The following report is a consultation analysis of John Deere Component Works costing

structure. Included is a discussion of the existing cost system as well as a comparison with the
proposal of the Activity ased Costing system. The solutions to the re!uired discussion issues
have "een thoroughly prepared and are here"y included.
Problem Statement:
The demand for John Deere Component Works (JDCWs) products has suffered due to
the collapse of farmland value and commodity prices. A number of continuous failures in
JDCWs competition for bids have placed an onus upon manaement to !uestion its current
costin methods. As a result" an analysis must be made reardin the current costin methods in
order to determine their validity and to aid the company in adoptin a more sound costin system.
Analysis
John Deere Component Works #as a subdivision of John Deere and Company #hich
dealt e$clusively #ith the manufacturin of tractor component parts. %y the mid &'()s" JDCW
found that its available e$cess capacity #as increasin. To neutrali*e this problem JDCW
attempted to take advantae of the efficiencies of its ne#ly ac!uired automatic turnin machines
by biddin on parts offered from #ithin the company. This lead to a direct bid of +,- of the ./-
parts offered by John Deere and Company. 0ut of the possible +,- parts" JDCW #as successful
in the biddin of only -( parts" #hich happened to be lo# volume parts. This became a concern
for JDCW because its aim #as to attain the bids that offered the hiher volume parts" as to allo#
it to take advantae of its machines hih volume efficiency. 1n reality" the problem for JDCW
#as not the number of bids they received" but the alarmin discrepancy #ithin its bid prices and
that of its competitors. JDCW reali*ed that somethin #as #ron in their accountin system" and
decided to revie# its current cost structures.
The e$istin cost system is stron in that it is simple and easy to maintain. 0verhead
allocation #as based on direct labor hours" machine hours and material dollars. The use of
standard costs allo#s JDCW to compare actual labor overhead costs #ith budeted rates in order
to determine the follo#in years overhead costs. 1n fact" the old cost structure #orked !uite #ell
in the past since the company produced a speciali*ed line of products that #as periodically
consistent. This in the aspect that the products differed little or not at all in both unit and volume.
2o#ever" this cost method does not provide the best system for JDCWs cost allocation.
%y usin only three overhead rates the present system rossly undermines the true production
costs since other activities of the production process are not ackno#leded. The system also fails
to compute material usae variances" #hich only further discredits the accuracy of the accountin
&
cost structure. 3or more accurate measure of material usae" the !uality assurance department
must include this variance calculation in its #eekly report. A further #eakness is that the
accountin department issues reports that only indicate ho# each area operates" rather than
evaluatin the performance of each area" #hich #ould prevent a constriction in cost efficiency.
These #eaknesses prevent JDCW from accurately accessin its true costs. 4ssentially" #ith the
current cost system" manaerial analyses is hihly fla#ed due to a lack of crucial in5depth cost
information.
3ailures in the e$istin cost system are due to several factors. 3irst of all" #hen JDCW
calculates its standard direct labour" direct machine hours" and total overhead" the volumes are
calculated on a lon5term basis. 2o#ever" if the actual production volume is not for the lon
term it becomes a problem" this in the sense that it is difficult to modify the system as to
accommodate for any increases or decreases in the production demand.
6econdly" #hen JDCW updates its overhead rates for the upcomin year" its forecasts are
based on the previous years fiures. This system is oin to result in serious inaccuracies"
especially #hen the company attempts to tackle production volumes that are completely 7alien8
to the companies historical production trends. An e$ample bein the biddin attempt on the +,-
parts. This reflects the companys constricted cost system that revolves around a limited product
diversity trend" instead of allo#in for a correct forecast of diverse products that more
realistically represent the volatile demand of the industry. 2ence" it #ould only be loical to state
that the JDCWs yearly updated overhead rates are inaccurately calculated.
As foreshado#ed" the standard accountin cost system used by the company is
sinificantly out of date. This is because the system #as oriinally desined to handle a direct
labor intensive production process #ith little overhead costs. 2o#ever" #hen the company
chaned its production process to a more automated system" it simultaneously increased its
overhead costs. This dramatic overhead increase #as embodied throuh increases in supervision"
maintenance" electricity" and setups. 6ince more overhead costs #ere no# bein incurred" a ne#
system had to be implemented to adapt to this ne# environment.
These #eaknesses further support the fact that JDCWs bids #ere continuously
miscalculated in relation to their competitors. 9sin the e$istin system" manaement at JDCW
continually under5costs its lo#5volume parts and over5costs its hih volume parts. 1f its bids #ere
to be based on the A%C method" JDCWs costs #ould be more accurate" and it #ould most likely
ac!uire a hiher number of bids. 6ince the production of lo# volume parts is less efficient than
hih volume parts" it is in the interest of JDCW to attain hiher volume bids. 2o#ever" since its
6tandard Cost system is fla#ed" the bid proposals submitted by JDCW are also fla#ed. To
+
clearly illustrate this point" a comparison of the t#o cost systems for part A&)/ hihlihts the
discrepancy. 9nder the 6tandard Cost system" part A&)/ costs :++.() #hile under the A%C
method" the part costs :/+.&(. (6ee Appendi$ %)
RECOMMENDATIONS
1t is imperative that JDCW chane from 6tandard Costin to Activity %ased Costin.
This is essential because the 6tandard Cost system only #orks #ell in a stable production
environment. With the advent of ne# technoloies bein employed at JDCW" the 6tandard Cost
system is incompatible and therefore makes it difficult for JDCW to attain precise fiures. The
A%C method" on the other hand" provides manaement #ith more accurate cost allocations"
enablin it to make bids that truly represent its production costs. 6ince the standard system bases
its costs on volume related overhead rates" costs that are product5related" batch5related or facility
sustainin are not accurately allocated. 1f total overhead costs are based solely on a volume5
related basis" distortions #ill result because not all costs are driven by production volume. (6ee
Appendi$ A) With the A%C method" this problem is rectified.
6ince the A%C approach assumes that overhead costs can be traced directly to products"
the total overhead costs are better allocated to the products" ivin JDCW a closer indication of
the behaviour of its overhead costs. The A%C method allo#s overhead costs to be assined to
products accordin to the proportion of demand that each product places on that activity. 2ence"
creatin more accurate product cost estimates.
1n implementin an A%C system" maners #ill be motivated to consider a different set of
actions from that of the old cost system. They #ill be removed from relyin solely on previous
years fiures and #ill most likely be involved in a more unstable production environment.
6pecifically" manaerial decisions #ill include modifications of pricin" product mi$es" and
customer mi$es; enhancin supplier and customer relations; improvin the desin of products and
services; and performin activities more efficiently. 0verall" manaers that s#itch to an A%C
approach #ill find the e$tra burden of plannin and maintainin a #ider variety of cost pools.
SUMMARY AND CONCLUSION
The issue that made JDCW !uestion its cost structure is the fact that its bids on part
productions #ere out of line #ith those of its competitors. A closer look at the problem reveals
that indeed the 6tandard Cost system currently in place is outdated. A more accurate system is
needed to remain competitive" and in this situation" the A%C approach is most commendable.
/
BACKROUND
The John Deere Company has been operatin in the farm e!uipment industry for &.+
years. John Deere Component Works #as established as a separate division of the John Deere
Company durin the &',)s as continued ro#th created the need for increased production space.
JDCW had been structured to be a captive producer of parts for Deeres e!uipment divisions"
particularly tractors. Thus it had to produce a #ide variety of parts #hose volume #as relatively
lo#. Due to lo# capacity durin the mid &'()s" the <ear and 6pecial =roducts Division of
JDCW decided that comple$ machined parts offered a promisin niche. 6ince this process
re!uired more automated machines" more overhead costs #ere to be incurred. As part of the
stratey of the <ear and 6pecial =roducts Division" it set out to market machine parts to the
outside #orld. 1n order to obtain production orders <ear and 6pecial =roducts decided to bid on
+,- out of the ./- parts that Deere and Company offered. They soon found out" ho#ever" that its
bid prices #ere not in line #ith those of its competitors" and since the key to successful
competition in the outside #orld is price" JDCW had to rethink its pricin strateies.
>
APPENDI! A
O"ER#EAD COST POOLS
Direct ?abor 9nit
@achine 0perations 9nit
@achine 6etups %atch
=roduction 0rder %atch
@aterials 2andlin %atch
=arts Administration =roduct56ustainin
<eneral and Administrative 3acility56ustainin
-
APPENDI! B
STANDARD "ERSUS ABC COSTIN $OR PART A%&'
STANDARD MET#OD
Total Cost A Direct ?abor B Direct @aterials B 0verhead
Direct ?abor A .&(- labour hours $ &+.,.Chr A +./.
Direct @aterials A ..>>
0verhead A Direct B =eriod
Direct ?abour 02 A +.)- $ .&(- $ &+.,. A >.('
@achine 2ours 02 A +,.-. $ ./&) A (.->
@aterials 2andlin 02 A .)', $ ..>> A )..+
Total Cost ()er %&& )arts* +,,-..
ABC MET#OD
Total Cost A Direct ?abor B Direct @aterials B 0verhead
Direct ?abor A .&(- $ &+.,. A +./.
Direct @aterials A ..>>
0verheadD
?abour 6upport 02 A &.&& $ .&(- $ &+.,. A +..+
@achine 0peration 02 A ((.'' B ..,&) $ .)/& A -.&-
@achine 6etup 02 A (//.,. $ >.+ $ +) C () A /.->
=roduction 0rder 02 A (&&>.+, $ +) C () A +.(.
@aterials 2andlin 02 A &'.>+ $ > A ).',
=arts Admin. A (>(, $ &) C () A ..)'
<eneral and Admin. A (.)'& $ &+.,.) $ (.&(,) B +&.+/ A +.&>
Total Cost ()er %&& )arts* +',-,%
.