Playing defense, Toyota cranked up r&d -- and reaped benefits

Strong yen, domestic competition were factors

Hiroshi Okuda: His strategy was a key factor in development of the Prius.

It was early 1995, and Hiroshi Okuda worried that Toyota Motor Corp. was at risk. It needed to hone its competitive edge.

Okuda, then Toyota's executive vice president for finance, decided the solution was to spend more on r&d. Safety was becoming more important. Toyota needed to build on the early success of the Lexus brand by adding models, which meant more prototypes and testing. But above all, he wanted to boost outlays on powertrains.

In late 1996, Okuda explained his reasoning to Automotive News. Speaking through an interpreter, he said, "We haven't been able to determine which is better: trying to improve the current internal combustion engine or developing alternative engines. So we're devoting efforts equally on both sides."

SPEND TO DEFEND

Okuda's decision to open the wallet was a defensive move for the Japan market but it also paid huge dividends in America. Toyota was facing a brutal combination of an increasingly strong yen, a barely growing home market and rising imports of foreign cars into Japan.

The rising yen made exports from Japan less competitive in North America and Europe. The overseas factories of Toyota and other Japanese automakers were ramping up to meet demand in those markets and even starting to ship cars back to Japan.

The growth of Japan's auto industry was built on exports. During almost all of the 1980s, an era when so-called voluntary export restraints limited shipments to the United States, Japanese makers exported 53 to 58 percent of their car production. That slipped to 48.6 percent in 1989, but held above 45 percent through 1993. In 1995, though, only 38.1 percent of all cars built in Japan were exported.

If the strong yen meant the loss of those export markets, the implications were staggering. Factories in Japan would have to rely increasingly on the domestic Japanese market as the outlet for their production.

Fighting for sales in the domestic Japanese market promised to be a slugfest.

The Japanese new-car market had not yet rebounded fully from the recession that had followed the bursting of Japan's real estate bubble in 1990.

Frugal Japanese consumers were turning increasingly to minicars, which had dinky 660cc engines and were taxed at similarly dinky rates. Toyota, which has never made minicars, was missing the wave. It left minicars to its Daihatsu Motor Co. affiliate.

And the strong yen made imports of foreign cars into Japan more competitive on price, hurting Toyota in the large-car segment.

Japanese consumers who previously bought Toyota's large Crown, Mark II and Majesta sedans, cars that brought the fattest margins, were being tempted by imports. Mercedes, BMW, Opel and Volkswagen were boosting their sales, often by touting their superior level of safety compared with Japanese models. Even American models such as the Ford Taurus and Jeep Cherokee were conquesting Toyota owners.

By the end of 1994, imports had taken an unheard-of 25 percent of the market in Tokyo's tony Setagaya ward.

Detroit's Big 3 would have been thrilled if all imports combined had only 25 percent of the market in Marin County in California and less in every other county across the United States. But it wasn't the comparison that mattered. It was the trend, and it had Okuda worried.

He proposed a simple, yet enormously significant, boost in the r&d budget. The change would be effective with the fiscal year that began April 1, 1995, and would apply every year thereafter.

For years, that budget had held fairly steady in the range of 4 to 5 percent of parent-company revenues. In the previous 10 years it had topped 5 percent only twice. Both times it was because revenues had slumped after the bursting of the real estate bubble, and Toyota hadn't slashed r&d spending fast enough to keep pace.

THE 5+% SOLUTION

Okuda proposed that r&d spending be set at more than 5 percent of parent-company revenues, indeed at close to 6 percent. And he wanted most of the boost to go to powertrains.

Okuda's proposal faced some resistance, of course. But Toyota insiders say the naysayers were few.

"Some finance guys may have objected, but that's the nature of their job in the company. Almost everybody supported it," Akihiro Wada recalled, speaking in Japanese. He was Toyota's executive vice president in charge of r&d at the time.

A consensus soon built around the proposal. "We all knew that safety and environmental issues were growing," said Wada, 73. "The trend of the r&d budget was one of gradual increases due to safety and environmental problems, plus the costs of all the new systems that were being added to cars. So we knew we were going to have a lot more work to do."

An extra 1 percent of sales doesn't sound like much. But given Toyota's size, it was huge.

The proposal was approved, starting in the fiscal year that began April 1, 1995. That year Toyota's parent-company revenues were 6.74 trillion, or $62.81 billion at the then-current exchange rate of 107 to the dollar.

Toyota's r&d spending that year was $3.61 billion. That represented 5.7 percent of revenues. Had Toyota stuck with the ratio it spent in the previous fiscal year, 4.8 percent of revenues, its r&d spending would have been $3.00 billion.

Accepting Okuda's proposal gave Toyota an extra $610 million to invest in alternative powertrain r&d in that year alone. That was huge compared with what others were spending on alternative powerplants at the time.

The U.S. Department of Energy's 1996 budget for electric vehicles, including battery research, was $26.2 million. And by 1996, General Motors had spent upward of $350 million on its EV1 electric-car project — but over several years.

Toyota soon began to see a payoff from the budget boost.

The city of Osaka hosted the 1996 Electric Vehicle Symposium, an event held every two years in a different country. Toyota took center stage with a vehicle powered by a fuel cell that ran on hydrogen. Toyota had produced two of the vehicles at a cost of $1 million each. Both were converted RAV4 compact SUVs.

Fitting the fuel cells and hydrogen tanks into a RAV4 was an eye-popping achievement. Until then, the most compact fuel cell vehicle had been built by Mercedes-Benz. Mercedes filled the inside of a full-sized panel van with the fuel cells. With no room left inside, Mercedes had to put the hydrogen tanks, shaped like two massive torpedoes, on the roof.

In addition, Toyota that year began selling electric RAV4s powered by nickel-metal hydride batteries in Japan. The vehicles then went on sale in California in 1997.

Dave Hermance, who in the late 1990s was general manager of powertrain development for the Toyota Technical Center in Los Angeles, said the quick development time for the electric RAV4 — one year — was tangible evidence of Toyota's new spending priorities.

"Toyota is spending money on alternative-fuel research like it's water," he said in 1996. Hermance, later executive engineer for advanced technology vehicles at the Toyota Technical Center, died in a private airplane crash in November 2006.

Even as it spent big money to develop future alternatives to the gasoline engine, Toyota Motor Corp. was remaking its existing lineup of powerplants.

Toyota was working "to carry out a far-reaching revamping of our powertrains, and develop a more simple, high-performance engine and transmission," said Ryuji Araki, Toyota's director of finance, in 1996.

PRIUS PAYOFF

The biggest payoff came when Toyota unveiled the Prius hybrid car in late 1997. Development of the groundbreaking car got a huge lift from the decision to boost Toyota's r&d budget.

With the Prius, Toyota gained a competitive edge beyond what Okuda and his fellow board members had envisioned. The car was not only a sales winner but a huge image booster for Toyota.

Until then, Toyota was well known within the industry as a manufacturing innovator. But innovation was not part of Toyota's brand image among consumers. They knew Toyotas as reliable and durable, but hardly exciting or innovative. In effect, Toyota's reputation was built on cars as appliances — it made the best toasters on wheels.

The Prius changed all that. Suddenly, Toyota was known as a technical leader. The decision to boost r&d spending was possibly the best marketing investment Toyota ever made.

You can reach James B. Treece at jtreece@crain.com.