Oct. 23 (Bloomberg) -- Germany’s car industry needs to speed up work on new technology and shift its focus to smaller models to remain competitive with Chinese and Indian companies, an Ernst & Young LLP consultant said.

Automotive executives in Europe indicated in a survey that they may put off research spending, Peter Fuss, a partner at Ernst & Young, said at a press conference in Frankfurt yesterday. Innovation ranked eighth among managers’ immediate priorities, rising to second place only in three years.

Volkswagen AG, Bayerische Motoren Werke AG and Continental AG are among manufacturers that have cut production as they confront the worst auto market in six decades. General Motors Co. and Ford Motor Co., the two largest U.S. carmakers, are selling European units as they reorganize to stem losses. Half of the respondents in the August survey of 300 executives at carmakers and suppliers predict industry consolidation in 2010, Ernst & Young said.

“We see a great danger that urgently needed investment in state-of-the-art technology, particularly for engines and reduction of fuel consumption, will succumb to cost cutting,” Fuss said. “Developing new engine technologies has become so expensive that we’ll see an increasing number of mergers and cooperation agreements.”

Better or Cheaper?

Luxury auto manufacturers in Germany may need to look at building smaller, more fuel-efficient models to win back customers, Fuss said. About 70 percent of managers in the survey foresee sales of small cars increasing until 2014, while only 19 percent predict delivery gains for high-end models and 45 percent expect a decline, according to Ernst & Young.

Daimler AG, the world’s second-largest luxury automaker, said yesterday it’s expanding capacity for the smallest models in its Mercedes-Benz product line. Tata Motors Ltd., the Mumbai- based automaker that bought the Jaguar and Land Rover luxury marques in the U.K. last year, plans to begin European sales of the $2,500 Nano, the world’s cheapest car, in 2011.

“Auto manufacturers have to be prepared for increasing polarization in the industry: either the car is better or it’s cheaper,” Daimler Chief Executive Officer Dieter Zetsche said at a small-car plant in Rastatt, Germany, where he announced a 3 billion-euro spending plan for the company’s German plants.

Rastatt Factory

Daimler is spending 1.4 billion euros ($2.1 billion) to boost small-car production capacity, as it prepares to double the number of compact models to four. The investment includes a new 800 million-euro factory in Hungary and spending of 600 million euros to expand the Rastatt factory that builds the Mercedes-Benz A-Class and B- Class compacts.

Stuttgart-based Daimler needs to make its small-car lineup more profitable and that the two new models in the next two years may help achieve that goal, Zetsche said.

Munich-based BMW’s spending on research and development in the second quarter fell 19 percent from a year earlier. The growth rate in VW’s research and development costs slowed to 8 percent in the first half from 9.6 percent in the first quarter.

Still, the manufacturers are investing in small cars. BMW plans to introduce a line of urban vehicles under “project i” by 2015. The vehicles will have two to four wheels and be propelled by electric and conventional motors.

VW is developing a mini car known based on the Up concept, while its Audi unit is reviving the A2 compact and plans to introduce a new version of the A1 hatchback next year.

Boost From Incentives

Daimler rose as much as 98 cents, or 2.7 percent, to 37.71 euros and traded at 37.27 euros as of 10:57 a.m. on the Frankfurt exchange. Volkswagen climbed 0.6 percent to 117.18 euros. BMW added 1.5 percent to 35.89 euros.

A 5 billion-euro German government “cash-for-clunkers” incentive, which expired in September, helped boost industry deliveries in the first nine months by 26 percent from to 2.99 million vehicles, with growth dominated by small cars, according to the Federal Motor Vehicle Office.

Foreign brands, including the Lada division of Russian carmaker OAO AvtoVAZ and Seoul-based Hyundai Motor Co., and local mass-market companies, such as Wolfsburg-based VW and General Motors Co.’s Opel unit, led the increase while BMW, the world’s largest luxury carmaker, and Daimler posted declines.

“The industry is going through a reshuffle,” Fuss said in the report. “While manufacturers are battling financing problems and weak sales, cash-rich players from China and India are right now getting ready to tackle the market.”

Beijing Automotive Holding Co. is a partner in a bid for GM’s Saab Automobile division in Sweden and was a suitor for the Detroit-based carmaker’s Opel unit in Germany. Ford is in talks on selling its Volvo Car brand in Sweden to Geely Holding Group Co., China’s biggest private automaker.

To contact the reporter on this story: Cornelius Rahn in Frankfurt at crahn2@bloomberg.net; Chris Reiter in Rastatt, Germany, via creiter2@bloomberg.net.

Last Updated: October 23, 2009 04:59 EDT