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Johnson Elevators

Stephen M. Gilbert
January, 2005

Sarah Edison, the manager of the Johnson Elevators plant in St. Louis, was
contemplating an oer that had been made to her by one of her key suppliers,
Smithfield Electric Motors. She was concerned because the oer involved a
quantity discount, and to take advantage of it, she would have to hold more
inventory. Would the savings in unit costs be sufficient to oset the costs of
holding more inventory? She knew that this was the right question to be asking,
but she was not quite sure how to go about answering it.
Johnson Elevators produces a variety of elevators and escalators primarily
for use in commercial construction. In the St. Louis plant, for which Sarah was
responsible, three main lines of products were produced. A hydraulic elevator
was produced for use in low rise installations where moderate car speed was
acceptable. For high rise installations, two types of elevators were produced: one
based on a geared traction system, and the other based on a gearless traction
system. All three lines of product required similar power systems and used
motors supplied by Smithfield Electric Motors.
The sales of elevators is closely linked to the health of the construction
industry which traditionally has been highly cyclic. However, during most of
the last decade, demand for elevators had been unusually stable. As a result,
Sarahs plant operation was fairly smooth. In her planning process, she typically
planned aggregate volumes of production about a year in advance, but for the
individual products, the daily production rate was typically adjusted about once
per month. For example, in August, the plant produced hydraulic elevators at
a rate of 8.5 per day, but in September, this was scaled back to 7 per day.

Procurement Planning
In total, the plant produced about 6,000 elevators per year. For each of these,
a variety of components had to be procured from suppliers. The motor was
by far the most critical of these components. The same motor was used in
every elevator that was produced and it was supplied by Smithfield. Prior to
the recent proposal, Smithfield had charged $2,100 per motor. In addition, each
time that Johnson placed an order, it had to pay $1,000 for a truck, which could
hold up to 240 motors, to drive the motors from the Smithfield plant in Chicago.
Currently, Sarahs purchasing manager, Bud McNeally, was having shipments

of 120 motors delivered once per week based on a corporate mandate to reduce
inventories. Bud was quite proud of the fact that by ordering this often, he had
managed to cut his average on-hand inventory to about 60 units.

The New Oer

In Septmeber 1999, Smithfield Electric Motors hired a a new marketing man-
ager for its construction products division. The new manager, who had just
completed several years working for a major consulting firm, eagerly began im-
plementing new policies. One of these policies was a quantity discount. The
discount worked as follows:

Quantity Price Per Unit

< 200 $2,100
200 $2,075

This discount policy was an all-units discount. Thus, if at least 200 units
were purchased, the price for every unit in the order dropped by $25. Sarah re-
alized that if she took advantage of this opportunity, she would save $150,000 in
purchasing costs annually. She also realized that it would have implications for
her plants cash flow, as well as its transportation and inventory costs. In order
to better understand the trade-os, she obtained the following information:

Physical Holding Costs

The St. Louis plant was attached to a warehouse that was used for storing
electric motors and other purchased parts and materials for production. The
cost of maintaining the warehouse was about $20,000 per year. Rarely, if ever,
was more than about 80% of its capacity used. The warehouse could hold up
to 1,000 electric motors if it were completely emptied of other raw materials,
which typically occupied about 40 percent of its capacity. Recently, a consul-
tant developed a scheme for allocating the costs of maintaining the warehouse.
The allocation mechanism, which was based on the number of square feet that
each s.k.u. occupied, resulted in an estimate of $20 as the cost of physically
storing an electric motor for one year. However, there was some controversy
over whether this allocation of warehouse costs should be used to guide decision

Other Holding Costs

In addition to the the costs of physical storage, there were also costs associated
with insurance and financing. The cost of insurance for raw materials was ap-
proximately 5 percent of the value of inventory, and it was estimated that the
cost of capital was about 15 percent.

Ordering Costs
In addition to the transportation costs that were incurred each time that an

order was placed, Bud McNeally told Sarah that they needed to worry about
the costs associated with their EDI software. The software had been updated
earlier in the year. It had cost about $20,000 to update the software. Since
this was regarded as an expense, instead of an investment, this amount was
to be allocated over the anticipated volume of transactions which was approx-
imately 2,000 per year. In addition, the cost of maintaining the software was
about $5,000 per year. (Most of the maintenance costs were related to adding
suppliers or item identification numbers to the database.) The allocation of the
updating and maintenance costs was computed to be $12.50 per transaction.

1. Evaluate the current approach to procurement of electric motors from

Smithfield. Estimate the total cost annual associated with procuring and
stocking the motors from Smithfield based on their current approach of
ordering 120 units at a time?
2. Comment on Bud McNeallys decision to order in quantities of 120 in order
to cut the average on-hand inventory.
3. Should Sarah take advantage of the new quantity discount? How would
doing so aect the plants total annual cost associated with procuring and
stocking electric motors?

The Smithfield Marketing Policy
Mark Potter had recently come to work for the commercial products division
of Smithfield Electric Motors after spending several years working for a well
known consulting firm. While he was in consulting, Mark had specialized in
supply chain management, and had become quite enthusiastic about identifying
opportunities to improve the coordination among firms.
At Smithfield, a single plant supplied both the commercial products divi-
sion as well as the consumer products division. Commercial products tended to
be large, relatively expensive items that were designed for specific customers,
whereas consumer products were much more standardized. For example, about
15 dierent firms manufactured electric motors that were essentially interchange-
ble for use in appliances. Another important distinction between the two mar-
kets was that, for commercial products, Smithfield tended to interact directly
with the OEMs who used them, whereas for consumer products, they typically
sold through distributors.
Although the commercial products tended to have larger margins, there was
currently an abundance of demand for consumer products. In fact, even though
the Smithfield plant was operating three shifts per day, seven days per week,
there was still more demand for consumer products than they could satisfy.
Shortly after coming to Smithfield, Mark recognized that one way to improve
sales would be to reduce the amount of time spent changing over the production
line between products. Whenever an order came in from one of the commercial
customers, the line was changed over to produce the order. Then after the
order had been completed, it was changed back to producing one of two types
of motors for the consumer market. With his encouragement, the plant manager
had managed to reduce the time required to change the line over to only 4 hours,
down from a full shift. However, it did not appear as though it would be easy to
reduce this further, and it was estimated that it cost the plant about $10,000 per
hour in gross margin for every hour that it was shut down for a line change-over.
One of Smithfields biggest commercial customers was Johnson Elevators.
Johnson was currently ordering 170 units at a time at a price of $2100 per unit.
They bought a total of about 6,000 units per year, so they ordered slightly less
often than once per week. Smithfields variable cost per unit was estimated to
be $1500. Although it took only about 8 hours to produce the 170 units, it took
another 4 hours to change-over the production line. Since Johnson had a habit
of requesting minor engineering changes, it was not possible for Smithfield to
produce orders in advance. After observing the situation, Mark Potter suggested
that they oer Smithfield a quantity discount, such that if they ordered at least
200 units at a time, they would pay only $2,075 per unit (for each of the 200 or
more units).
1. Evaluate how Marks quantity discount program will aect Smithfields
2. How would Marks quantity discount aect the combined profits of the
supply chain, Smithfield and Johson together?

3. Is there another quantity discount that would allow Smithfield to do even