Case Discussion

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 and forestry equipment and commercial and consumer equipment. The company had
annual sales of $ 4 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 I). 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 cents. 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.

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.

EXHIBIT 1 Profitability Analysis for Gathered Chain

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 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.

Questions

1. Why Glen felt that the budgeted cost-price ratio for the gatherer chain was unacceptable? Why bother?
Use the information to estimate the magnitude of the opportunity (cost saving), assuming a $30 selling
price.
2. What are the available information that we have to estimate Saunders’ costs?
3. Use the information to estimate the cost of the gatherer chain? What do you think is a fair price to pay
Saunders for the gatherer chain?
4. How would you handle negotiations with Wayne Saunders?
5. Why not just develop a new supplier rather than negotiate with Saunders?