nickel, palladium and other materials threaten to slow and even temporarily reverse the long-term trend of falling costs of batteries, the most expensive part of EVs, hampering the broader adoption of the technology.

Tesla’s vertically integrated production model puts the company at greater risk, owing to the fact that Tesla manufactures its own batteries at its gigafactories. Battery manufacturers, in this case Tesla, typically have long-term contracts with their raw material suppliers under which prices rise to reflect increases in the cost of key raw materials such as nickel and palladium. As a result, when there are supply chain issues, the cost of producing a car rises faster for Tesla because the company must account for higher inventory costs as well as the fixed costs associated with having a battery production factory. As a result, Tesla’s ambitions to produce more affordable electric vehicles were hampered. All in all, Tesla being the producer of its own components means they are liable to maintain more raw material supplier contracts than other automakers. Maintaining a contract includes various kinds of costs, commitment leading to inflexibility for the company itself.

Different industries are impacted by economic uncertainty in different ways, some more so than others. A 2021 study on consumers in the US, China, and other nations by OC&C Global Speedometer found that more than half of consumers are unwilling to pay $500 more upfront to purchase an EV despite lower operating costs. This clearly indicates that Tesla must be more careful about external factors affecting its operations, as they are not agile enough to adapt to changes in markets, unlike many of its combustion engine competitors, who don’t use vertically integrated production models.

Tesla has been investing heavily in the faith of the certainty that the future must be electric. Their message is clear, electric vehicles will reduce the environmental impact overall. Even though it might sound pretty straightforward to an average citizen, how much of it is actually true? Tesla might not be able to survive as a company if the future doesn’t turn their way due to their lack of agility as discussed previously.

Tesla’s long-term success will be determined by its ability to overcome a number of concerning engineering and energy issues. Initially, the use of electric vehicles will reduce carbon emissions in a solar, wind, or hydro grid-dependent nation. China, India, the United States, and Japan produce more than three-quarters of the world’s coal-fired electricity. In Europe, however, where sales are increasing at the fastest rate in the world, electric vehicles in Poland and Kosovo produce more carbon emissions due to the grids’ reliance on coal.

Even among nations that are gradually transitioning to solar as an alternative energy source, this may not represent a genuine opportunity for Tesla. Due to the fact that lithium-ion batteries can only store energy at full capacity for approximately four hours, Thus, even nations that generate significant amounts of solar and wind energy during the day struggle to keep it available for nighttime charging.

Then there are issues with the cost of recycling batteries, which is possible but costly at the scale required to recycle an entire EV battery (which can weigh over 1,000 pounds), and historically it has been less expensive to mine for new lithium than to recycle and reuse it.

Decisions about each country’s future energy source will be informed by a combination of cost-benefit analysis and political relationships. Some nations may opt for the electric route, while others may not. An optimistic company like Tesla may therefore struggle to scale up globally and produce affordable electric vehicles due to its lack of agility, a necessary evil of having their growth formula: vertical integration.