El-Tek
Role of Sal Granger, President of Magnetic Advances
By Max H. Bazerman & Jeanne M. Brett
1996-2014 Dispute Resolution Research Center (DRRC), Kellogg School of Management, Northwestern University.
All rights reserved. Revised 2002.
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You are Sal Granger, President of Magnetic
Advances, a Division of El-Tek, Inc. El-Tek, Inc. is
an international organization engaged in the design,
manufacture, sale and servicing of a wide variety of
electrical products and components. Today, it is
recognized as a leader in the electrical industry with
sales over $30 billion. The firm employs over
100,000 people at locations throughout the world.
El-Tek is a decentralized, product-centered
organization. Divisions are responsible for particular
product lines and are operated as profit centers.
Division presidents have the responsibility for
determining and implementing policies and practices
related to the development of new products,
discontinuation or expansion of product lines,
production facilities, and the costing, pricing and
selling of products. Division presidents are rewarded
primarily on the basis of the bottom line profitability
of their division.
Divisions are chartered to sell and license their
products to customers outside the company. Divisions
that use another division’s product as a component in
their own products have the authority to either
purchase the component from the other El-Tek
division or to produce it themselves; buying the
product outside of El-Tek is also an option, but only
under special circumstances. Divisions selling
products within the company are expected to make a
“reasonable profit” of 10% on these internal sales.
The division charters were intended to preclude
competition among the divisions on the sale of
general product lines to customers outside the
company. They were not designed to diminish
competition among the divisions in such areas as
product development, production, and sales within
the company. In choosing this organizational
structure the CEO realized that there would be
numerous problems to be resolved among the
divisions. However, the CEO also realized that unless
division presidents made as many decisions as
possible on their own and among themselves, the
small top corporate management team would be
overwhelmed. In addition, the CEO believed that a
decentralized structure would increase the
entrepreneurial spirit in the company, and that this
benefit outweighed any potential loss of coordination.
A further consideration in adopting this structure was
the belief that effective managers should be able to
deal with the coordination issues that arise in a
decentralized structure. For all these reasons the
charters give division presidents broad authority to
make decisions and to work out problems among
themselves. The CEO also made it clear that a pattern
of kicking decisions up to corporate would be
disadvantageous to managers careers.
Your division, Magnetic Advances, is primarily in the
business of manufacturing and selling magnets and
magnetic materials. It is the only El-Tek division with
the charter to sell or license magnets externally.
About 75% of its net sales of $1.6 billion are to
customers outside the company. Bottom line profit is
approximately $240 million. Of the $400 million in
internal sales, $7 million is sold to Audio
Components. Variable costs on the magnets that you
manufacture are 60% of sales. Fixed costs on making
magnets are typically 25% of sales. These costs are
best estimates for the newest magnetic material that
Audio Components engineers have just finished
developing.
The history of the new magnetic material is as
follows. Three years ago, El-Tek’s Advanced
Development Laboratory (ADL, the basic research
laboratory of El-Tek) developed a theoretical concept
for a new magnetic material that would have
properties that might permit the manufacture of highpowered, small, inexpensive magnets. In conformity
with company policy, ADL approached your division
2 El-Tek/President of Magnetic Advances
as the logical group to do the developmental research
on the new concept. Engineers in your division were
dubious that ADLs concept could be developed, let
alone produced commercially, and passed on the
opportunity to develop the new magnetic material.
ADL then offered the concept to another El-Tek
division, Audio Components.
Audio Components manufactures and sells a wide
variety of miniaturized products and components
related to sound amplification, such as: hearing aids,
microphones and special-purpose amplifiers. Net
sales are slightly under $2 billion. Magnets are an
important component in three-quarters of the 200
different products manufactured by Audio
Components. About half of these magnets are
purchased from your division and the rest are
manufactured in Audio Components’ own foundry.
Audio Components also sells about $10 million in
specialty magnets and magnetic components to other
divisions within the company. The reason that Audio
Components makes some of its own magnets is that
Audio Components often needs small lots of
production that Magnetic Advances is not interested
in producing and has no other customers for. Audio
Components variable costs on manufacturing
magnets are 65% of sales. Fixed costs of making
magnets have been 25% of sales.
Audio Components invested three years and $12
million (in todays dollars) before the new magnetic
concept, called Z-25, became a commercial reality.
At the reception following the public announcement
of Z-25, you went up to Chris Carlson, President of
Audio Components, to offer congratulations on Audio
Components’ outstanding success in developing Z-25.
You went on to say that Magnetic Advances was
ready to exploit all of the commercial possibilities of
the new product and begin manufacturing Z-25. You
then made an appointment to get together with your
team and Carlsons team to discuss the transfer of the
Z-25 technology.
You are sure that Z-25 has enormous commercial
possibilities. You expect that the product will have a
lifetime of two years. Since Magnetics has the
exclusive charter to sell magnets externally, only
Magnetics can exploit the commercial opportunities
associated with Z-25. However, Audio Components
owns the rights to Z-25. You can only obtain these
rights by reaching a mutually acceptable agreement
with Audio Components or by a top management
decision. You really do not want to see the decision
concerning the future marketing of Z-25 made by top
management. You are somewhat embarrassed by your
department’s decision three years ago not to develop
Z-25. If top management gets involved now in the
decision about marketing Z-25 commercially, the
folly of your previous decision will become salient
again.
You suspect that Audio Components does not want to
transfer the Z-25 technology to Magnetic Advances
for a number of reasons. First, if Magnetic Advances
is selling Z-25 on the open market, Audio
Components’ direct competitors could buy it and
Audio Components would lose the competitive
advantage that Z-25 would contribute to its array of
products. Second, Audio Components probably
intends to recoup its development costs of about $12
million (in today’s dollars) plus obtain a reasonable
profit by producing Z-25 for sale to other divisions in
El-Tek.
To prepare for your meeting with Audio Components,
you had your division’s best financial analysts
estimate the net profit to Magnetic Advances for
producing and selling Z-25. The attached chart shows
the future profitability to Magnetic Advances for
various agreements that you might be able to reach
with Audio Components. The numbers in the chart
estimate the two-year lifetime expected incremental
value in todays dollars to Magnetics as a result of
manufacturing and selling Z-25. You are very
confident of the accuracy of these estimates.
The outcomes include a dollar figure for Magnetic
Advances profit depending on different competitive
advantage scenarios and the transfer price (TP) that
Magnetic Advances anticipates paying Audio
Components for the technology. The competitive
scenarios prohibit Magnetic Advances from selling
the product to Audio Components direct
competitors, and/or to the competitors of other ElTek divisions. The reason to consider the prohibition
periods is that Audio Components may require some
protection in order to prevent their direct competitors
from gaining access to these magnets. In addition, a
transfer payment to Audio Components may be
necessary to get them to release the product to you.
The outcomes include a dollar figure for the net profit
that you would earn from selling Z-25 and TP, a
variable figure representing the money that you would
have to pay Audio to release the technology to you.
TP is equal to an amount that is negotiated between
the two divisions to compensate Audio Components
for the transfer of the magnet technology to Magnetic
Advances.
3 El-Tek/President of Magnetic Advances
Look at Outcome # 2. In this scenario you would get
$140 million of bottom line profitability over the twoyear life of the product in today’s dollars. This
consists of $120 million in profits from external sales
plus $20 million in profits from internal sales to other
divisions of El-Tek, including Audio. Since you know
that your division makes 15% profit on external sales,
this means that your external sales volume is $800
million. Since you are only allowed a 10% profit on
internal sales, you can figure that your internal sales
will be $200 million. Audio may want you to supply
Z-25 either at cost or for free. For every one hundred
dollars of Z-25 you supply for free you can subtract
one hundred dollars from your profits (i.e., you would
be spending $90 on materials, and have to forgo $10
of profits). The Audio division meanwhile will be
able to pocket these savings.
Any cash transfer payment you make to Audio will
erode your profitability, as will any market
restrictions that you accept, for example, if you agree
to restrict external sales either to Audios direct
competitors and/or competitors of other El-Tek
divisions. Your analysts have quantified this for you
in the table. For example, the $140 million in
Outcome 2 includes $20 million of internal profit and
$120 million of external profit, while the $47 million
in Outcome 10 includes $20 million of internal profit
and $27 million of external profit, which has been
severely eroded by restrictions.
If you decide on an agreement that is between two
options on the chart, you should interpolate linearly
what your divisions profits would be.
4 El-Tek/President of Magnetic Advances
Granger and the Magnetic Advances Negotiating Team
Lifetime Profit-Outcome Lifetime Profit —
Net Profit to M.A.
1) Audio produces Z-25 and the product is sold only internally $0
2) Magnetics produces Z-25 and no limitations are put on its distribution $140M TP
3) Magnetics produces Z-25 and is prohibited from selling to Audios direct competitors for
6 months $130M TP
4) Magnetics produces Z-25 and is prohibited from selling to competitors of any El-Tek
divisions for 6 months (Audios direct competitors and competitors of other el-Tek
divisions)
$100M TP
5) Magnetics produces Z-25 and is prohibited from selling to Audios direct competitors for
12 months $120M TP
6) Magnetics produces Z-25 and is prohibited from selling to Audios direct competitors for
12 months and from selling to competitors of El-Tek divisions other than Audio for 6
months
$90M TP
7) Magnetics produces Z-25 and is prohibited from selling to competitors of any El-Tek
divisions for 12 months (Audios direct competitors and competitors of other El-Tek
divisions)
$60M TP
8) Magnetics produces Z-25 and is prohibited from selling to Audios direct competitors for
20 months $107M TP
9) Magnetics produces Z-25 and is prohibited from selling to Audios direct competitors for
20 months and from selling to competitors of El-Tek divisions other than Audio for 6
months
$77M TP
10) Magnetics produces Z-25 and is prohibited from selling to Audios direct competitors for
20 months and from selling to competitors of El-Tek divisions other than Audio for 12
months
$47M TP
11) Magnetics produces Z-25 and is prohibited from selling to competitors of any El-Tek
divisions for 20 months (Audios direct competitors and competitors of other divisions) $20M TP
M = Million
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