Caterpillar Looks for a Few Close Friends

Mike Render, an engineer who has worked for Caterpillar (CAT) since the 1970s, has spent the last three years trying to break with the company's past. Render suggested his employer partner with a supplier to design a component that cuts emissions, rather than simply dictate specifications and choose the cheapest vendor. His team ended up working with 12 engineers and managers of catalytic-converter manufacturer Tenneco (TEN). At Caterpillar's Mossville (Ill.) engine center the team created a mock production line to work out kinks in the manufacturing process. Using the joint design, assembling the component at a Tenneco plant in Nebraska cut Caterpillar's costs on the part by 20 percent.

The collaboration is a cultural shift for Caterpillar, whose suppliers in the past have complained about a lack of dialogue, says Stephen Volkmann, an analyst at Jefferies & Co. (JEF) "It was, 'Give me what I want when I want it, and the rest is your issue to manage,'" he said. "The big change in attitude is from the servant-master relationship to more of a team-type relationship."

Caterpillar, the world's largest maker of construction and mining equipment, expects the Tenneco collaboration to become a benchmark, says Chief Executive Officer Douglas R. Oberhelman, who succeeded James W. Owens in July. The company is shrinking the number of suppliers it relies on to 6,000 from 9,000 and is working more closely with 200 companies it has identified as critical to its growth.

Improving the supply chain is a key piece of Oberhelman's strategy to pull 25 cents of profit from each new dollar of sales as demand in emerging markets surges. He plans to apply engineering and quality-control expertise from suppliers inside Caterpillar factories to help build the company's signature yellow-and-black machines more efficiently.

Caterpillar wasn't prepared for the last increase in global demand, from 2006 to 2008, and the mistake proved costly. Sales rose 24 percent during that period while profit growth was flat as Cat paid more for raw materials and faster delivery of parts from suppliers. "In the next cycle, Caterpillar wants to have a better playbook," said Larry De Maria, an analyst at Sterne Agee. "It's critical that they have [enough] wheels, tires, bearings, and everything else, which is essential to maximizing returns to shareholders, return on capital, and operating margins."

Oberhelman knows Cat must change, and he's appointed an outsider with a "deep background in supply-chain collaboration," as his new chief procurement officer. Frank Crespo, who previously held that post at Honeywell International (HON), started work in August. "We are still a bit behind in our supply-chain efficiency," Oberhelman said. "If we get that right, the profit pulls through pretty quickly."

Caterpillar may not have needed to focus on collaborating with suppliers in the past because of its size and dominant position in the industry, said John W. Henke Jr., president of Birmingham (Mich.) Planning Perspectives, which advises manufacturers on supplier relationships. Now, "competition is going to be based on the supply chain, not an individual company," said Henke, who has developed an index that quantifies buyer-supplier relations. "Toyota and Honda are good because of their supply chain and great supplier relations."

In Planning Perspectives' ranking for automotive supplier relations this year, Honda Motor (HMC) was the leader, followed by Toyota Motor (TM). Both have also fared better financially than some other carmakers during the downturn.

Henke said improving relations with suppliers entails communication and engendering trust that spurs vendors to give manufacturers their best technology. Depending heavily on suppliers can present pitfalls. Boeing (BA) in August postponed the first delivery of its 787 Dreamliner aircraft to early 2011 partly because of Rolls-Royce Group's inability to supply an engine for flight tests. Boeing is also working through quality issues in body sections built by Finmeccanica's Alenia Aeronautica.

Caterpillar's collaboration model isn't "the absolute Japanese definition," Oberhelman said. "It's [also] not the American automotive supplier collaboration, where it's price cuts, costs down, and then you go bankrupt together. We are trying to find a spot in the middle."

Tenneco's experience building parts that reduce emissions for the automotive industry has benefited Caterpillar, Render said. The partners reduced the complexity of the device they worked on. They made two versions of a part used to burn soot in the emission-reduction device for Caterpillar's various machines, compared with the 43 versions made by Caterpillar in 2007 just for truck engines, which it also makes. "It's a bit like playing a Rubik's cube," said Render, a Caterpillar product manager. "If we do this, what will happen? If we do that, what will happen? They helped with the innovation. Tenneco has given us a model" of how collaboration should occur.

The device Caterpillar and Tenneco worked on to reduce diesel emissions, as required under federal law starting next year, will be used in about 100 Caterpillar models including various types of excavators, backhoes, wheel loaders, and bulldozers. "When we come up with what we think is a pretty great technical innovation, the first guys we talk to are the guys at Caterpillar," says Brent Bauer, a senior vice-president who oversees the project for Tenneco. "When you have everybody in the same room, there are some magical things that happen. We get great products. We optimize costs and we add speed."

The bottom line: In a bid to boost profits, Caterpillar is increasing collaboration with its suppliers. That's a culture shift for the big equipment maker.

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