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The task is to evaluate the best costing alternative for Lehigh steel. For this, an improvised costing system is developed which overcomes the assumptions of ABC and TOC costing and the optimum product mix for Lehigh Steel is calculated using the same
Executive Summary
Lehigh Steel is a manufacturer of speciality steels for high strength, high use applications. Its financial performance has generally trended wit but outperformed the industry as a whole. Following the general recessionary trend of the market, Lehigh Steel reported record losses in 1991 after posting record profits in 1988. This had led to an increasing need to rationalizing Lehigh Steels product mix. Traditionally, Lehigh Steel has followed Standard Cost Method for cost accounting. Jack Clark, CFO of Lehigh Steel has given Bob Hall the task of implementing Activity Based Costing at Lehigh Steel. Mark Edwards, Director of Operations and MIS explored the implementation of Theory of Constrains (TOC) accounting for Lehigh Steel. The task is to evaluate the best costing alternative for Lehigh steel. For this, an improvised costing system is developed which overcomes the assumptions of ABC and TOC costing and the optimum product mix for Lehigh Steel is calculated using the same.
Situation Analysis
Company Analysis
Founded in 1913, Lehigh Steel enjoyed a niche position as a manufacturer of speciality steels for high strength, high use applications. Products included high-speed, tool and die, structural, high temperature, corrosion-resistant and bearing steels, available in a wide range of grades in a variety of shapes and finishes. Its markets included aerospace, tooling, medical, energy and other performance industries. Lehigh Steels premium market position came from its superior ability to integrate clean materials with precision processing to produce high quality products which were often customized for specific applications, and bundled with metallurgy and other technical services. It also operated a small distribution division which served certain market segments by offering a broad product line comprising of products from multiple manufacturers. Lehigh Steel was acquired by The Palmer Company in 1975. The Palmer Company was a global manufacturer of bearings and alloy steels with revenues of $1.6 billion in 1992. Palmer believed that long-term specialization developed knowledge and innovation, the true source of competitive advantage. Palmers corporate objective was to increase penetration in markets providing long-term profit opportunities by taking a long-term view in decision making by strategically managing (the) business, and emphasizing the fundamental operating principles of quality, cost, investment usage and timelines. The acquisition of Lehigh Steel gave Palmer speciality in Continuous Rolling Mill (CRM) that could convert steel intermediate shapes to wire for Palmers bearing rollers.
Lehigh operated under a matrix organization structure. Reporting to the company president were the General Managers of Primary Operations, Finishing Operations, and Marketing and Technology; Vice President of Sales; Director of Operations Planning and MIS; and CFO. Their performance was measured by product contribution margin calculated using standard costs: revenue less materials, direct labour, and direct manufacturing costs such as utilities and maintenance; other overhead was considered beyond their control. Lehigh had 7 product lines Alloy, Bearing, Conversion, Corrosion, Die Steel, High Speed and high Temp. Out of this Alloy, Die Steel and High Speed comprised 70% of the sales, Lehigh also carried niche product lines Bearing, Corrosion and High Temp are whose volume fluctuated with market conditions. Conversion involved the processing of non-Lehigh owned material on equipment such as the PFF or the CRM that was not economical for some products to own. Conversion was subtly complex, as the breadth of the end customers product line translated into multiple rolling specifications, and multiple setups.
Industry Analysis
Structure
Speciality steel comprised roughly 10% of the total US steel industry, and like other hightech, speciality industries, and offered growth and profit opportunities to firms who targeted specific applications and developed unique technical competencies. Speciality steel was characterized by variations in metallic steel composition and manufacturing processing which enhanced the properties of basic carbon steel. Steel products were defined by several attributes which determined the product application and defined quality. Grade described the metallic (chemical) composition of the steel, or the elements added to the basic recipe of iron and carbon to create the desired properties. Product described the shape of the product, including semi-finished shapes (blooms, billets and bars) and finished shapes (wires and coils). Surface finish described the smoothness and polish that could be applied to the materials surface to enhance presentation. Size described the latitudinal and longitudinal dimensions of the product. Structural quality described the absence of breaks in the inner metallic structure. Surface quality described the absence of cracks or seams on the surface. Because specific applications called for specific attributes, many products were customized along one or more attributes for the customer. However, of all attributes, customers valued most the grade, which determined product performance. Producers typically focussed on a portfolio of product shapes within a single segment to carve niches in a broad industry. This focus strategy protected capital investments in a capital intensive industry. The industry was capital intensive because (i) lumpy and expensive capacity additions, (ii) cost structure was significantly changed only by generational, expensive new technologies (like Lehighs Precision Forging Facility (PFF)) and finally, (iii)
knowledge work performed by metallurgists and other technical specialists was a significant portion of the cost structure. Economics and focus also divided the industry into manufacturers and finishers/developers. Manufacturers were the ones who melted, refined, moulded and rolled steel into basic shapes. Finishers/Distributers were the ones who broke semi-finished steel orders and shapes down to specific products for metalworking shops and original equipment manufacturers (OEMs). Manufacturers and Distributers worked closely together, often as separate divisions within a firm.
Problem Statement
Industry wisdom stated that steel profits were a function of prices, costs and volume. Volume was available at market price, though in form of niche specialities and small orders, but virtually disappeared at premium prices. Costs failed to decline with price or volume: shrinking operating rates drove up unit costs, and broader customer bases and product lines
bred complexity and increased labour resources, particularly in scheduling. Profit could not be generated by simply working the traditional levers of price, cost or volume. In 1992, Lehigh CFO Jack Clark hired Bob Hall to implement activity based costing at Lehigh. On the other hand, Mark Edwards, Director of Operations Planning and MIS explored Theory of Constraints (TOC) based costing system for Lehigh Steel. Clark has to base his costing decision based on the reports of these two costing systems as well as the outcome of standard costing system.
Evaluation of Alternatives
Standard Costing
Lehigh Steel along with the rest of steel industry has followed standard costing method. But this method did not seem completely accurate as the company showed record profits in 1988 and record losses in 1991. In this costing method, profits from steel sales were a function of prices, costs and volume. Product weight (pounds) was taken as the primary cost driver for the measurement of standard cost, which included materials, labour, direct manufacturing expense and overhead cost categories. Direct manufacturing costs such as maintenance and utilities were allocated to products based on machine hours. Indirect manufacturing and administrative costs were allocated to products on the basis of pounds produced, since weight was assumed to be the primary driver of resource consumption. From the context of this strategy, Alloys was the most profitable product and was extensively promoted by the company. In spite of this, Lehigh witnessed record losses in 1991. The calculation of costs by standard costing is shown below.
Standard Costing Standard Cost ($/lb) Price Materials Direct labour Direct manufacturin g expense Contribution margin ($) Contribution margin (%) Total Contribution( $) Manufacturin g & Admn. Overhead Operating profit ($) Operating profit (%) Total Operating profit ($) Total Profit($) Alloy : Condition round 2.31 0.54 0.29 0.24 Conversion : Roller wire 0.77 0 0.07 0.06 Die steel : Chipper knife 1.02 0.12 0.28 0.23 Die steel: Round bar 0.93 0.21 0.18 0.16 High speed: Machine coil 2.33 1.58 0.14 0.12
0.64
0.64
0.64
0.64
0.64
0 0% 0
-$2,437,098
Activity-Based Costing
In 1992, Lehigh CFO Jack Clark decided to try out alternatives to standard costing. In order to find the correct product mix to maintain profitability even in recessionary periods, he decided to implement Activity Based Costing in the company. As a manufacturer of thousands of SKUs that shared the same production processes,, Lehigh was ideal for implementing ABC. Implementing ABC was a 2-stage process, (i) identifying activates and their cost-drivers and (ii) allocating activities to products and customers using appropriate cost drivers. The results of implementing ABC were unexpected: Company profitability was found to be highly dependent on high volumes of High Speed and Die Steel sales which was a departure from their earlier stance of making more Alloys. However, there were some results which were counter-intuitive. For example, high temps showed a similar profitability to high speeds, even though high speeds could be processed across the CRM at a 6 times faster rate. Lehigh Activity Cost Pools
Activity Driver Driver volume Amount ($) Rate Cumulative Rate
Melting - Dep Melting Maintenance Melting utilities Refining - Dep Refining Main Refining Utilities Molding - Dep Molding Main Molding Utilities Rolling - Dep
Melt machine minutes Melt machine minutes Melt machine minutes Refine machine minutes Refine machine minutes Refine machine minutes Mold machine minutes Mold machine minutes Mold machine minutes Roll machine minutes
56,91,042
780104
0.137075776
0.744599495
Rolling - Main Rolling Utilities Finishing Dep Finishing Main Finishing Utilities G&A Mat Handling & Setup Order Processing Production Planning Technical Support
Roll machine minutes Roll machine minutes Finish machine minutes Finish machine minutes Finish machine minutes Pounds orders orders orders SKUs
0.586521306
40,57,311
780104
0.192271187
0.72382891
0.21511193 0.107376089 86.37492782 69.1848916 58.43701332 868.199187 0.107376089 86.37492782 69.1848916 58.43701332 868.199187
ABC Costing
ABC Cost ($/lb) Price($) Materials($) Direct labor($) Contribution Margin($) Manufacturing expense: Melting Refining Molding Rolling Finishing G&A Mat handing, setup Order processing Production planning Tech support Total Operating Profit Operating profit % Total Operating profit Alloy : Condition round 2.310 0.540 0.290 Conversio n: Roller wire 0.770 0.000 0.070 Die steel : Chipper knife 1.020 0.120 0.280 Die steel: Round bar 0.930 0.210 0.180 High speed: Machine coil 2.330 1.580 0.140
1.480
0.700
0.620
0.540
0.610
0.200 0.156 0.031 0.059 0.043 0.107 0.173 0.138 0.117 0.564 1.589 -0.109 -4.738 -52386.495
0.000 0.000 0.000 0.088 0.014 0.107 0.173 0.138 0.117 0.197 0.835 -0.135 -17.546 281218.895
0.090 0.074 0.018 0.194 0.051 0.107 0.115 0.092 0.078 0.150 0.970 -0.350 -34.339 -845267.107
0.090 0.074 0.021 0.053 0.058 0.107 0.043 0.035 0.029 0.022 0.533 0.007 0.761 47427.417
0.090 0.074 0.018 0.018 0.036 0.107 0.035 0.028 0.023 0.035 0.465 0.145 6.238 367778.317
Theory of Constraints
Another thing that caught the managements attention (apart from ABC results) was that despite the decrease in demands, Lehighs lead times had not decreased comparably. Excess material could be found on the shop floor despite the reduced process batches. The Theory of Constraints argued that in the short run the only costs that were variable were the operating costs and advocated that management should focus only on the constraint. To increase the throughput through the constraint was to increase throughput for the entire system. Time was
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the only resource that mattered in TOC but time was not typically a factor used in Lehighs decision-making. The key to profitability was to send only the most profitable products (higher gross margins) through the constraint. The results were again very different from what was expected. TOC Costing
TOC Cost Alloy : Condition round Conversion : Die steel : Chipper knife Die steel: Round bar High speed: Machine coil
($/lb)
Roller wire
Price Materials
2.31 0.54
0.77 0
1.02 0.12
0.93 0.21
2.33 1.58
1.77
0.77
0.9
0.72
0.75
0.21
0.15
0.33
0.1
0.1
Throughput/min
Cost Driver
Time orientation
Short Term Oriented The overhead costs are fixed and cannot be altered over given time duration Only matrial costs included, hence only economies/diseconomies of scale in procurement may be involved
Application
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. According to the ABC system,
Z ( pi ci ) X i s j qij X i
i i, j
(1)
(2)
Where pi= Price of the ith product ci = Cost of the ith product Xi = Quantity of product i sj = Cost of the jth activity qij = quantity of activity j used for product i Qj = Capacity of activity j
The product mix decisions are taken by maximizing Z in the above two equations for the ABC and TOC systems respectively under the constraints of resource capacity and demand. As an alternative to ABC and TOC systems, the following system can be used which integrates both the controllable and non controllable indirect costs. According to this system, Profit Z ( pi ci ) X i s j ( N j R j )
i i, j
(3)
Where Nj = Portion of labour and overhead costs that do not depend upon the management control Rj = Portion of labour and overhead costs that depends upon the management control In this case the Nj is taken as the period expense and Rj is taken as the product cost and hence in order to find the optimal product mix Z is to be maximised under the constraints of non controllable resources and the capacity of controllable resources. For ABC system Rj = Qj as the management has complete control over the labour and overhead resources and for TOC system Rj = 0 as the management has no control over the
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labour and overhead resources. But in general 0 < Rj < Qj , and thus in these cases the ABC system and the TOC system can only find sub optimal product mix. Taking the general equation (3) we can find the most optimum product mix.
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References
1) Cost Accounting: A Managerial Emphasis, Horngen, Datar, Foster, Rajan and Ittner, Thirteen Edition 2) A comparative analysis of utilizing activity-based costing and the theory of constraints for making product-mix decisions, Robert Kee, Charles Schmidt, Int. J. Production Economics 63 (2000) 1}17
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