The existing cost system used by John Deere Component works based the allocation of overhead on direct labor hours, machine hours and material dollars. The use of standard costs allows JDCW to compare actual labor overhead costs with budgeted rates in order to determine the following years’ overhead costs. The cost method does not provide the best system for cost allocation for the company. By using only three overhead rates the current system grossly undermines the true production costs since other activities of the production process are not acknowledged.
The system also does not compute material usage variances, which only further discredits the accuracy of the accounting cost structure. For a more accurate measure of material usage, this variance should be factored in. Another notable weakness is that JDCW’s accounting department only issues reports that indicate how each area is operating, instead of evaluating the performance of each area, which would help promote cost efficiency in each department. These weaknesses prevent JDCW from accurately accessing its true costs. Essentially, with the current cost system, managerial analyses are highly flawed due to a lack of crucial in-depth cost information.
Failures in the existing cost system are due to several factors. Firstly, when JDCW updates its overhead rates for the upcoming year, its forecasts are based on the previous years’ figures. This system will lead to serious inaccuracies, especially when the company attempts to tackle production volumes that are completely “alien” to the companies’ historical production trends. The bidding attempt on the 275 parts is a perfect example. This reflects the company’s constricted cost system that revolves around a limited product diversity trend, instead of allowing for a correct forecast of diverse products that more realistically represent the volatile demand of the industry. Hence, it would only be logical to state that the JDCW’s yearly updated overhead rates are inaccurately calculated.
Secondly, when JDCW calculates its standard direct labor, direct machine hours, and total overhead, the volumes are calculated on a long-term basis. However, if the actual production volume is not for the long term it becomes a problem, because it is difficult to modify the system to accommodate for any increases or decreases in production demand.
The standard accounting cost system used by the company is significantly out of date. This is because the system was originally designed to handle a direct labor intensive production process with little overhead costs. However, when the company changed its production process to a more automated system, it simultaneously increased its overhead costs. This dramatic overhead increase was due to increases in supervision, maintenance, electricity, and setups. Since more overhead costs were now being incurred, a new system had to be implemented to adapt
Case 3: John Deere Component Works
In the 1980s, the farmland values and commodity prices has been collapsed which led to the worst and most sustained agricultural crisis since the Great Depression. In response, Deere adjusted its level of operations downward, cut costs and restructured manufacture process. However, the cost system did not keep up with the new dynamics of the business. The information needed to calculate costs has to be obtained through at least three office including industrial engineering, quality assurance and accounting. There would be lots of mistakes to trace the costs. There is no one responsible for centrally coordinating and compiling this[a][b] information. Since it only allocate overhead on direct labor, machine hours and materials handling, it is not clear which activity is actually generated the overhead. Major factors were being ignored. For example, some fixed costs such as process engineering costs and setup costs were associated with every order, whether the order was fulfilled or not. These order related costs were counted in the general overhead.
Some symptoms including the price of the components is higher than its competitors for the equally efficient machinists and equipments. The transfer fee is too high to encourage the internal sales department to buy its own components. Only 58 out of 275 bided components was taken which is low in volume and below expectation
Compared to the existing cost system, the proposed ABC system allowed the company to classify cost activities into those overhead pools, and identify cost drivers attributable to the products it produced. The primary drawback of the existing cost system was that it allocated overhead costs by only two accounts, which are direct labor and machine hours. As we can see from the diagram attached, there are many more categories of cost activities and cost drivers in the proposed ABC system. By adopting the proposed ABC system, the company will be able to track its overhead costs much more precisely.