a) How much profit does ML make on the sale of fasteners and the sale of attaching machines. Show these separately. Hint: Go through the case facts (look in pages 2 and 3) to identify what the attaching machine costs are. They are in General overhead account. Look in exhibit 8 for a description of line items in GOH account. Use Exhibits 1 and 5 to get attaching machine revenues.

b) Exhibit 6 shows the reported product costs for five representative products. How accurate are these numbers? If you think they are inaccurate, what is your best estimate of their product costs? Note: Total budgeted direct labor dollars (including setup) for 1986 were $1.61 million (Exhibit 1). The direct labor dollar content (including setup) of the five representative products is: S-spring $1.32 Ring $1.43 Prong(B) $0.14 Prong (SS) $0.27 Tack $0.66 These numbers include direct labor dollars in the finishing department. Hint: Use the attaching machine(AM) costs and the total budgeted direct labor dollars to calculate a correction factor for the AM costs charges to the fasteners. You can then recalculate fastener costs and profitability. c) How would you change the firms pricing strategy to compete better with the Japanese? Discuss the pros and cons of implementing your suggested changes in pricing, if any.

d) How should Richard Welkers respond to the Japanese competition?

Exhibit 2 Representative Products a. S-spring snap fastener c. Open prong snap fastener b. Ring socket snap fastener Exhibit 4 Characteristics of Attaching Machines a. Manual machines are sold, not rented. b. Automatic machines are rented, not sold. Rental fee equals average paid for all outstanding models. c. Average number of fasteners attached per minute. d. Low volume is fewer than 50,000 fasteners per year. High volume is greater than 300,000 fasteners per year. e. Includes machines manufactured in earlier years and still on rental contracts. Exhibit 5 Competitive Analysis-Predicted Sales by Fastener Product Line (\$ millions) a. $30 million prong brass +$30 million prong stainless steel Exhibit 3 Attarhine Marhinec c. Pneumatic powered manual attaching machine (M3) Iuny dutullauc attaching machine (A3) Mueller-Lehmkuhl GmbH According to Dr. Richard Welkers, president of Mueller-Lehmkuhl: The merger with Atlas has significantly increased our ability to compete with the Japanese. As we are now the largest single manufacturer of apparel fasteners in Europe, we can reap the benefits of economies of scale. At the moment, we are cost competitive with the Japanese. While the Japanese have lower wages and overhead, we are closer to the market and have lower selling costs. Historically, the Japanese have been most successful when they were the low-cost producer. Currently, the Japanese are pricing 20% below us. It is not enough to offset our quality advantage, but if they can match our quality or drop prices even further, we could have a problem. Company Background Mueller-Lehmkuhl (ML), a West German producer of apparel fasteners, was founded in 1876 as a manufacturer of shoe accessories. Soon after, other products were added, including the singlepost snap fastener. Production of these items increased substantially when the company merged with a Hannover firm called Weiser. In 1929 Mueller-Weiser merged with Felix Lehmkuhl to become Mueller-Lehmkuhl. Sales growth and product diversification continued, and in 1938 the firm was acquired by the Moselhammer group. In 1982 ML formed a joint venture with the German subsidiary of the Atlas group, an American multinational. Atlas was a conglomerate of six major businesses, one of which-Apparel Fasteners-complemented ML. At that time ML dominated a relatively small segment of the market, while Atlas Germany serviced a broader customer base. The objective of the merger was to integrate ML's technological superiority and higher margins with Atlas's access to the market. While substantially increasing its sales volume, one effect of the merger was to limit ML's potential markets to Europe and Africa: the rest of the world was serviced by other Atlas divisions. In 1986 ML had estimated revenues of $103 million 1 (see Exhibit 1). 1 In 1986 , the exchange rate was $1 equals DM 2.1. Research Associate Dagmar Bottenbruch prepared this case under the supervision of Professor Robin Cooper as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright @1986 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwise-without the permission of Harvard Business School. Exhibit 8 Description of General Overhead Accounts Factory support included the unallocated supervision, floor space, and janitorial services that were consumed by fastener production. Production management was also contained in this account. Factory supplies included oil, grease rags, and miscellaneous tools used in the fastener production departments. Technical administration included attaching machine service costs and those engineering costs not included in R\&D. Support department included costs for production scheduling, fastener inventory control, the apprentice workshop, and the worker council. Machining department included material labor and overhead for the manufacture of production and attaching machines. a Tooling department included material, labor, and overhead costs for the manufacture of tools. a. Under German accounting principles, given the nature of the lease agreement, the entire cost of the attaching machines was written off to general overhead in the year in which the machines were manufactured. While the different products appeared relatively similar to the inexperienced eye, they could actually have significantly different cost structures (see Exhibit 9 for the cost structures of five representative products). Japanese Competition Hiroto Industries (HI), the major Japanese competitor in Europe, was a trading company that sold a broad range of fashion accessory products to the shoe, leather goods, and garment industries. Typical products included belts, buckles, and zippers. HI was approximately ten times larger than ML, and the two firms competed in only 20% of HI's markets. Unlike ML, HI purchased approximately 85% of the products it sold. The 15% it produced were all high-volume, low-diversity product lines. HI's stated objective was to become number one in Japan and be a major worldwide competitor. It wanted about 25% of its business to be European-based. The existing fastener technology, which exhibited significant economies of scale, required a base market size of approximately 200 million people to support several competitors. Japan with 120 million people and Germany with 60 million people were not large enough to support domestic producers without significant international sales. The larger Japanese market provided Japanese producers with a significant economic advantage. The high price that Japanese garment manufacturers had to pay for their fasteners ( 120% of German prices) reflected the isolation of the Japanese market. HI entered the European market in 1973. It faced substantial entry barriers, in particular the longstanding relationships of European companies with customers, its lack of high-quality attaching machines, and the absence of a network of distributors and service personnel. In Welker's opinion, to help mitigate these barriers, HI had focused on the high-volume products, such as workwear, leather goods, and babywear, where the market consisted of a few customers ordering very large volumes of products. In 1982, as part of the rationalization program between Atlas and ML, several service personnel were laid off. To strengthen its ability to deliver service in the European market, HI hired these personnel. This move enabled HI to penetrate the market even further. When ML rehired the most critical person in HI's team, this strategy failed and HI lost most of its newly acquired customers. To compensate, HI adopted a new marketing strategy (Exhibit 10). Rather than rent the attaching machines themselves, HI identified distributors that were willing to purchase attaching machines and then rent them to its customers. These machines were purchased from the companies that manufactured only attaching machines because the firms that manufactured both attaching machines and fasteners would sell or rent their machines only to the end user. 3HI then supplied these dealers with fasteners at about a 20% discount on the prevailing European prices. This strategy had several advantages for HI. First, HI did not own the machines and consequently did not have to provide service. Second, invested capital was kept to a minimum; and, finally, HI did not bear the risk of returned machines. The dealers benefited because they could now compete with companies like ML. They had a significant price advantage and could "steal" those customers who were not contractually obligated to use a specific firm's fasteners. 3 If no suitable European machines were available, HI would ship its own machines and sell them to the distributor. Exhibit 9 Product Cost Structures of Representative Products (\$ per 1,000 units) a. Includes setup labor in all departments and the direct labor in the finishing department. Exhibit 10 Comparison of Mueller-Lehmkuhl and Hiroto Industries Product Distribution Approaches was used. The same contractual condlitons applled. b. Some Hilroto-manufactured attaching machlnes were sold to the distributors. The same contractual condtions applled. Exhibit 11 Estimated Japanese Market Share of European Market in 1986 HI's new strategy threatened two segments of ML's market. The first was the small-volume customer who used fasteners that were very popular. Several such firms were effectively equivalent to a large-volume customer. However, given that these customers owned their own equipment, they were free to purchase fasteners from whomever they chose. The second, a more worrisome trend, was when a large-volume customer decided to use Japanese fasteners on ML equipment. Although most fasteners were customized, some of the really high-volume fasteners, such as stainless steel spring fasteners, were standardized and could run on anybody's equipment. Certain ML customers, even though contractually obligated to purchase product from ML, were beginning to experiment with the Japanese product. ML had threatened to cancel the equipment leases if it caught any firm violating the contract. In fact, one firm had been caught, but immediately agreed to stop "experimenting" with Japanese fasteners. HI's new strategy met with some success and by 1986HI had achieved about a 6% overall market penetration (Exhibit 11). ML's European sales manager voiced his opinion: My biggest concern is keeping price levels as high as possible in the face of Japanese competition. We do not want to lose market share to them, but the problem is that their prices are so much lower than ours that matching them would be too expensive. They do not present an immediate threat because our quality is so much higher. However, even though our customers carefully analyze the situation and decide to stay with us, they are left with the feeling that they would be better off if they bought Japanese. required replacing all components specific to the fastener. The company estimated that an average modification cost $2,000. Although the rental contract did not specify free service, it was industry practice to provide preventive maintenance and emergency service at no charge. Even though most large customers had downtime insurance, ML viewed reliability and fast service response as an important sales tool. Consequently, it was not unusual for service personnel to be flown to a customer site within hours of an emergency call. In 1986, service was expected to cost about $4.5 million. To partially make up for the cost of providing this service, ML attached two conditions to the rental of a machine: (1) only ML fasteners were to be used on the machine and (2) at least $10,000 worth of fasteners were expected to be purchased during the year. However, due to uncertain demand and overly optimistic customers, the average rented machine attached only about $7,000 worth of fasteners per year. Market Conditions ML had positioned itself in the large-volume market, where automatic machines were required. Large volume referred to the quantity of a given fastener sold, not to the overall fastener consumption by a given firm. ML's preferred target market could be broken into two major segments: (1) large companies purchasing large volumes of a number of different fasteners and (2) smaller companies needing major quantities of a single fastener. Large-volume customers accounted for 85% of fastener sales. The European market could be characterized as a stable oligopoly consisting of 4 firms that together accounted for 65% of the European fastener market (Exhibit 5). An additional 13 firms (including the Japanese) accounted for the rest of the market. Most of these firms sold fasteners and attaching machines. In addition to the fastener manufacturers, there were several companies that produced only attaching machines. Their machines were usually cheaper and of inferior quality to ML's. ML's fastener sales to customers using third-party equipment were thought to be about 10%. The exact percentage was unknown because ML could not be certain on which machines its products were actually used. The four major players, all providing equivalent services, had over the years settled into peaceful coexistence. They never initiated price wars and rarely tried to steal each other's customers. Customers had helped achieve this stability by sourcing from multiple suppliers. Customers normally identified a primary source but ordered from at least one other firm. If ML attempted to move from a secondary supplier to a primary supplier by price cutting, the adversely affected company could easily retaliate by trying to become the primary source for one of ML's customers. There were several other factors that helped reduce the level of competition between the major players. First, the companies developed longstanding personal relationships with their customers. These relationships, coupled with high customer satisfaction, made it difficult to lure away any business. Second, the policy of renting machines, coupled with designing the fasteners so that they could be used only in the supplier's own machines, made switching an expensive undertaking. Third, there were virtually no standard prices. Each customer paid a different amount for its fasteners, making it difficult to compete on price. Despite these limitations, the firms did compete on three dimensions: 1. The quality of the fasteners and, in particular, the tolerance to which they were manufactured (the higher the tolerance, the less likely fasteners were to cause machine downtime and the longer their life expectancy once fastened). 2. The performance of the attaching machine (in particular speed, reliability, safety, noise level, and ability to attach fasteners without scratching the surfaces). 3. The quality of service provided. Product Description Snap fasteners are used by the garment industry to replace buttons and buttonholes. ML produced about 700 different fasteners in five major product lines: s-spring socket snap fasteners, ring socket snap fasteners, two open prong snap fasteners (brass and stainless steel), and tack buttons (Exhibit 2). In 1985 ML introduced a new fashion line of products. These consisted of snap fasteners and tack buttons that were manufactured from a wider range of materials in a broader variety of shapes. The company's marketing manager wanted to convince the market that snap fasteners could be fashionable and could be used to replace conventional buttons in a wide array of clothing. Each product line was designed for a specific application. The s-spring fasteners were used for medium-thick materials (1.4mm to 2.0mm ). They could not be used for stretch materials, since they were attached centrally (through one stud) and would damage the material. The ring spring fasteners were used for thicker materials (up to 6.5mm ) and could be used on materials exposed to heavier strains. The open prong fasteners were especially well suited for use on thin (.25mm to .75 mm ) and stretchy materials since they did not damage the materials. All fasteners could be washed, dry cleaned, and ironed. Tack buttons were used to replace conventional buttons and were usually used on blue jeans. Fasteners were customized either by applying various colors of finishes or by embossing the customer's logo on the cap. As part of its strategy of being an integrated manufacturer, ML also manufactured attaching machines. In 1986 ML manufactured six attaching machines-three manual and three automatic (Exhibit 3). All of the machines could be modified to attach any of the company's fasteners. An operator using a manual machine placed the two parts of the fastener into the machine by hand, positioned the material, and operated the machine. In an automatic machine, one or more of the parts was positioned automatically. The operator still had to position the material manually. The three manual machines differed from each other in the position of the operating switch and the motivating force. When using the simplest machine, the operator pulled down a lever compressing the two parts together. A slightly more expensive version of this machine allowed the operator to supply the motivating force by pushing a lever with one foot. The most advanced manual machine was pneumatically powered. The operator simply pushed a button with one foot to operate the machine. The advantage of foot operation was that both hands were left free to position the fastener parts and material. Automatic machines were used for high-volume production, the increased speed offsetting the higher cost of the machines. The three automatic machines differed from each other in the number of parts automatically positioned and the speed of operation. The pneumatically powered semiautomatic machine automatically positioned one-half of the fastener, leaving the operator to position the other half manually. The fully automatic machines automatically positioned both parts of the fastener. The only difference between the two fully automatic models was their speed: the electrically powered machine was substantially faster than its pneumatic counterpart. The electric machine was particularly suited to garments that required attaching several identical fasteners on the same garment (for characteristics of the machines, see Exhibit 4). Over the years, the firm had developed a policy of selling the manual machines and renting the automatic ones. Manual machines were sold because, unlike automatic machines, they did not cost much, did not require service, and were easily and inexpensively modified to allow them to attach different fasteners. Automatic machines were rented on an annual basis, though the company was willing to take them back at any time. About 10% of the 7,000 rented machines were returned in the average year. The company inventoried these machines until new orders arrived. It then modified the old machines to enable them to attach a different fastener. Modification was expensive, since it 2 ML sold its products in approximately 20 countries. These countries differed in language, safety regulations, labor costs, taste, tariff barriers, payment terms, and currency. Even the smallest product required marketing materials, product descriptions, and labels to be in every language, adding to overhead and production costs. In some countries tariffs could add up to 100% of cost to the product, rendering a foreign producer uncompetitive with local producers. In other countries, labor costs were so low that even for large-scale production the use of manul attaching machines was still economical. In some countries, it was impossible to succeed without at least one salesperson fluent in that country's language. To deal with these local differences, ML used agents in some countries, distributors in others, and regional sales offices in yet others to sell fasteners. Attaching machines were always purchased or rented directly from Mueller-Lehmkuhl. Agents generally represented a range of associated but noncompetitive products. They promoted ML products and were paid a 6% to 10% commission on fastener sales. Agents did not maintain inventories. Distributors differed from agents by maintaining inventory, thus reducing the uncertainty of local supply. Like agents, they enabled the local customer to deal with a fellow national. Overall, agents and distributors accounted for about 75% of sales. Product purchased through a distributor usually cost about 10% to 15% more than when purchased directly. In countries where local differences were not a major factor or ML maintained a regional sales office, large customers could purchase directly from the firm at reduced prices. The European market was relatively mature, with overall growth expected to be 1% per annum (Exhibit 6). This low growth rate had caused ML to look for new markets, in particular Africa. The African market was more price sensitive than the European market. Low-cost producers had a significant advantage because quality was not important and no premium for a better product could be charged, making it difficult for quality-oriented producers to penetrate those markets. Since the textile industry was continuously shifting its production into less-developed countries, low-cost producers could position themselves well to service these growing markets. Unfortunately, the merger with Atlas had reduced ML's opportunities for geographic expansion, since the continuing offshore movement of the garment industry was moving ML's business into areas serviced by other Atlas divisions. Production Process ML's production facility was a four-story building located next to the head office in Dsseldorf, West Germany. The top floor of the building, which contained the machining and tooling departments, was primarily dedicated to the production of attaching machines. All design and prototype work for the attaching machines was completed in-house. This represented about 30% of the engineering staff's activities. Purchased parts, consisting of motors, engines, and all electrical parts, constituted about 30%2 of the total cost of an automatic or semiautomatic attaching machine. Metal parts were cast according to ML's specifications by a local cast-iron business. After these parts were delivered to the company, they were prepared for welding, then welded, and finally the machines were assembled. Welding and final assembly required highly skilled labor, especially for the automatic and semiautomatic machines. All product-specific parts (i.e., those that had to be changed if a machine was modified to attach a different fastener) were produced by ML. Precision was crucial in order to make the machine fit a customer's specifications. Therefore, testing was a major part of the production process. Frequently, up to 10,000 pieces of product had to be run through a machine before it could be delivered to the customer. 2 This percentage was considerably smaller in the manual machines, since they did not contain any electrical parts. 4 In addition to attaching machines, the company manufactured some of its own production machines. In early 1986 the company announced that it would start producing a new line of automated material-handling machines. These new machines relied heavily on the technology developed for attaching machines. The machining department labor force was split into two groups_one producing attaching and production machines and the other refitting returned attaching machines. Management estimated that 80% of the labor force that was producing machines was dedicated to attaching machine production. The tooling department, which was also located on the top floor, manufactured and repaired tools that were used in the production of both fasteners and machines. Tools used in the production of fasteners were very costly and were frequently reworked, whereas tools used in the production of attaching machines were relatively inexpensive and usually replaced when they showed signs of wear. No attempt had been made to determine how the tooling department's capacity was split between production and attaching machine tools. The other three floors of the factory were dedicated to fastener production. Fastener production consisted of three major steps: stamping, assembly, and finishing. Each floor was primarily dedicated to a single step. In stamping, the material components were stamped out of large coils. If the fastener was being produced in very large quantities, then automated machines were used that could produce up to 12 components with a single stamp. These high-volume machines required expensive tooling, often costing up to $50,000. At low production volumes, less-sophisticated machines were used. The stamping department contained 47 different types of machines. In the stamping department, it was not unusual for a single operator to run several machines simultaneously. In assembly, the stamped components were combined by machine. The tack button, for example, consisted of five components-three in the button and two in the underpart (Exhibit 7). The button was assembled from a cap (often with a logo stamped in the surface), a plastic insert that formed the locking mechanism, and a socket plate. These three parts were crimped together to form the button. The underpart consisted of two components, a stud and a cap, which were crimped together. The type of machine used to assemble the components again depended on the production volume. Altogether there were 112 different types of machines in assembly. Once assembled, the parts were then washed and, if required, heat-treated before being sent to finishing. Several different finishes were produced. These included plating (the part was plated to make the surface smooth and shiny), painting or enameling (the part was spray-painted in a variety of colors), tumbling (to produce a matte surface), and polishing (to produce a smooth surface). There were 15 different types of machines in the finishing department. Finished parts were packed ready for shipping. Only minimum work in process and finished goods inventories were maintained, because most fasteners were produced to order. On the surface, fasteners seemed to be simple products requiring fairly low technology; in fact, however, they had to be machined to within a hundredth of a millimeter. This required precision stamping and high quality control. Similarly, the attaching machines were on the forefront of automated material handling technology. To maintain its technological superiority, the firm maintained a strong research and development department. The introduction of the fashion line required significant R&D resources. Management estimated that at least two-thirds of current R\&D projects were related to fastener production, with the new high-fashion fasteners accounting for about 50%. The cost accounting system had recently been overhauled. According to the corporate controller, the old system, which consisted of about 70 cost centers, failed to differentiate appropriately between automatic and manually operated machines. The new system contained more cost centers: one per machine class. Material, after adjustment for scrap, was charged directly to the product. The new cost system also identified a material overhead charge. This included the costs associated with purchasing, material handling, and inventory storage. Products were allocated material overhead on the basis of the material dollars they consumed. In the stamping and assembly departments, labor costs, after dividing by the number of machines the operator was running, were charged directly to each product. Setup labor costs, after dividing by the lot size to produce a per-part setup charge, were also charged directly. Overhead was divided into two sections: machine costs and general overhead. Machine costs were those costs that could meaningfully be allocated directly to the machine: floor space, energy, maintenance, depreciation, and an interest charge for invested capital. The total cost of these items for each machine class was divided by the projected direct labor dollars (including setup) expected to be worked on that machine class to give the machine class overhead burden rate per direct labor dollar for the coming year. The resulting machine class burden rate was multiplied by the standard direct labor dollar content of each product to give the machine-related overhead portion of product cost. General overhead consisted of factory support, factory supplies, technical administration, support department costs, machining department costs, and tooling department costs (Exhibit 8). Where possible, general overhead costs were traced directly to the fastener production departments; otherwise they were allocated to each department on the basis of direct labor dollars (including setup dollars). The general cost pool for each fastener production department was then divided by projected direct labor dollars (including setup dollars) for each department for the coming year to give the machine overtime burden rate per direct labor dollar. The resulting departmental burden rate was multiplied by the standard direct labor dollar content of each product to give the generaloverhead-related portion of product cost. Batch costing was considered the most appropriate approach for costing products in the stamping and assembly departments. In the finishing department, process costing had been adopted. Each finish process was treated as a cost center, and all of the costs associated with that center were aggregated into a single cost pool. These costs were then allocated to the products, using equivalency factors that reflected the value of resources consumed by the products. In summary, the cost system reported standard product costs using the cost of a component in the following manner (the unit of measurement was a "mil," which was equal to 1,000 pieces): Material standard cost + material overhead Stamping and Assembly Labor standard labor hours standard pay rateumber of machines operated Setup standard setup labor hours standard pay rate / lot size Machine OH standard labor dollars machine burden rate General OH standard labor dollars departmental burden rate Finishing total departmental cost equivalency factor