* Prefers Tennessee plant over Mexico for new SUV - source
* Needs new SUV to help reverse fall in U.S. sales-analysts
* Sluggish U.S. sales putting world No. 1 ambitions at risk
By Andreas Cremer and Bernie Woodall
BERLIN/DETROIT, Jan 10 (Reuters) - Volkswagen is preparing to build sport utility vehicles in North America as it struggles to conquer a market whose resistance is threatening its bid to be world No. 1.
The German carmaker prefers its Tennessee factory over a Mexican plant to produce the new SUV and may announce the plan as soon as next week's Detroit auto show, said a source familiar with the matter who asked not to be identified.
The Volkswagen (VW) group, with brands ranging from no-frills SEAT to Bentley, is aiming to sell 10 million cars in 2018 to overtake General Motors and Toyota - including 800,000 U.S. deliveries for the core VW badge.
Following a 2011-12 sales surge, the German group has hit an American pothole in the road to global supremacy and needs more models designed for U.S. consumers and manufactured competitively in the region, analysts say.
"Having a competitive crossover (SUV) would be a huge step forward for Volkswagen in the U.S.," said Juergen Pieper of Bankhaus Metzler in Frankfurt.
VW's U.S. deliveries fell 7 percent in 2013 as a push into competitive midsize cars lost traction, with the brand languishing in the bottom third of quality rankings - a mirror image of its European standing that puzzles German bosses.
The Passat, Golf and imported Tiguan and Touareg SUVs lost ground to fresher models from U.S. and Japanese rivals, which increased sales in a market that grew 7.6 percent overall.
Company spokesman Mark Gillies said VW was aware of U.S. quality challenges and had yet to make a final production decision on the "CrossBlue" SUV concept unveiled last year.
"We're making good progress (on quality) but there is more work to be done," Gillies said, adding that warranty claims were falling.
VW began its U.S. offensive three years ago and now builds Passats at the $1 billion Chattanooga, Tennessee factory opened in 2011. Since the 1988 closure of its previous U.S. plant, the group had focused on expanding in China and Brazil.
Despite stronger sales by the upscale Audi division, North American operations are expected to have contributed little or nothing to 2013 group operating earnings of about 11.5 billion euros ($15.6 billion), with the VW brand still losing money.
The carmaker last month ousted U.S. divisional chief Jonathan Browning, whose successor Michael Horn makes his first appearance at the Detroit show opening Monday.
The main task facing Horn is to make the case for more new U.S. models, London-based analyst Arndt Ellinghorst said.
"VW executives are so deeply in love with their over-engineered cars that they simply haven't been taking U.S. customers seriously," said Ellinghorst, an autos specialist with International Strategy & Investment.
Horn, whose promotion from global after-sales head took effect on Jan. 1, declined to be interviewed for this article.
VW has lost face as well as sales in North America, dealers and other industry insiders say.
To price cars competitively, it tried offsetting the cost of its sophisticated mechanics by stripping out features and using entry-level trims in the Passat and Jetta.
VW misjudged the mass market by "trying to sell German engineering in austere cars with austere interiors", said Jim Ziegler, an independent consultant to U.S. auto retailers.
"I'm an American - give me bells, give me whistles," Ziegler said. "Americans will buy a pretty car faster than they will buy a well-engineered car."
The attempt to woo customers with spartan vehicles also led to quality issues that enraged group CEO Martin Winterkorn during a recent test-drive visit with U.S. managers.
Winterkorn, feared for his ability to fixate on detail, was disappointed with the dashboards, seat adjustment levers and interior finish he discovered in the Passat and Golf, one company official said. "The boss was fuming."
VW has improved its latest JD Power "initial quality" scores but still ranks 23rd out of 33 brands, with 120 problems reported for every 100 new cars within the first 90 days.
Some issues have stemmed from a failure to gauge U.S. consumer expectations - down to the positioning of cruise control buttons - that has frustrated the group's own dealers.
At a gathering in November, according to one participant, VW told showroom owners it expected little growth in 2014-2015 sales, followed by an unprecedented surge to the 2018 goal of 800,000 deliveries, almost double last year's number.
"They're out of their minds," the East Coast dealer said.
The German carmaker has long since given way to demands for larger cupholders, but the same dealer still recalls VW executives objecting that they were designing a car, not a restaurant. And other misunderstandings still arise.
"We have to tell them it's whatever the people buying it want it to be - a motel, a restaurant, a computer on wheels," he said.
VW insists its 2018 goal is within reach and says last year's decline was expected between model updates. Neither the Passat nor the Jetta has been revamped in three years.
But production cuts at Chattanooga tell a different story. In May the company laid off 500 shift workers it had hired months earlier and remains in talks with the United Auto Workers union over representation.
Restoring U.S. momentum will be hard, analysts say, even after the new SUV arrives in 2016 at the earliest. Falling fuel prices are lifting demand for pickups - which VW doesn't offer - and undermining the sales pitch for its efficient diesels.
The competition is also getting tougher.
"The Passat is up against a redesigned Nissan Altima, a redesigned Honda Accord and a redesigned (Ford) Fusion - all undercutting VW on pricing," said Alec Gutierrez, an analyst with Kelley Blue Book, which tracks U.S. car values.
The VW brand's U.S. sales will reach 524,000 cars in 2018, according to forecasters IHS Automotive, a third short of the goal and endangering the group's bid for global leadership.
Looking askance at German rivals BMW and Mercedes-Benz, whose U.S.-built SUVs are powering sales gains, VW executives already have some cause for regret.
"They sent America the wrong product," dealer consultant Ziegler said.