Choosing the Right Manufacturing Technology In 1986, John Deere was building a c
ID: 388434 • Letter: C
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Choosing the Right Manufacturing Technology
In 1986, John Deere was building a capital-intensive factory to produce large, four-wheel-drive farm tractors when the price of wheat dropped dramatically. Demand for these tractors also fell because they’re used exclusively for harvestingheat. In response, John Deere stopped construction of its factory and attempted to purchase Versatile, a Canadian company that assembled tractors in a big garage using off-the-shelf components.
We can characterize John Deere’s decision as abandoning their capital-intensive factory, characterized by big fixed cost but small MC, in favor of Versatile’s technology, characterized by small fixed cost but big MC. Did John Deere make the right decision?
As you should now begin to realize, the answer is “it depends.” In this case, it depends on how much John Deere expected to sell. Suppose that the capital-intensive technology had fixed costs of $100 and MCs of $10, whereas Versatile’s technology had fixed costs of $50 but MCs of $20. (Note: We’re deliberately choosing easy-to-work-with numbers so that we can illustrate the general point.) To answer the question, we compute the break-even quantity— the quantity at which John Deere is indifferent between the two technologies.
In the following table, we see that for a quantity of five units, the total costs of the two manufacturing technologies are the same.
In-House
Versatile
Quantity
5
5
Fixed Costs/Year
$100
$50
Marginal Cost
$10
$20
Total Cost
$150
$150
If John Deere expects to sell more than five units, it should choose the low-marginal-cost technology; and for less than five units, they should choose the low-fixed-cost technology.
In this case, John Deere decided to acquire Versatile because projected demand was low. However, the antitrust division of the U.S. Department of Justice challenged the acquisition as anticompetitive7 because John Deere and Versatile were two of just four firms that sold large four-wheel-drive tractors in North America.
We end this section with a warning to avoid a very common business mistake:
Do not use break-even analysis to justify higher prices or greater output.
Managers sometimes reason that they must raise the price to cover fixed costs. Similarly, managers sometimes reason that since average fixed costs decline with quantity, they must sell as much as they can to reduce average cost. Both lines of reasoning are flawed because, as you know, pricing and production are extent decisions that require marginal analysis, not break-even analysis.
Remember, if you start your analysis by looking at costs you will always get confused. Instead, start your analysis by asking a question. For an extent decision, like how high to price or how much to produce, fixed or sunk costs are irrelevant because they do not vary with the consequence of the decision. For an investment decision, fixed or sunk costs are relevant because they haven’t yet been incurred.
The authors present an example of technology choice based on an actual case from 1986. John Deere is one of the leading manufacturers of agricultural and construction equipment in the world. Although they had been building large farm tractors for over 20 years, they decided to purchase the technology from a Canadian company called Versatile. The authors illustrate this decision by using some unrealistic but simple numbers (they acknowledge these simplifications in the text), but some key details are missing. In particular, what product price do the authors use to generate this example?
Also, the authors do not mention that the competing technologies are not identical. John Deere products had earned a reputation as premium quality equipment that included lots of features -- by analogy, large John Deere tractors were akin to Lexus or Mercedes automobiles. In contrast, Versatile tractors were known to be reliable but less sophisticated and were akin to Honda or Hyundai automobiles. Based on the discussion of the extent decision presented in Chapter 4, would we expect John Deere to charge the same price for the in-house product as they would for outside technology from Versatile? Finally, do you find any other problems with this example in Section 5.4?
In-House
Versatile
Quantity
5
5
Fixed Costs/Year
$100
$50
Marginal Cost
$10
$20
Total Cost
$150
$150
Explanation / Answer
The case here highlights how during an economic downturn, John Deere a reputed brand in the tractor space went ahead and bought the technology of a smaller Canadian company, Veratile, that basically assembled tractors off a garage space using off-the-shelf components. This was basically done to keep the fixed costs low as the fixed costs going into manufacturing at John Deere was nearly double of that of Versatile. However, the marginal costs were substantially higher in the case of Versatile. Hence negating the advantage due to the low fixed costs when the number of units produced were much higher. Since the demand for tractors itself had fallen pretty low, John Deere chose to keep the fixed costs low and acquire this technology despite opposition from the Competition regulators.
The point to realize here that the demand for tractors is a part of a cyclical industry and sooner or later the economy would revive and the demand would go up. John Deere should realize the fact they are a pioneer in the industry and a reputed brand in the tractor space for the past 20 years. Versatile on the other hand has a pretty different market segment where the customers are looking more for purpose being served rather than the quality and longevity of the product.
Hence, without any doubt if John Deere has acquired this technology they should be pricing it at a price much lower than their regular tractors. This would be an economy or budget range offering for customers looking for a tractor at an affordable price point for a short duration and would migrate to a high quality John Deere tractor once things get financially better. Hence, the offering itself has been altered and the target segment substantially different for the 2 sets of products being offered.
Another factor which should be considered is, in the long run when demand grows, John Deere’s technology with a higher fixed cost would be more capable to meet that demand as their processes and technology is far superior. In other words, the productivity would be far higher in comparison to a Versatile assembling components off a garage. Hence, the thinking should be more strategic and long-term, however in the short-term as a smart tactic – Versatile as a competition can be killed and added to their portfolio as budget offering for a totally different target segment.
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