Volkswagen is in one of its periodic funks. But this time there's a plan to repair it for good.

(FORTUNE Magazine) – REMEMBER THE LITTLE CARS WITH BIG wind-up keys protruding from their backs and bumper stickers reading MADE IN DER BLACK FOREST BY DER ELVES? For six decades cute cars and humorous marketing created good will for Volkswagen. Adventurous drivers embraced the original Beetles in the '50s, hippies made the Microbus their flower-power vehicle in the '60s, and a younger generation fell in love with the New Beetle in the '90s.

Alas, the company has lost its allure. Americans bought 256,111 Volkswagens last year, 40% fewer than in 2001. True, VW's numbers have always been erratic--U.S. sales peaked at 569,696 cars in 1970. But a 28% drop in three years is extreme, even by Volkswagen standards. And the cold shoulder VW has been getting in the U.S. is only a symptom of the automaker's bigger troubles. The company's net profits fell sharply last year, to $841.4 million, a decline of 32% from 2003. That performance has crushed VW's stock, which in 1998 briefly poked above $104 per share but since 2000 has been bouncing between $30 and $60. Worldwide sales so far this year have been slack, and although first-quarter profits bumped up a bit, the company said earnings would rise only slightly in 2005.

The main problem is simple: VW's costs are too high. The company is solidly rooted in Germany, which afflicts it with high labor costs and low productivity. And unlike other car companies, VW can't pick up and move because 18.2% of its stock is owned by a provincial government. That's a horrible situation to be in if you're competing against the likes of the Japanese or the South Koreans. Or even the French--Peugeot and Renault both run leaner operations than VW.

Another trouble spot is quality. Volkswagen ranked 33rd out of 37 in the most recent J.D. Power survey of customer complaints after three years of ownership and next to last in complaints after one year (Hummer was last). "If VW didn't have a poor record for quality, it could move into the low-luxury position with Saab and Volvo," says Susan Jacobs, a New Jersey auto analyst and consultant. "But the VW brand doesn't carry any luxury cachet, so it doesn't merit the built-in price premium."

Given Volkswagen's cost and quality problems--plus an aging product line, a weak dollar, and a self-destructive tendency to ignore the U.S. market--it shouldn't come as a surprise that the company lost $2,250 per car in North America last year. That's a recipe for financial ruin. But the big question isn't whether VW can get out of its current slump. It's whether the company can break free of its vicious cycle--falling apart, recovering, then collapsing again every few years.

THE GOOD NEWS FOR VW IS THAT THE GUY IN CHARGE could conceivably pull that off. Bernd Pischetsrieder, VW's gentlemanly 57-year-old chairman, seems to have the long product cycles of the auto industry implanted in his DNA. He prefers to wait for results rather than rush them, which in the case of VW may be a good thing. "One can always argue everything is not fast enough," Pischetsrieder told FORTUNE during an interview earlier this year. "But when you look at the history of industry restructuring, you find far too many companies that were quickly rescued and the success was celebrated, but unfortunately they had to do it all over again after three years."

There's a fine line between deliberate speed and a snail's pace, but Pischetsrieder, who moved into his job in 2002, appears to be treading it. In March 2004 he negotiated a wage freeze with IG Metall, the union that represents VW's workers. In return for having its jobs protected until 2011, the union agreed to forgo pay increases until 2007. It also accepted a two-tier wage system under which new hires will be paid 20% less than current employees. Analysts say the agreement will take VW a long way toward its goal of cutting labor costs 30% by 2011. At the same time, Pischetsrieder is forcing VW to cut production costs. A program he established last year, ForMotion, contributed $2.1 billion to to the bottom line in 2004 through parts sharing, smarter component sourcing, and lower development costs. Pischetsrieder expects the savings to nearly double to $4.1 billion this year.

He has also taken steps to get his executives to quit pretending the U.S. doesn't exist. It's hard to believe, given the prominence of the brand, but ever since the introduction of the original Beetle, VW has treated the U.S. as an automotive backwater. It used the country as a dumping ground for excess production and made little effort to understand American driving habits. A classic example: cup holders, which for years VW ignored. The reason the U.S. has been such a blind spot is that VW's North American operations were run as a separate entity. Pischetsrieder says that at Audi, for instance, once a car was loaded on a ship bound for the U.S., executives at headquarters ceased paying attention to it. Nor did headquarters see any need to rush new models to the States, which meant that by the time they did arrive they were practically obsolete. The latest version of the Golf was introduced to European buyers in October 2003, but it won't be launched in the U.S. until the first quarter of 2006.

The negligence has left VW vulnerable in the U.S. to smarter, harder-working rivals. "From day one it has been a nightmare for me," Pischetsrieder says of the company's tradition of disdaining all things American. "The U.S. is such an important market that if every single person, whether in sales or marketing or engineering or quality control or production, doesn't have the American customer as part of his responsibility, we will never be successful here."

Pischetsrieder added North America to the job description of his marketing director back in Germany, which has helped put the world's largest auto market on VW's radar. Engineers are paying more attention to what customers want (and will pay for) than what German engineers want to build for them. The all-new Jetta and Passat--now with excellent cup holders--are bigger than earlier models, which should make them more appealing to American customers. But new models may not be enough to overcome the weak dollar, and analysts expect another big loss in North America this year.

PISCHETSRIEDER'S DELIBERATE APPROACH CONTRASTS sharply with that of his predecessor, Ferdinand Piëch, who took charge of Volkswagen in 1993 during another of its periodic crises and spent lavishly on improvements. He bought Bentley, Lamborghini, and Bugatti to give VW a presence in the hyper-luxury segment and poured billions into new technology and models. Among his more grandiose projects, Piëch championed an eight-cylinder engine for the midsized Passat and a new $70,000 luxury car called the Phaeton. He also started work on a $1.3 million Bugatti that has a top speed of 248 mph, faster than Formula One cars. (Piëch didn't have a monopoly on failed big ideas. Before joining VW, Pischetsrieder ran BMW, where he masterminded the purchase of Britain's Rover Group. High costs and inefficient operations were gradually crushing Rover, but Pischetsrieder didn't do anything at first to fix it. When a belated intervention proved insufficient and more capital was required, Pischetsrieder was forced to resign in 1999. A year later BMW broke up the Rover Group and sold off the pieces. The whole adventure cost BMW an estimated $5 billion.)

Under Piëch's iron hand VW lurched forward, but his impatience proved to be its undoing. The eight-cylinder engine turned out to be too rich for Passat buyers, and the Phaeton was too rich for everyone. Luxury-car shoppers didn't want to pay a premium price for a badge that translated into "people's car." The result: Volkswagen is selling only 8,000 Phaetons a year, instead of the 20,000 it planned. The Bugatti supercar has yet to appear on the market.

The erratic performance of VW under Piëch hasn't been lost on Pischetsrieder. (Piëch, who has been chairman of VW's supervisory board since 2002, still has the power to hire and fire, but Pischetsrieder runs the company.) He casually zings one of Piëch's more unfortunate decisions--hurrying new models to market, thereby producing a showroom traffic jam. "Our model cycles are anything but wisely laid out," Pischetsrieder says. "Under Piëch, everything had to be done simultaneously." The most visible example: The Golf and the Passat were on parallel product cycles; they were redesigned at the same time and reached obsolescence together. The better approach, Pischetsrieder says, is to stagger launches in order to smooth out sales numbers.

Now that he has set the wheels for VW's revival in motion, Pischetsrieder is waiting for them to grind out some results. "I'm quite happy," he says. "The only question obviously is, Is the pace fast enough?" To make sure that it is--and that the company's problems in the U.S. are addressed--Pischetsrieder last year hired Wolfgang Bernhard, 44, a flamboyant engineer with a reputation for being as brilliant as he is overcaffeinated, and put him in charge of the VW brand. Despite their contrasting personalities, Pischetsrieder wasted no time going after Bernhard, who gets a big share of the credit for Chrysler's recent comeback. (As chief operating officer, he led the company's surprising product revival with cars like the Crossfire and 300C that combine high style with good value. But after being promoted to run Mercedes-Benz in 2004, he was forced out of the company for being too impatient and outspoken.) He brings VW a sure hand at product design and an ability to control expenses. He recently told employees that VW's problem is high costs not "the wrong products."

IT'S TOO EARLY TO SAY WHERE BERNHARD WILL FOCUS his energies. VW remains strong in Germany and the rest of Europe, despite stagnant industry sales. But it's a safe bet that way up there on his to-do list is regaining momentum in China, VW's second-largest market after Germany. Just as it did in the U.S., VW started strong in China but got complacent. It began forming joint ventures there 20 years ago and today operates the largest retail and service network in the country. In the 1990s, VW's brands accounted for more than 50% of all passenger-car sales in China. But VW began to slump when competitors arrived and consumers demanded more up-to-date models. The company's market share dipped to 12.4% in the first two months of this year, according to UBS. Profit margins have collapsed too--from about 16% in 2001 to what some analysts expect will be a loss in 2005. Nor does VW have China to itself anymore. Pischetsrieder knows the days of 50% market share are over, so he's concentrating on higher margins and counting on big investments in new models for the Chinese market to get him there. In 2003 the company announced plans to boost the capacity of its two joint ventures from 800,000 autos to 1.5 million, at a cost of $8 billion. VW's next step is to help its joint-venture partners engineer and build their own models. "If they have a local product with our support, it might be a competitor," Pischetsrieder says. "But the competition will be there anyway, with us or without us, and I prefer it to be with us rather than the opposite way."

That knack for making the best of whatever circumstances present themselves should serve both Pischetsrieder and VW well. Without a supreme production system or a reputation for building exquisite cars, it's difficult to imagine VW ever becoming an industry superstar like Toyota or BMW. But it may be able to squeeze enough mileage out of its redoubtable engineering to prosper again--and perhaps regain some of that old Black Forest magic. ■