On Wednesday, February 18, Jim Elsey, cost management specialist at Deere & Company in Moline, Illinois, received

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Question:

On Wednesday, February 18, Jim Elsey, cost management specialist at Deere & Company in Moline, Illinois, received a call from Glen Lowery, sales manager in the Agricultural Products Division:

Jim, I need you to look into our costs on the gatherer chain. Our margins have really shrunk and we need to do something about this problem. Get back to me and let me know what you think.

1 The Gatherer Chain

Deere & Company (Deere) manufactured and distributed a full line of agriculture equipment as well as a broad range of construction and forestry equipment and commercial and consumer equipment. The company had annual sales of $14 billion with operations in more than 160 countries.

A popular product sold by the Agricultural Products Division was a conveyor system. Materials placed on the front end of the conveyor sat on the gatherer chain, which carried the material to the opposite end. The gatherer chain was joined together in links, fastened by pins, and included small hooks that helped to carry the material. It sat on rollers that required regular lubrication to keep the conveyor system in good working condition.

The Agricultural Product Division had produced the conveyor system for several years, with only slight modifications in its design. As standard practice for each product, Deere sold replacement parts, including gatherer chains, through its dealer network. Management intended to ensure that its aftermarket products were price competitive. As a result, the sales department regularly benchmarked pricing for its products.

Jim learned that the gatherer chain was purchased from Saunders Manufacturing (Saunders), a supplier located in Decatur, Illinois, Saunders was a family-owned business run by Wayne Saunders, the son of the company's founder. Saunders had a long-term relationship with Deere, and Wayne had a reputation as a tough, successful businessman who had grown the company to the point where it now employed approximately 300 people.

Table 1: Profitability Analysis for Gatherer Chain

Two Year Ago Last Year Current Year Budget

Aftermarket price $40.00 $36.25 $30.00

Purchase cost $21.25 $22.61 $24.12

Cost-price ratio 53% 62% 80%

Unit sales 475,000 410,000 350,000

Reviewing the sales margin for the gatherer chain, Jim could see why Glen was concerned. Over the past three years, the sales revenue and margin had been declining steadily (see Table 1). The budgeted selling price for the current year was based on the need to match the price set by a major competitor.

2 Financial Analysis

Jim arranged a meeting the following day with Susan Tessier, from purchasing, and Jose da Costa, from engineering. During the meeting, Jim laid a gatherer chain on the conference room table and asked Jose to estimate the raw material content. After a little bit of work, Jose estimated that the product consisted of approximately 11.6 pounds of steel and 46 pins that joined the links. He also expected that Saunders would have approximately a 20 per cent scrap rate, for steel only, as part of their normal production cost. Jose also commented that Saunders could use general-purpose equipment for the manufacturing and assembly process.

Susan then pulled out her material cost file and made the following observations:

We just finished negotiations with our steel suppliers and expect to pay approximately $28.00 per hundredweight for this type of material. I am also buying the same pins for a couple of our divisions, and I figure Saunders is paying about 3.5. Don't forget that for this part we pay the freight, which usually costs about 3 per cent of the purchase price, and they pay for the packaging.

We have looked around for other suppliers for this part and haven't been able to find anyone that capable of beating the current price. Saunders has been a good supplier. Their quality and on-time delivery performance have been excellent. I wouldn't want to lose them as a supplier.

Following the meeting, Jim examined the Annual Survey of Manufacturers, published by the U.S. Department of Commerce. Within the report was a breakdown of manufacturing costs, as a percentage of sales, for U.S. companies in Saunders' industry code. According to data from the previous year, the breakdown was material, 42 per cent; direct labour, 13 per cent; indirect labour, 6 per cent; and overhead, 20 per cent.

3 Supplier Negotiation

Glen felt that the budgeted cost-price ratio for the gatherer chain was unacceptable and was anxious to see what could be done to address the problem. He remarked to Jim:

The competition is pretty strict about maintaining a 50-50 cost-price ratio on their product lines. Why is it they can sell this product for $30.00 and we can't match their cost structure?

Jim felt that he had gathered enough information to do some preliminary analysis. However, he was aware that he needed to think about how he could use the information in his negotiation with the vendor. Susan had indicated that Wayne Saunders had been a tough negotiator, with a "take it or leave it" attitude regarding pricing, and had been unwilling to share any specific cost information to justify his requests for price increases.

GUIDING QUESTIONS

Assuming that Deere estimates the raw material cost for producing a gatherer chain is $4.20, using the U.S. Department of Commerce data in Section 2, how much should be the estimated total cost for producing a gatherer chain by Saunders?

The engineers in Deere later adjust the raw material estimation and calculate the total cost should be $12.00, assuming a 20% cost markup pricing approach (i.e., estimate cost and add markup percentage), how much should Saunders charge Deere per gatherer chain?

What can the above calculations tell? Why should a buyer be interested in these calculations? Please further elaborate on the importance of effective purchasing practice.

Susan mentioned in Section 2 that "We have looked around for other suppliers for this part and haven't been able to find anyone that capable of beating the current price." Based on this information, what can be concluded about Deere's effort in identifying potential supply sources? If Deere decides to look for potential suppliers, what factors should be considered?

Susan also mentioned in Section 2 that "Saunders has been a good supplier. Their quality and on-time delivery performance have been excellent." Saunders' quality and on-time delivery were good over time, why quality is so important for any buyer? Why Deere would like to negotiate with Saunders first, rather than engaging with a new supplier straight away?

Based on the information provided in the case, what other issues can you identify?