Germany's engineering sector in transition

By Patrick Heinemann and Sven Siepen

Machinery and plant engineering has always been one of Germany's leading export and innovation industries. Consisting mainly of small and medium-sized enterprises, including many hidden champions, the sector constitutes a large part of the country's industrial backbone. It is also an innovation driver for important developments such as Industry 4.0, CO2 neutrality, energy efficiency and electric mobility. For decades before the Covid-19 pandemic hit, the clear focus on global quality leadership under the "Made in Germany" label secured full order books and decent profits for the industry. But its business model is now coming under pressure from all sides.

Competition from Asia threatens the "Made in Germany" model

The engineering sector faces major challenges and is undergoing a process of profound transformation. The traditional business model, which aims to build the best machine from a technological standpoint, is increasingly being challenged by changing customer needs. Automotive suppliers, for instance,need new production systems and machining processes to even be able to manufacture the parts needed for the post-ICE era. And in the looming crisis, mechanical engineering customers will increasingly switch to simpler product variants and maintain the same high quality and reliability levels. What companies need to do is therefore rethink their value creation and product development and prioritize customer needs to a greater degree.

On the technology side, too, the industry will have no choice but to change given the skyrocketing importance of software, AI, big data and cloud/edge computing. But the persistent skills shortage threatens to raise barriers to innovation. Companies are zooming in on better salaries and working conditions – including ESG compliance – to counter the problem, but that drives up staffing costs and intensifies the pressure on margins.

The new geopolitical order poses yet another challenge. As a key customer for quality machinery from Germany, China has become a serious market contender and sparked fierce price competition. Additional competitors from emerging countries are ramping up the cost pressure even further. Even though "Made in Germany" still means higher quality and commands a price premium as a result, German engineering firms must press ahead with digitalizing their business and adapting it to new customer needs, otherwise they will see their quality leadership in jeopardy.

Added to that is the growing protectionism that largely shields China's domestic market from overseas competition. As an export-led industry, Germany's engineering sector depends on free trade. Yet increasing trade restrictions threaten market access and supply chains. One solution could be to shorten supply chains and indeed value chains to minimize dependencies on individual suppliers and sales markets located overseas. However, with such steps being so capital intensive, it is not so easy to actually take them, especially for smaller companies.

Automation and product portfolio expansion offer a useful strategy

Unsurprisingly against this backdrop, some German companies have already begun reshoring their production and pushing ahead with automating their manufacturing facilities. That's because a high level of automation brings efficiency gains and thus a better cost position. It is also better at showcasing quality advantages to customers and it leads to shorter supply chains and increased flexibility. In addition, the new regionalization strategy offers German engineering companies the opportunity to expand their product portfolio with offerings such as plant operation and automated maintenance, enabling them to move towards Machining as a Service (MaaS) and to stand out from competitors in the Asian market. And new sales approaches such as leasing or subscription models and output-based pricing can help smoothen revenue volatility. By expanding their service business and having new financing models and the recurring revenues that come with them, Germany's engineering firms can not only significantly reduce the cyclicality of their business but also use these business models as a crucial differentiation factor with which to secure or expand their market position.

The market is losing momentum and inflation is ratcheting up the uncertainty

First Covid-19 and now the Ukraine war: The current crisis scenarios serve to further heighten the pressing need to act. 2020 was a particularly tough year for Germany's engineering sector, with companies finding many projects postponed or canceled. Even though the Covid-19 pandemic continued to cause disruption in 2021, the industry saw growth in both orders and revenues as robust demand from the United States in some cases more than offset the drop in demand from other countries. The start of 2022 was also promising.

However, the outbreak of war in Ukraine immediately put the brake on any momentum. Although the industry so far remains able to manage the immediate consequences of the war, such as higher energy costs, companies now face sharp rises in inflation. We may well see a situation where, instead of buying machinery from the front segment, customers could switch to "good enough" alternatives to keep their costs down. This is not the least of the reasons why the industry must be prepared for some intense price bargaining with customers. There is a big question mark over how far engineering companies will be able to get suppliers to reduce costs to enable them to protect their margins given that suppliers themselves will have to pass on the anticipated procurement price rises to their own customers. So it is all the more important for engineering firms to act fast to slim down their product portfolios to a mid-price offering that still features "good enough" functionality and quality.

China's zero-Covid policy and rising interest rates remain challenging

Besides the growing pressure on prices and margins, China's ruthless zero-Covid strategy remains a major challenge. That is because the just-in-time logistics that ran smoothly prior to Covid-19 imploded virtually overnight with the backlog of goods trying to get out of Chinese ports. Added to that, the historic interest rate rises are currently making financing substantially more costly for the first time in over a decade. For Germany's engineering companies, most of which have a solid equity base in their home market, this development should not pose a problem for the time being. On the customer side, however, rising interest rates could cause demand to plummet, which would consequently hit the industry hard.

Shaping the transformation from the front

The crises have not caught the German engineering sector unprepared, not by any means. However, despite many major trends being noted in past years, few of them have been translated into a pioneering role for the industry's players. Even though engineering has managed to emerge stronger from the crises of the past, the challenges remain substantial and the transformation pressure is building. Germany's engineering firms can drive change from the front if they act now and give themselves a strategy overhaul.

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