A.J. Rassi, who became the general manager of the wheel loader and excavator division in Aurora, Ill., shortly after the reorganization, recalls the first time he saw his divisional P&L: “I was so excited, because I was in a very profitable business unit and I could see that we were making a lot of money for this corporation. We had meetings every month and shared the P&L statements with our top management people in the Aurora group. And, in our plant managers’ meetings, we showed every plant, profit or not. Before, there was nothing.”
Others experienced a rude awakening. When Jim Despain became vice president of the track-type tractor line — the product line on which Caterpillar was founded — he was shocked to learn that “we were losing a lot of money. We had no idea how to fix it. [And this was the] first time we realized it, because the company was profitable, and we had the best product, the original plant, the most seasoned employees.”
But resourceful, empowered managers eventually figured out how to run profitable businesses. The accountability and autonomy of the new model unleashed a vast amount of entrepreneurial energy and managerial discipline from Cat’s considerable talent pool. “People really started intensely looking at how they made money in their division,” recounts John Pfeffer, then a plant manager at Caterpillar, who has since retired. “You’d say, ‘I’ve got to take $20 million, or $50 million, out of my cost structure this year, and the only way is to identify the stuff that clearly I shouldn’t be doing. So why is my assembly and engineering plant cutting steel? I’ll outsource this to Mexico at $4 an hour versus us doing it at $45 an hour.’ That was really the catalyst. People started putting together one-year and three-year plans, and it was almost embarrassing what people could come up with,” compared with their performance in the past.
Information Heroes
At the same time, Caterpillar completely changed the information flows in the organization and the metrics used to measure performance. A high return on assets became the overall goal. ROA was correct, simple, and straightforward to use, which was particularly important for the pragmatic engineers who were mostly now running Cat’s businesses.
Only a few of Caterpillar’s divisions sold to outside customers; the rest lacked any natural measure of revenue to use as the top line of their P&L. For the profit-center model to work, Cat needed to create a measure of internal revenues. This was provided through transfer prices, at which Caterpillar divisions “bought” and “sold” intermediate goods from each other. It is easy to underestimate the importance of transfer prices. After all, they are tantamount to “trading wooden nickels,” since they only move money from one division in the organization to another. However, because transfer prices enable organizations to re-create supply and demand economies inside their boundaries, they are the often-overlooked linchpins that hold decentralized organizations like Cat’s accountable model together.
Using market-based benchmarks, divisions would negotiate with each other to determine transfer prices. These negotiations were often contentious and protracted, and consumed a lot of management time and attention. But they were essential to making the new organization work properly.
Jim Owens recalls a meeting of the administrative council two years after the reorganization in which “a large group of vice presidents from materials purchasing and the plants gave a little presentation about all the time they spent doing commercial negotiations over transfer prices. ‘We’re too inward looking; we’re wasting our time.’ And Fites got up and said, ‘You don’t understand. Half your cost is purchases from outside suppliers. U.S. Steel didn’t have any trouble whatsoever establishing those prices. So that’s the way we’re going to run the railroad. If you can’t work that way, you can get another job.’ That ended the debate rather succinctly.”
