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SUBMITTED BY: SECTION E (GROUP 3) Alok Nigam (PGPGP2011530) Bhangle Ninad Rajesh (PGP2011588) K Pallavi Jha (PGP 2011672) K. Harish Kumar (PGP2011674) Navpreet Singh (PGP2011744) Rohit Arya (PGP2011829) Sumit Prakash (PGP2011907)
Executive Summary
Lehigh Steel is a manufacturer of speciality steels for high strength, high use applications. Its financial performance has generally trended with 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 high-tech, 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 semifinished 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 semifinished 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.
orders which allowed continuous operations at high setup time workstations. In low demand times, firms chase low volume niche businesses to fill plants, rationalizing the poor margins as volume that would contribute against fixed-cost while adding little variable cost. Steel performance trended with the economy. Industry profitability fluctuated widely, ranging from -16.7% to 5% in the late 1980s. Industry capacity utilization peaked in 1988 at 89.2%, plummeted to 74.1% in 1991, and recovered partially to 82.2% in 1992.
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 had been traditionally doing standard costing and had been recording profits when in 1991, it suddenly reported losses. In this costing technique, steel profits were a function of prices, costs and volume. Product weight (pounds) was the primary unit of measure for 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 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.
Standard Costing
Price Materials Direct labour Direct manufacturing expense Contribution margin ($) Contribution margin (%) Total Contribution($) Manufacturing & Admn. Overhead Operating profit ($) Operating profit (%) Total Operating profit ($) Total Profit($)
0.64
0.64
0.64
0.64
0.64
0 0% 0
-$2,437,098
Activity-Based Costing
In 1992, when Lehigh realized that standard costing had failed to help the company find the correct product mix, they decided to shift to activity-based costing. Lehigh was a perfect application for ABC as a manufacturer of thousands of SKUs that shared the same production processes.
ABC followed a 2-stage methodology of identifying activates and their cost-drivers and then, allocating activities to products and customers using cost drivers appropriate for that activity. The results were unexpected: Company profitability was highly correlated with high volumes of High Speed and Die Steel sales which was a departure from their earlier stance of making more Alloys. However, some results remained counter-intuitive. For example, high temps showed a similar ABC profitability to high speeds, even though high speeds could be processed across the CRM at a rate 6 times faster.
Lehigh Activity Cost Pools
Activity Melting Dep Melting Maintenance Melting - utilities Refining Dep Refining Main Refining - Utilities Molding Dep Molding Main Molding - Utilities Rolling Dep Rolling Main Rolling - Utilities Finishing Dep Finishing - Main Finishing - Utilities G&A Mat Handling & Setup Order Processing Production Planning Technical Support Driver Melt machine minutes Melt machine minutes Melt machine minutes Refine machine minutes Refine machine minutes Refine machine minutes Mold machine minutes Mold machine minutes Mold machine minutes Roll machine minutes Roll machine minutes Roll machine minutes Finish machine minutes Finish machine minutes Finish machine minutes Pounds Orders Orders Orders SKUs Driver volume Amount ($) Rate Cumulative Rate
51,45,632 51,45,632 51,45,632 56,91,042 56,91,042 56,91,042 42,26,965 42,26,965 42,26,965 82,58,382 82,58,382 82,58,382 40,57,311 40,57,311 40,57,311 5,02,99,420 57,147 57,147 57,147 6,642
21,39,865 975130 2036477 1711892 780104 1745551 427973 390052 290925 2995811 975130 872776 1283919 780104 872776 5400955 4936068 3953709 3339500 5766579
0.415860481 0.189506362 0.3957681 0.300804668 0.137075776 0.306719051 0.101248295 0.092277083 0.068825978 0.362760042 0.118077609 0.105683656 0.316445794 0.192271187 0.21511193 0.107376089 86.37492782 69.1848916 58.43701332 868.199187 0.72382891 0.586521306 0.262351356 0.744599495 1.001134943
ABC Costing
ABC Cost Alloy : Conversion: Die steel : Die steel: High speed:
($/lb)
Roller wire
Round bar
Machine coil
Price($) Materials($) Direct labor($) Contribution Margin($) Manufacturing expense: Melting Refining Molding Rolling Finishing G&A Mat handing,setup Order processing Prodn planning Tech support Total Operating Profit Operating profit % Total Operating profit
0.200226989 0.156365894 0.031482163 0.058652131 0.043429735 0.107376089 0.172685257 0.13831804 0.116830322 0.564073099 1.589439718 0.109439718 4.737650134 52386.49481
0 0 0 0.087978196 0.014476578 0.107376089 0.172746287 0.138366925 0.116871612 0.197285483 0.83510117 -0.13510117 -17.54560649 -281218.8946
0.090102145 0.07445995 0.018364595 0.193552031 0.050668024 0.107376089 0.115176162 0.092254205 0.077922507 0.150378076 0.970253784 0.350253784 34.33860628 845267.1068
0.090102145 0.07445995 0.020988108 0.052786918 0.057906313 0.107376089 0.043189514 0.034594088 0.029219894 0.022295812 0.532918831 0.007081169 0.761416011 47427.41748
0.090102145 0.07445995 0.018364595 0.017595639 0.036191446 0.107376089 0.034542435 0.02766792 0.023369706 0.034994862 0.464664786 0.145335214 6.237562842 367778.317
Total Profit
- $763666.7616
Theory of Constraints
Apart from ABC figures, what was more intriguing was the fact that despite a decrease in demand, Lehighs lead times had not decreased comparably. Excess material could be found on the shop floor despite the reduced process batches. TOC advocated that management should focus only on the constraint. To increase the throughput through the constraint was to increase throughput for the entire system. Time was the only resource that mattered in TOC but time was not typically a factor used in Lehighs decision-making. The key to profitability was to send only the most profitable products through the constraint. The results were again very different from what was expected.
TOC Costing
Conversion : Die steel : Roller wire Chipper knife 0.77 0 0.77 0.15 1.02 0.12 0.9 0.33
Price Materials Throughput Contribution ($) Time taken in Bottleneck stage (mins) Throughput/min
Cost Driver
2 3
Independent of Time Major Component of Cost is direct Variable Cost Cost pool not homogeneous
Short Term Oriented The overhead costs are fixed and cannot be altered over given time duration Only material costs included, hence only economies/diseconomies of scale in procurement may be involved
could be redeployed to productive uses elsewhere within the firm or terminated, the product mix selected with the TOC may be suboptimal and its profitability understated. Consequently, management's discretionary power over labour and overhead determines when the TOC and ABC lead to an optimal product mix. Management's control over labour and overhead is generally a function of the time horizon selected. For example, the shorter the time horizon, the less control management generally has over labour and overhead resources. Conversely, the longer the time horizon selected, the more control management has, or has the ability to acquire, over labour and overhead. Consequently, managers should focus on the discretionary power they have, or can acquire, over labour and overhead resources over a given time horizon to determine when the TOC and ABC will lead to optimal product-mix decisions rather than focusing on time alone.
Z ( pi ci ) X i s j qij X i
i i, j
(1)
Z ( pi ci ) X i s j Q j
i j
(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. Now as an alternative to ABC and TOC systems we propose a system which attempts to integrate the advantages of both the systems. 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 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.
In order to do that we need to find out the bottleneck process for each product and find the unused capacity of the non bottleneck resources. Now we need to find out whether we need to incur the cost of unused resources or can it be avoided by bringing the corresponding resource under the management control. Based on the above we can find out the total operating cost for each product line and also the contribution for each product line can be obtained by deducting the direct cost components from the selling price of the corresponding product. Then based on the demand conditions the most optimal product mix can be obtained. This helps us in identifying the most constrained resource and helps us to increase operational efficiency by removing the constraints of the resource.
1.77
0.77
0.9
0.72
0.75
0.15 Rolling 5
0.33 Refining 3
0.1 Refining 7
0.1 8
Maximum Profits Melting Minutes Available Refining Minutes Available Molding Minutes Available Rolling Minutes Available Finishing Minutes Available
(16,52,914.14)
(19,47,831.30)
89,553.84
18,38,019.41
Product Mix Strategy From the table above, only 2 products - Die Steel: Round Bar and High Speed: Machine Coil are the only 2 profitable products and hence, need to decide how much of each to manufacture.
Die steel: High speed: Round bar Machine coil 0.007 0.145 54,05,248.70 72,41,510.20 10,87,855.72
The amount of the products that should be produced is given in the table: Die Steel : Round Bar(lbs) 54,05,248.70 High Speed : Machine Coil(lbs) 72,41,510.20 Total Profits(RS) 10,87,855.72
Thus based on the data given in the case the above product mix is the most optimal one as obtained by integrating ABC system and TOC system.
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