Lehigh Steel Final Document

Q1. Compute profits for the five sample products under ABC and TOC Standard Costing:

Lehigh Lehigh Steel had been traditionall traditionally y doing doing standard standard costing and had been recording profits when in 1991, it suddenly reported losses. In this costing tech techni niqu que, e, stee steell prof profit its s were were a func functi tion on of pric prices es,, cost costs s and and volu volume me.. Product weight (pounds) was the primary unit of measure for standard cost, which included materials, labour, direct manufacturing expense and over verhead head cost cost cat catego egories. ies. Direc irectt manuf anufac actu turring ing cost costs s such as maintenance and utilities were allocated to products based on machine hours. Indirect manufacturing and administrative costs were allocated to products based on pounds produced, since weight was assumed to be the primary driver of resource consumption. The results indicated alloys to be the most profitable product which was already being promoted by the company. Yet, profits were not increasing. Activity-Based Costing

In 1992, when Lehigh realized that standard costing had failed to help the company find the correct product mix, they decided to shift to activitybased costing. Lehigh was a perfect application for ABC as a manufacturer of thousands of SKUs that shared the same production processes. ABC followed a 2-stage methodology of identifying activates and their cost-d cost-driv rivers ers and then, then, alloca allocatin ting g activi activitie ties s to produc products ts and custom customers ers usin us ing g cost cost driv driver ers s appr approp opri riat ate e for for that that acti activi vity ty.. The The resu result lts s were were unex unexpe pect cted ed:: Comp Compan any y prof profit itab abili ility ty was was high highly ly corr correl elat ated ed with with high high volumes of High Speed and Die Steel sales which were a departure from their earlier stance of making more Alloys. Howe Howeve ver, r, some some resu result lts s rem remaine ained d coun counte terr-in intu tuit itiv ive. e. For For exam exampl ple, e, high temps showed a similar ABC profitability to high speeds, even though high speeds could be processed across the CRM at a rate 6 times faster.

Profits of five products under ABC 

StandardCost($/lb) Price($) Materials($) Direct labor($)

Alloy: Condition Round 2.31 0.54 0.29

Contribution Margin($) Manufacturing Expenses Melting Refining Molding Rolling Finishing G&A Order processing Production planning Mat handing, setup Tech support Total Expenses Operating Profit Total Operating profit

Conversion: Die Stel: Die Steel: Roller Wire Chipper Knife Round Bar 0.77 1.02 0.93 0 0.12 0.21 0.07 0.28 0.18

High Speed: Machine coil 2.33 1.58 0.14

1.48

0.7

0.62

0.54

0.61

0.20 0.16 0.03 0.06 0.04 0.11 0.14 0.12 0.17 0.56 1.59 -0.11

0.00 0.00 0.00 0.09 0.01 0.11 0.14 0.12 0.17 0.20 0.83 -0.13

0.09 0.07 0.02 0.19 0.05 0.11 0.09 0.08 0.11 0.15 0.97 -0.35

0.09 0.07 0.02 0.05 0.06 0.11 0.03 0.03 0.04 0.02 0.53 0.01

0.09 0.07 0.02 0.02 0.04 0.11 0.03 0.02 0.03 0.03 0.46 0.15

-51423

-277030

-842029

50798

368797

Theory of Constraints Apart from ABC figures, what was more intriguing was the fact that despite a decrease in demand, Lehigh’s lead times had not decreased comparably. Excess material could be found on the shop floor despite the reduced process batches. TOC advocated that management should focus only on the constraint. To increase the throughput through the constraint was to increase throughput for the entire system. Time was the only resource that mattered in TOC but time was not typically a factor used in Lehigh’s decision-making. The key to profitability was to send only the most profitable products through the constraint. The results were again very different from what was expected. Profits of five products under TOC 

($/lb) Price Materials Throughput(Contribution $) Max. Time taken in Bottleneck  stage (mins) Throughput/min

Alloy: Condition Conversion: Round Roller Wire 2.31 0.77 0.54 0 1.77 0.77

Die Stel: High Speed: Chipper Die Steel: Machine Knife Round Bar coil 1.02 0.93 2.33 0.12 0.21 1.58 0.9 0.72 0.75

0.21

0.15

0.33

0.1

0.1

8

5

3

7

8

Q2. Identify the differences in assumptions between Standard Costing, ABC and TOC.

Standard Costing

Cost 1 Drivers  Time Orientati 2 on Linearity of  Variable 3 costs

Applicati 4 on

5 6

Standard costs are calculated using engineering estimates of standard quantities of  inputs, and budgeted prices of those inputs. For example, for an apparel manufacturer, standard quantities of inputs are required yards of fabric per jean and required hours of sewing operator labour per  jean.

ABC Costing

TOC

Activitybased costing looks at resources and activities as cost generating

Dependent events exist that result in interactions between resources and products

Independent of Time

ABC has a long run horizon

Cost pools are not homogeneous.

Cost pools are homogeneo us

Actual variance are measure against standard cost

Products or customers consume activities

Model is consumptio n rather than spending. Resources consumed have numerous causes

 TOC has a short Run impact Within every manufacturing environment statistical fluctuations and random events occur  Throughput is defined as revenue minus the variable cost of materials and energy.  There is always at least one constraint on each product that limits the firm’s revenue.  There are three types of  resources: scarce bottleneck resources, nonbottleneck resources,

7

and capacity constraint resources (CCR).  The optimized production technology system is implicitly stable—at any given time bottlenecks Activities of  are identified, wide array and the order can be mix is stable identified with respect and to given measured resources.

Q3. Identify a fourth method of calculating profits that corrects assumptions identified above that are inappropriate to Lehigh’s business situation.

Both ABC and TOC have some disadvantages when it comes to deciding the product mix. In case of ABC the product mix was decided on the basis of profitability of each product and the production of the most profitable product was maximized. This ABC completely ignores the opportunity cost of utilizing the bottleneck.  TOC on the other hand takes into consideration the effect of the most critical resource in finalizing the product mix. This system maximises the product which gives maximum profit on utilizing one unit of the critical resource. Hence TOC is focused in planning the product mix in synergy with the operating efficiency of the system. However, selecting ABC or TOC based costing is dependent upon the context in which the system is operating. The effectiveness of selecting a particular process is dependent upon the assumptions made about the relevance of labour and overhead for selecting an optimal product mix.  The TOC method of costing is recommended to be used in the short run as in the short run, it may be difficult for management to control or influence the labour and manufacturing overhead costs. On the other hand, ABC can be used in the long run as in a longer time period the manufacturing overheads and labour costs can be better controlled by the management. However, there may be certain circumstances when management has

control over labour and manufacturing overhead in the short run or some situations when it cannot control these costs even over an extended time period, the suggestion that the TOC should be used in the short run and ABC should be used in the long term may be misleading.  TOC and ABC are ideally implemented in extreme circumstances. The management has either complete or no control over labour and overhead resources. The ABC system assumes that the management has complete control over labour and the overhead resources and they will vary according to the quantity of products produced. On the other hand the  TOC costing system assumes that the management has no control on the quantity of supplied resources. So no matter what is the demand in the market the operating cost of producing the products barring the direct material cost will remain fixed. However, a proportion of the allocated resources always remain under the control of the management and another portion remains uncontrollable.  Thus there will be a minimum operating cost that the firm will have to bear regardless of the amount of production but beyond that the operating costs are variable with the amount of the production. The production capacity of the system depends on the system bottleneck and hence the capacity utilized of the non-bottleneck process depends upon the bottleneck process. The important distinction between the costing structure of the ABC and TOC system is the allocation of the costs associated with non-bottleneck processes. In order to maximize profits, the product mix decisions are an important factor for consideration for ABC and TOC under the constraints of resource capacity and demand

Applying ABC TOC mix method to Lehigh Steel  The costing system of using both ABC and TOC method can be applied to the Lehigh Steel to determine profitability of individual product lines and based on the results the optimum product mix can be decided in accordance with the profitability of these product lines. To achieve that, the bottleneck process for individual product lines has to be determined and the unused capacity of the non-bottleneck resources has to be calculated. The control of management upon this unused capacity will determine whether it is to be taken as fixed or variable cost. This will help determine the total operating cost for each product line and also the contribution for each product line can be obtained by deducting the variable cost components from the selling price of the corresponding product. Using this result and the demand for individual products in the market an optimum product mix can be calculated. This will help identify the most constrained resource and also to improve operational efficiency by removing the constraints of the resource.

Q4. Based on profit calculations and other business considerations, make recommendations for Lehigh’s product mix in 1993

In deciding the product mix, the bottleneck process of each of the product line is decided and according to that the maximum throughput of the 5 sample products are obtained based on TOC system. But some of the products which give maximum throughput are non-profitable according to the ABC system. Thus we need to determine the control on indirect costs in order to reach the optimum product mix. The most profitable products among the five sample products are High Speed: Machine Coiland Die Steel: Round Bar. The quantity of production of  each is obtained by solving an optimization problem where the constraints are the resource capacity constraints.