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It could be described as the automotive industry's biggest elephant in the room: how the structural costs of the Volkswagen Group's German operations have held back the company's financial competitiveness for decades.

On 4 September the company's CEO Oliver Blume stood alongside his CFO Arno Antlitz at the company's Wolfsburg headquarters and addressed workers about the desperate need for the company to cut the cost base from its German operations. Both men were heckled by a huge crowd of around 20,000 workers as they told a story that those workers simply did not want to hear: Maintaining the status quo was simply not an option. The workers shouted "Auf Wiedersehen"-German for 'goodbye'—to the men, expressing the notion that it was management, not workers, that has been the issue at VW for decades.

And thus the battle lines were drawn for the biggest showdown between management and workers in German industrial history.

In the old days the company could bury its head in the sand and simply ignore this extremely expensive elephant that was flattening the company's profits. Despite the massive €35 billion-plus cost of the VW emissions scandal, the company was still able to achieve reasonable profitability in the latter part of the 2010s and in the early 2020s, including the pandemic.

In the current debate and spotlight on Volkswagen's profitability, it should be highlighted that the discussion is primarily focused on one element within the Group—the Volkswagen passenger car brand.

The Volkswagen passenger car brand has six car plants in Germany, from the giant Wolfsburg facility that also acts as the company corporate and symbolic headquarters to smaller, more flexible facilities, such as Osnabruck that has been used more recently as a contract manufacturing facility for Porsche. One of the major issues is that these plants are simply not making anywhere near as many cars as they were a decade ago. According to S&P Global Mobility these plants (which also included the Wolfsburg 2 line in our old forecast, with this now being consolidated into all Wolfsburg volumes) made just under 1.4 million cars in 2015. By last year this figure fell to just under 782,000 units.

And it is not just the fact that less cars are being made. The company also has its own components manufacturing plants in Kassel, the largest automotive component manufacturing plant in the world with 16,500 employees, as well as Braunschweig, which has 7,000 staff and Salzgitter which has 7,500. In total the VW brand has about 120,000 staff employed in its German operations.

These men and women are some of the best paid automotive workers in the world. Blume said last week in an interview with Bild am Sonntag that the company's German workers are often paid more than twice that of their peers in VW's other European locations. In another interview, Antlitz said that since the pandemic European auto demand has not rebounded, with deliveries still 2 million units below peak levels. Antlitz noted that VW has lost sales equivalent to around 500,000 cars, necessitating increased productivity and cost reduction.

The main actors in this drama are Blume; Antlitz; the head of the all-powerful works council Daniela Cavallo; Thorsten Gröger, the chief negotiator of IG Metall, Europe's biggest union; and the VW Group's equivalent Arne Meiswinkel. On the eve of the second round of talks between all parties, Cavallo decided to go public with all of VW's demands, despite the fact that the company had not at that stage officially revealed them to the outside world. She stated that the plan was to close three of the German plants and trim tens of thousands of the workforce. This is in addition to a 10% across the board pay cut for remaining workers that VW had already publicly requested from its workers.

For a company that has not shuttered a German plant in its 78-year history, this represents a bloodbath. The company's latest financial figures were announced just as the second negotiating round got underway and provided serious ammunition for VW and its negotiation team, while offering grim reading for their counterparts and the company's shareholders. Volkswagen Group operating profit dropped almost 42% in the third quarter of this year and its operating margin was just 3.6%. The Volkswagen brand had an operating margin of just 2.1%. The target is 6.5%.

The company is facing two major issues that mean the German labour elephant can no longer be ignored. VW was for decades the market leader and a dominant presence in the Chinese market, with the company at various stages generating the majority of its profits from the market. The rise of the hugely impressive new generation of Chinese OEMs such as BYD, SAIC's MG brand, Nio, and a host of others, means that this is no longer the case, especially with their impressive BEV designs in the market that is the world's biggest for electric vehicles. This is without even mentioning the impact that Tesla has had on both its Chinese operations and its business elsewhere.

As Blume said in his September Wolfsburg workers address; "There are no more cheques coming from China." The company is also finding the move to electrification massively profit sapping. Its cars are not particularly cheap if sold near list price and the tech is not as impressive to most buyers as those in the aforementioned Chinese brands. And R&D costs are enormous, while focus is diluted by issues with the CARIAD tech development unit and its standalone battery unit PowerCo.

German chancellor Olaf Scholz has also had his say on the dispute. He said that: "Possible wrong management decisions from the past must not be at the expense of employees." This might be good politics from a chancellor wanting to retain his position. But this is magical thinking that ignores an inconvenient truth. VW cannot be globally competitive with domestic labour costs twice that of elsewhere in Europe. The truth is that VW's German structural costs are strangling the company financially and the elephant needs to be put on a crash diet.

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This article was published by S&P Global Mobility and not by S&P Global Ratings, which is a separately managed division of S&P Global.