Question 1
Background
The New Brunswick Company is a midsized subsidiary of the Sun Corporation, which manufacturers various textile and similar material composites. Sales are made to affiliate companies within the Sun Corporation, as well as to external companies. Approximately one-half of New Brunswick's sales are to affiliated companies.
New Brunswick's formal mission statement reads as follows:
New Brunswick's mission is to develop and supply unique, cost effective fabrics and related non conventional structures to proactively support the Sun Corporation's worldwide consumer and professional market.
An extension of New Brunswick's mission is to capitalize on the resultant unique product and fabric capabilities by developing profitability franchises in selective growth-oriented consumer and industrial markets.
This will be accomplished while satisfying the expectations of the company and fostering commitment, challenge, and reward for our employees.
This statement has received wide approval from the corporate level and from the management boards. It serves as the driving force for New Brunswick's management and sets clear objectives.
The Product
Fifteen years ago, New Brunswick research began evaluating a fabric formation technol-ogy (originally developed by the Smith Company, a competitor) called Super Weave. In this technology, fibers are entangled mechanically using water sprayed under high pressure. The resulting fabric is very cloth like in appearance, feel, and comfort. The Smith Company realized early on that this fabric would make an ideal barrier in the operating room. The new fabric would provide an effective disposable replacement for operating room drapes and gowns, providing a greater degree of sterility than had been attainable in the past.
Within the Sun Corporation's family of companies, Sanitech is responsible for asepsis within the operating room. To this end, Sanitech markets operating room apparel, gloves, and disinfectants.
Ten years ago, Sanitech began marketing operating room packs and gowns using the Smith fabric. Although the franchise was successful, the relationship between supplier and customer did have drawbacks, which the Sun Corporation, Sanitech, and New Brunswick fully understood:
1. Product improvements made by Smith might not be exclusive to Sanitech in the future, be¬cause Smith could sell to Sanitech's competitors.
2. Smith's capacity versus Sanitech's demand.
3. Lack of a second source.
4. Fear of monopolistic pricing practices.
New Brunswick's Entry into the Market
Six years ago, New Brunswick developed a material equivalent to the Super Weave fab-ric for sale to Sanitech. Entering this business required New Brunswick to make a significant capital investment in plant and equip¬ment. The total investment would approach $30 million, the largest single investment in the company's long history. Given the Sun Corporation's policy of decentralized operat¬ing companies and New Brunswick's mission, New Brunswick's resources alone were used to fund the project In addition, Sanitech as the marketing company was at liberty to select the fabric that, from its perspective, would best meet its customers' requirements at the lowest cost to Sanitech.
New Brunswick's proposal was presented to the executive committee of the Sun Corpo-ration, who gave final approval for New Brunswick to proceed.
Smith's Response
Three years ago, New Brunswick began making fabric of a quality comparable to Smith's. However, New Brunswick found itself in a significantly changed market environment:
1. Concurrent with New Brunswick's entry,
Smith's prices to Sanitech immediately dropped.
2. Smith introduced pricing strategies that rewarded Sanitech for high volume and pro-vided multiyear incentives.
3. With the exception of price escalation, Sanitech and Smith had developed an effective partnership since 1975.
4. After several years of manufacturing, Smith had been able to maximize manufacturing efficiencies and achieve lower cost. New
Brunswick realized it was at a cost disadvantage and could not price on the basis of inter-company transfer formulas (normally, full cost plus a percent return on invested capital and working capital).
New Brunswick understood very quickly and clearly that, in order to be successful, it must beat Smith's pricing and in the long run minimize manufacturing costs or New Brunswick would have to be content as a secondary source of supply.
New Brunswick's Problem
The vice president of affiliate marketing at New Brunswick requested the assistance of the chief financial officer in developing a plan that would enable New Brunswick to sell its product to Sanitech while achieving the following objectives:
1. Establish a price that is competitive while recovering the capital investment in a reasonable number of years.
2. Establish the longer-term profitability for New Brunswick.
3. Provide the corporation with the lowest-cost product over the long run.
Required:
(1) How should New Brunswick develop its pricing strategy?
(2) How should the benefit to the Sun Corporation be measured?
(3) What might Smith's reaction be to your strategy?
(4) Should vertically integrated corporations be forced to procure raw materials from other divisions?
(5) Should inter-company pricing policy be inflexible?