Case Write-Up: John Deere & Mueller-Lehmkuhl Gmbh

John Deere:

Question A3: What caused the existing cost system to fail in the 1980’s?  What symptoms and evidence indicate cost system failure?

A combination of the changes within the industry and company prompted by the collapse of farmland values and commodity prices in the 1980s, a drastic internal reorganization of the company (including lack of clarity about the division’s mission and business objectives and its fit within the company), and a cost system that did not keep up with the new dynamics of the business. The responsibility for generating information from which costs were calculated was spread among at least three offices (industrial engineering, quality assurance, and accounting) and it appears that no one was responsible for centrally coordinating and compiling this information to conduct a bird’s eye analysis and determine whether all appropriate activities were being considered. There was also an over reliance on calculating overhead based on direct labor until 1984 when machine hours was favored, even though the processes in the company had become significantly less labor intensive.

Further, when overhead categories beyond direct labor and machine hours were added, over 41% of overhead costs were attributable to the 5 new categories, representing a significant shift in how the overhead should have been calculated. In other words, major factors were being ignored in the previous cost system.

Question A4: Diagram the proposed ABC system for the turning machine area.  How were the limitations of the existing cost system overcome by the ABC system?

The ABC system allowed John Deere to identify the true activities and cost drivers attributable to the machinery it was producing.  The existing cost system only took into account two costs - direct labor and machine hours.  As we can see from the ABC system diagram (see below), and the cost shifts described below, 5 additional categories of activities and cost drivers were identified that actually accounted for 41% of the machinery’s cost.

Question A5: Compare the cost of product A103 (See Exhibit 11) under the existing cost system and under the ABC approach.

The cost of product shifts drastically from the standard cost system to the ABC method. As noted above, 41% of overhead costs are now attributable to non-direct labor and non-machine hours categories, five categories of cost which did not exist under the standard system. The direct OH rate drops from 117% to 83.4% and period OH drops from 88% to 27.4%. Cumulatively, the direct OH rate drops from 205% to 111%, representing a nearly 46% reduction. The machine hours/operation OH also drops significantly. Direct drops from $9.83 to $6.77 per hour and the period rate drops from $17.73 to $9.94 per hour. Cumulatively, the period OH rate drops from $27.56 per hour to $16.71 per hour, representing a drop of approximately 39%. It becomes apparent that machine setup, production order, part administration, and general and administration OH costs contribute substantially to the costs of manufacturing with each ranging from 8.0% to 10.9%.

Mueller-Lehmkuhl GmbH:

Question 3: How much profit does ML make on the sale of fasteners?  How much profit does ML make on the sale and rental of attaching machines?

Part 1:

Using Exhibit 9

Assumptions:

• All costs are before reductions through tariffs, commissions or distributor markups.

• R&D costs are not calculated into each product’s unit price.

Average selling price = $46.75+$39.83+$15.28+$20.32+$38.40 = $160.58 for all 5 fasteners

Total cost + total direct labor = ($39.86+$37.84+$9.65+$14.14+$28.17) + ($1.32+$1.43+$0.14+$0.27+$0.66) = $133.58

Average profit = $160.58 - $133.58 = $27 for all 5 types of fasteners

Average profit per fastener = $27/5 = $5.40 per one type of 1000 fasteners

Part 2 (detailed calculations found in Excel spreadsheet):

Using Exhibit 1 & Exhibit 4

Profit on Sales:  Affects manual machines only

Assumptions:

• From Exhibit 1, manual and automatic machines require the same dollar amount of “Cost of Goods” and “General Overhead” per unit.

• Although automatic machines are more complex when compared to manual types, more are fabricated, thus driving down the cost per unit through economies of scale.

• Based on total machine production (manual and automatic), manual machines account for 16.67% of production, thus accounting for 16.67% of “Cost of Goods” and “General Overhead” ($11,666,666.67 of $70,000,000 total) – see Excel spread sheet for these calculations and breakdown

• All machines produced are sold

M1 Profit (see Excel spreadsheet for year-over-year calculations for manual machines):

• Sales price - production cost = $200

• Y1 = 1986 = 35 units

• Revenue Y1 = number of units x selling price = 35 x $200 = $7,000.00

• … Y20 = 700 units; Revenue Y20 = $140,000

• Total M1 Machine Revenue = $ 1,470,000 for Years 1-20

M2 Profit: Sales price - production cost = $250

• Y1 = 1986 = 70 units

• Revenue Y1 = number of units x selling price = 70 x $250 = $7,000.00

• … Y20 = 1400 units; Revenue Y20 = $350,000

• Total M1 Machine Revenue = $ 3,675,000 for Years 1-20

M3 Profit: Sales price - production cost = $500

• Y1 = 1986 = 105 units

• Revenue Y1 = number of units x selling price = 35 x $200 = $7,000.00

• … Y15 = 1575 units; Revenue Y15 = $787,500

• Total M3 Machine Revenue = $ 6,300,000 for Years 1-15

Total