John Deere Components Works
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JOHN DEERE COMPONENTS WORKS (JDCW)
The main takeaway point from the case was that economic decisions should not be taken on the basis of mere accounting costs. Also, opportunity costs and sunk costs play a vital role in our decisions. We also learnt from the managers of John Deere the nature of the mistakes that we are likely to commit when making pricing decisions.
JDCW used a standard cost accounting system to allocate costs associated with the components which led to numerous problems in the costing. Costs such as order and handling costs, setup costs, and other administrative costs were not calculated separately under this standard system. They were combined together with the direct costs while other costs such as electricity and depreciation were part of period costs for materials, labor and machine hours. Because of this, low volume orders showed lower costs than actually incurred, while high volume orders showed higher costs than actually incurred.
Therefore JDCW decided to use Activity Based Costing (ABC) to arrive at costs for individual units. The overhead could now be split into 7 different types namely direct labor, machine operations, setup hours, production order activity, materials handling, administration and general overhead. These costs were calculated per order and per hour and per unit, thus allowing John Deere to correctly allocate costs for each different unit, which was not possible in the standard cost accounting system.
HANSON MANUFACTURING COMPANY
Hanson Manufacturing Company made three products 101, 102 and 103. After some bad decisions, it was discovered that the company had a loss of over $100,000 in a good year. Thus after tremendous scrutiny of the the PnL statements of all the three products, it was realized that product 103 was making a loss of 43 cents per cwt. This led them to conclude that it was impossible to cut the costs of product 103 by 43 cents, and thus wanted to drop the product from the portfolio.
However eventually they went ahead with manufacturing this product. At the end of the first half of 1974, it was observed that foregoing the manufacture of 103 would have led to a loss of 1.2 mm dollars, in contrast to a profit of 103,000 dollars that was made with the product in the portfolio.
Another issue cropped up when the market leader reduced the price of product 101 from $4.90 to $4.50. However, Hanson was reluctant to reduce the price to $4.50, considering the fact that they would not be able to cover their costs on reducing the price, although their sales might be only 750,000 (which was the number last year) compared to 1 mm units if the price was reduced. Using process costing, which helps in assigning costs to different products manufactured in batches by the same company, Hanson could determine the contribution margin on reducing the price or retaining