John Deere Case Analysis

SUBMITTED BY

AKASH AGAMYA

GREAT LAKES INSTITUTE OF MANAGEMENT

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1. What is the problem in the company and why is the business not growing?

The issue with John Deere Components Works (JDCW) is that its bids on tractor component productions were out of line with those of its competitors. JDCW has open a bid for its 275 components out of 635,surplus due to new automatic turning machine, expecting higher volume bid of the parts but ended with only 58 components bid which is low in volume and below expectation. But In reality, it’s not the number of bids they received is the concern but the price of the components which is higher than the prices of its competitor. Price allocation for JDCW on the components is higher than its competitors for the equally efficient machinists and equipments. JDCW has something wrong with their cost allocation and accounting system. Some fixed costs such as process engineering costs and setup costs (costs incurred for setting up the machines’ databases)...etc were associated with every order, whether the order was fulfilled or not. These order related costs were counted in the general overhead. The overhead costs were then distributed according to the machine hours, direct labor and materials. For low volume orders, these costs were accounted to be low, as the machine hours, direct labor and materials used were less. Therefore for low volume orders, the perceived price of parts was lower than actuals. On the other hand, these costs were accounted to be higher for high volume products as these used more machine hours, direct labour and materials. Although actually, the order/setup costs were roughly similar for low volume and high volume parts, high volume parts bore the majority of the costs, while low volume parts seemed to cost less.

2. Compare and contrast the merits and demerits of the current cost system and ABC system.

Current cost allocation system is strong and simple to use. Overhead calculations are based on direct labour hours, machine hours and material dollars. This cost structure has worked quite well in the past since the company was producing a specialized line of products which were periodically consistent but now the products different volume of periodic production. Also, JDCW calculates its direct labor, direct machine hours, total overhead and the volumes on a long-term basis. And if the actual production volume is not for the long term then it becomes a problem because modifying the system to accommodate the deviation in production demand becomes difficult. Secondly, JDCW forecasts its overhead rates for next year based on previous years overhead figures. This result in serious inaccuracies, especially when the company gets the production attempts of volumes that are completely “alien” to the company and not congruent to past trends. Bidding attempt on the 275 parts is an example of that.Standard accounting cost system is significantly suitable for manual process of production where direct labor cost is intensive with little overhead cost. However, when the company switches over to the automated production process, its overhead cost increases significantly in supervision, maintenance, electricity, and setup costs. And, there you require a new and correct cost allocation system. JDCW is also going with the same issue.Under the current cost accounting system, actual one-time costs for an order were not properly accounted for. For e.g., the order costs, setup costs, were order based, should be tracked for every order and not allocated on an overhead basis. This meant that in the current system the actual costs incurred for an order was dependent on the size of the order itself. Depending upon the size, the difference between actual costs and accounted costs varied between positive and negative. ABC method of cost allocation is more accurate and gives better understanding of overhead costs. It also calculates the unit cost rather than just the total cost. This is an efficient method of cost allocation when the volume of production per part is fluctuating periodically. It results in greater accuracy by taking into account not just the costs of unit, but also costs for undertaking an order, order execution costs...etc and allocating them on a per order basis. Major disadvantage of ABC cost allocation method is that its time consuming in calculation and slightly costlier than the standard method in procurement and maintenance.

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3. If you are in-charge of pricing and profitability, how do you improve profitability of the company?

If I were the in-charge of the pricing and profitability I would have changed the Standard Costing to Activity Based Costing (ABC) system first of all to improve the profitability of JDCW. This is important because the Standard Cost system works well in the stable production environment and when most of the production processes are manual and not automated. Standard cost system works significantly well when the direct labor cost is intensive and overhead cost is not so much but fails when the production system is automated and there is significant overhead cost involved than the direct labor cost. Although the standard cost accounting system was changed in 1984 to reflect overhead costs based on machine hours and materials apart from direct labor, the costs accounting system was still erroneous as the order costs and order execution costs were improperly allocated. The Standard Cost system has become incompatible and therefore fails to give precise figures in cost allocation. The ABC method, on the other hand, would give more accurate cost allocations to management which will enable to make bids that represents the production costs correctly.

The ABC method allocates the costs to products according to the proportion of demand that each product places on that activity which helps creating more accurate product costing. Also, ABC cost method does not considers past trends to calculate the overhead it will give the correct cost estimates for the future forecasts even in an alien volume of production in future.As the costs are accounted for more accurately, the bids of high volume products would become far lower and low volume products might become higher. This will ensure that the company only takes up bids that are actually more profitable (high volume bids which lead to better efficiency of automatic machines and spreads the order costs over a larger volume, thereby reducing costs/unit). Low volume bids for which the efficiency of automatic machines coupled with higher setup & order costs would mean higher costs per unit as compared to outside vendors and may be outsourced leading to lower costs and hence improving profitability.

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