Case 11–1

Deere Cost Management

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.

THE GATHERER CHAIN

Deere & Company (Deere) manufactured and distributed a
full line of agriculture equipment as well as a broad range of construction,
turf, and forestry equipment. Additional supporting businesses were Financial
Services, Power Systems, Parts Services, and the Intelligent Solutions Group.
The company had annual sales of $35 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 Products 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. It was the intention of management
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.

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 Exhibit 1). The budgeted selling price
for the current year was based on the need to match the price set by a major
competitor.

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 percent
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 percent of the purchase price, and they
pay the packaging.

EXHIBIT 1 Profitability Analysis for Gathered Chain

Two Years 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

319

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
Manufactures, 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’s industry code. According to data from the previous year, the
breakdown was material, 42 percent; direct labor; 13 percent; indirect labor, 6
percent; and overhead, 20 percent.

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.
 
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