Professional Documents
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Managers of Primary Operations, Finishing Operations, called for specific attributes, many products \efre cus-
and Marketing and Technology; Vice President of Sales; tomized along one or more attributes for the customer.
Director of Operations Planning and MIS; and CFO. However, of all attributes, customers valued most the
Marketing managers assumed product line responsibili- grade, which determined primary product performance.
ties that crossed functional boundaries. They developed Producers typically focused on a selected portfolio
marketing strategies, determined product offerings, es- of product shapes within a single segment, carving
tablished minimum order quantities, selected orders and niches out of the broad industry. The focus strategy
set price, all with the goal of building volume at strong helped to protect volume and capital investments. The
prices. Their performance was measured by product industry was capital intense in several areas. First, ca-
contribution margin calculated using standard costs: pacity additions were 'lumpy' and expensive, with
revenue less materials, direct labor, and direct manufac- equipment scaled in 100,000 tons of annual production,
turing costs such as utilities and maintenance; other costing $10-$100 million, and requiring 18-24
overhead was considered beyond their control. Manu- monihs to install. Second, the cost structurc was signifi-
facturing staff executed the orders brought in by the cantly changed only by new technologies, such as
marketing managers, and were measured on variances Lehigh's Precision Forging Facility (PFF), which were
from standard cost for the output mix produced. Their expensive, risky, generational ventures. Finally, knowl-
goal was to deliver quality product within the specified edge work performed by metallurgists and other techni-
lead time at the lowest cost. cal specialists was a significant portion of the cost
structure. Hall summarized the 'focus' strategy: "You
Industry^Structure
-/r\- Specialty steel comprised choose to make product which you can make better than
roughly(107o\pf the total US steel industry, and like the competition."
other higlr.feefi, specialty industries, offered growth and Economics and 'focus' also divided producers into
profit opportunities to firms who targeted specific appli- manufacturers, who melted, refined, molded and rolled
cations and developed unique technical competencies. steel into basic shapes; and finisher/distributors, who
Specialty steel was characterized by variations in the broke semi-finished steel orders and shapes down to spe-
metallic composition and manufacturing processing cific products for metalworking shops and original
which enhanced the properties of basic carbon steel. equipment manufacturers (OEMs). Manufacturers and
For example, adding nickel and chromium to carbon distributors worked closely together, often as separate di-
steel created 'stainless' ste€I, which resisted corrosion. visions within a firm. The manufacturing process fo-
Tungsten and molybdenum combined to strengthen, cused largely on the materials science, in which metal-
harden and temper carbon steel for cutting applications. lurgists supervised the careful blending of alloy additives
Several industry segments evolved reflecting basic with carbon steel to create the precise properties required
metallic combinations, which required different equip- in a product application. Frormerly lnere warehousing,
ment and knowledge bases for manufacture. distribution had assumed the industry marketing role,
Steel products were defined by several attributes creating product lines across material segments and
which determined the product application and defined shapes, enabling a f,rm to serve a diverse metalworking
quality. Grade described the metallic (chemical) compo- market while maintaining focused manufacturing
sition of the steel, or the elements added to the basic processes. Both manufacturers and distributors provided
recipe of iron and carbon to create the desired proper- technical services for everything from material composi-
ties. Product described the shape of the product, includ- tion to design to installation ofthe finished product.
ing semi-finished shapes, such as blooms, billets and
bars; and finished shapes, such as wires and coils. Sur- Industry Conduct and Performance Maintaining
face finish described the smoothness and polish that high standards of product quality while keeping costs
could be applied to the material's surface to enhance competitive were essential to compete in the specialty
presentation. Size described the Iatitudinal and longitu- steel industry. Quality differences among manufactur-
dinal dimensions of the product. Structural4uality de- ers meant that products were not perfectly substi-
scribed the absence of breaks in the inner metallic struc- tutable. Considerable value differentiation across pro-
ture. Surface quality described the absence of cracks or ducers within product classes had actually been
seams on, the surface. Because specific applications confirmed and quantified by the International Trade
CHAMER 5 MEASURINC THE COST OF RESOURCE CAPACITY 267
Commission during trade case investigations. Intended ness to fill the plant, attracting many new customers in
toprotect suppliers, differentiation also benefited buy- l99l-2. Under standard costing this business looked
ers, who enjoyed a range of choices within a product potentially profitable Howeveq specialized products re-
category, and could pay for the precise level of quality quired specialized processing and were ordered in
required. Technical services also differentiated suppli- smaller quantities. The average order size declined from
ers while benefiting buyers, and were becoming in- 1600 pounds in 1988 to Iess than 1200 pounds in 1991.
creasingly important. Over time, customers had become Accordingly, trhigh's saies distribution broadened:
sophisticated about the value of rhe product, and the customer sales ranged from 95.9 million for 2.7 miliion
price theywould pay for it. pounds of steel, to $84 for 8 pounds, with the average
Not a commodity like carbon steel, which was sold customer buying 36,635 pounds of steel for $63,407.
primarily on a price and delivery basis, specialty steel Only 18 customers spent more than $1.0 million, and
was nonetheless highly price competitive. Producers only 130 spent more than $100,000; over 420 customers
were small, fragmented price takers in a market domi- spent less than $1,000.
nated by powerful, sophisticated customers. Market Lehigh had 7 product lines-Alloy, Bearing, Con-
share could be bought or sold by pricing slightly below version, Corrosion, Die Steel, High Speed and High
or above market price. Niches provided some protection Temp-of which three-Alloy, Die Steel and High
for producers. Reputation for exceptional quality and Speed-comprised 70Vo of sales. Die Steel was steel
technical services also earned producers some price hardened and strengthened for use in machine dies and
premiurn. However, when cost and price were notice- molds. The Die Steel market was broad, ranging from
ably out of alignment, manufacturers exited, pricing ingots to semi-finished and finished parts, and market
themselves quietly out of non-profitable products, participants felt the need to offer a full product line to
sourcing those critical to their product line from other maintain share. High Speed products served endurance
firms. Cost, therefore, was a significant competitive applications, such as metal cutting and punching, and
weapon in determining share and profits. were narrower in focus. Production of High Speed and ,!
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To manage utilization rates and unit costs, producers Die Steel products was relatively simpie, requiring little
sought volume and long production runs. When demand technical or process support. By contrast, Alloy prod-
was strong, producers could select high volume orders ucts were complex. Their applications in aerospace
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which allowed continuous operation at high-setup time frames, Ianding gears, missile cases and fasteners re- i!
workstations. In low demand, firms chased low-volume quired steel precisely graded by metallurgists within
niche business to fiIl plants, rationalizing the poor mar- tighter-than-standard ranges, super-cleaned by a double l
gins as volume that would contribute against fixed-cost melt, and precisely rolled to narrow tolerances. By
while adding little variable cosr. Unfortunarely, this virtue of its superior product performance, Lehigh was
business required short production runs if Lehigh were able to command a small price premium for its alloys.
to avoid inventory buildup of customized products. Lehigh also carried niche product lines-Bearing,
Steel performance trended with the economy. Indus- Corrosion and High Temp-whose volume fluctuated
try profitability fluctuated widely, ranging from -16.77o with market conditions. Bearing steels were designed
to 5.0Vo in the late 1980s. Industry capacity utilization for a broad range of aircraft bearings and similar highly
peaked in 1988 at 89.2Vo, plummeted to 74.lvo in 1991, stressed parts whose grade precision required a triple
and recovered partially to 82.2Vo in 1992. melt. Corrosion-resistant steels were designed 60 oper-
ate in challenging environments in markets such as oil
Markets andProducts Customers ranged from large and gas exploration and medical implants. High Tem-
forge shops to original equipmeilt manufacturers perature steels were designed to withstand sustained ex-
(OEMS), from distributors to tiriy,,/metalworkers, many posure to temperatures from 800F to 1300F, such as in
ofwhom added further value by iutting down the prod- jet engines. These product lines were highly complex,
uct or the order size. Lehigh classified its customers requiring significantly higher levels of support from
into 33 market segments whtise requirements for grade metallurgy, for making very clean steel, and process en-
specificity, technical supp6rt and shipping varied. See gineering, for testing and certification. For example, :ii
Exhibit I for a market summary. steel for artificiai limbs had to pass stringent require-
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During the recession, Lehigh pursued marginal busi- ments for purity, for which each part had to be certified. Ir-
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268 cHAprER 5 MEASURING rHE cosr oF REsouRcE cApAclry
Almost 80Vo of metallurgists' time was spent on the onal Molds, forming ingots. Once solidifigd, ingos
niche product lines. were stripped and left to soak in a storage Iu*..i to,
Conversion involved the processing of non-Lehigh maintain malleability and prevent damage. Molding :
owned material on equipment such as the PFF or the was a relatively laborious process, as each 2500-pound
CRM that was not economical for some producers to ingot had to be handled and moved manually. Some in.
own. The primary 'product' was the conversion of billet gots were then remelted to meet stringent purity re-
to roller wire for Palmer. Conversion was subtly com- quirements at either the Vacuum Arc Remelt Furnace or
plex, as the breadth of the end customer's product line the Electro Slag Remelt Furnace, which cleansed the
translated into multiple rolling specifications, and mul- steel in solid form. Ingots were then Broken down ifio
tiple setups. semi-finished (rectangular) shapes such as billets and
Lehigh's product hierarchy was structured as fol- bars. The Mesta press hot-worked bars over 12,, in dr-
lows: product lines were broken down into grades, ameter, a small percentage of overall output. Most ia-
which were subdivided into product shapes, and further gots were routed to the PFF. The pFF was $40 million
into skus, which reflected variations in size and finish. of relatively new technology in which an ingot was
In any one year, Lehigh produced over 100 grades of heated and forged by 4 hammers programmed to pro:
steel, 500 individual producrs, and over 7,000 individ- duce intermediate billets or bars. After being workd
ual stock-keeping units (skus). Over multiple years, ac- the solid steel underwent a thermal treat called anneal-
tual production could span over 10,000 skus. See Ex- ing, or slow cooling, to prevent shrinking and cracking
hibit 2 for a product line summary. caused by air cooling.
Rolling transformed intermediate billets and ban
Production Operations Specialty steel producers into finished shapes. A hot rolling mill had a soaking
used steel scrap as the primary raw material, and essen- furnace to heat the steel, followed by a series of sunds
tially recycled rather than manufactured steel. Produc- with progressively narrower rollers that pressed the hot
tion involved six steps, whose comptexity varied by steel into progressively thinner sizes until it achieved its
product. See Exhibit 3 for a sumrnary of the production final shape, such as a wire. A mill contained several seh
process. of stands to roll different shapes; however, only one
Hauled in with magnets and cranes, scrap purchased shape could be rolled at a time. Unique product shapes
for $114.20 per ton was pre-processed, or combined were rolled manually on the Hand Mill. 95Vo of inter-,
with iron-based compounds to achieve the low compos- mediates were rolled on the CRM into one of 4 prod- ;
ite residual (contaminant) levels required by Lehigh's ucts: rods, flats, coils and bars. Shape changeovers were
high-grade products. The scrap compound was Melted time-consuming events which dictated continuous 3
in the Electric Arc Furnace, where high-powered (80 shift production, as well as a set production schedule
megawatts) electrical charges heated the solid metal by witir dedicated windows rotating within a 4 week cycle. j
zapping it with arcs of electricity emanating from car- One out of four weeks was dedicated to the conversion
bon electrodes. Synthesized fluxes containing limes re- of billet to coil for Palmer. At $50 million, the CRM
fined the hot metal by binding with phosphorus and represented a capital investment that could not be dupli-
other impure elements, which were skimmed off. cated in less than five years. Labeling it the plant bonle,;
The steel was further Refined by Argon Oxygen De- neck, Hall described the CRM as "the one manufachu- ,
carbeurization (AOD), in which oxygen or argoil was ing process that has the most impact on Lehigh . . . in
bubbled through the molten metal to further burn off terms of the resources used and the schedule it drove."
impurities. AIIoys were then added to achieve the spe- The final step was Finishing, which included a vari-
cial properties. The Melting and Refining Drocesses ety of treatments. Most products were annealed a 6nal
constituted chemical reactions between various .ele- time to improve formability and make the surface more
ments which created the desired material. As tempera- durable, and rough turned, or straightened. Other tre{.
ture was an essential factor in generating the appropri- ments included pickling (dipping in acid to clean off
ate chemical reaction, the hot metal processes were scaling) and polishing (grinding ro produce a shin),,,
carefully monitored and controlled by metallurgists to buffed finish). Pieces were tested or inspected if cus- .
achieve the precise grade. tomer requested special tolerances in _srade or shap.
The molten steel was teemed from ladles into octag- Finished product was shipped directly to customers. l
CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY 269
upport activities were also critical to production. emphasize to convert sales into profits. Following its
ltenance, depreciation and utilities were basic costs market strategy, Lehigh targeted a high value product
ired to run the plant, and comprised 2l7o of rev- mix that would lever profits in strong demand, and
;s. Production support activities such as materia! cushion it in downturns with greater contributions to
tling/setup, production planning and order process- fixed costs per unit volume. CFO Jack Clark suggested
:bbed and flowed with order volume. Technical sup- a firm-wide product profitability analysis, which would
enable market managers to rationalize unprofltable
-metallurgy and engineering-was considered
ifeblood of Lehigh's reputation. Around the indus- products and focus resources on high value ones.
t was rumored that Lehigh had more metallurgists Clark reviewed the products' standard costs, which
on of steel than anyone in the world. General & ad- were used for both inventory valuation and decision-
strative included company-wide activities such as making. Product weight (pounds) was the primary unit
ngement, finance and research and development of measure for standard cost, which included materials,
D). R&D combined raw research in materials sci- labor, direct manufacturing expense and overhead cost
with applied research in production technologies. categories. Standards for materials and direct labor
were based on the bill of materials and routings, and in-
cluded yield factors for scrap and rework. Scrap pre-
Case for Change processing was handled as a material burden rather than
rstry wisdom stated that steel profits were a simple a routing step. Direct manufacturing costs such as
tion of prices, costs and volume. Howeveq 1991 maintenance and utilities were allocated to products
ented challenges in all three fundamental profit dri- based on machine hours. Indirect manufacturing and
. Market prices declined sharply to near or below administrative costs were allocated to products based on
luct cost, lower in real terms than 1982 levels. Vol- pounds produced, since weight was assumed to be the
was available at market price, though in the form of primary driver of resource consumption.
e specialties and small orders, but virtually disap- The results were not news: the most profltable prod-
.ed
at premium prices. Costs failed to decline with ucts-alloys-were already heavily promoted by mar-
: or volume: shrinking operating rates drove up unit keting and sales. If these products were truly profitable,
s, and broader customer bases and product lines where were profits?
i complexity and increased labor resources, particu-
, in scheduling. Profit could not be generated simply The Case for ABC ln 1992,Clark attended a serninar
vorking the tradition levers of price, cost or volume. on Activity-Based Costing. He realized that Lehigh was
)articulady pressing were the simultaneous decline a perfect application for ABC as a discrete manufac-
he average order size and shortening of lead times, turer of thousands of skus that shared the same produc-
ch had left volume-driven Lehigh flush with inven- tion processes, serving a diverse customer base with a
es and cost. In an effort to meet these demands and wide range of support needs. They knew that individual
rinate inventory 'waste', Mark Edwards, Director of customers and products made different demands for re-
:rations Planning and MIS, drove the 1991 move to sources, and that their standard cost syslem was likely
ckonous flow manufacturing. Edwards believed that averaging the diverse resource use by products and cus-
'ota's lean, pull-based manufacturing concepts were tomers. Resources were heavy on his mind: support re-
to reducing inventory cost, and pushed for their sourcos had increased through the recession. The num-
ption at Lehigh. The new approach appealed to the ber of production planners alone had increased by 257o
:keting managers, who could broaden their customer to handle the increased scheduling complexity of the
e by offering smaller orders. However, under the extra business.
rent technology, it proved difficult to eliminate the Believing that ABC presented an opportunity to ui1-
ls in setups and changeovers critical to efficient derstand the drivers of profitability, Clark hired Bob
throughput, and production staff observed a
,rl[ order Hall from Armco Steel. A steel industry accountant,
matic decline in efficiency. with undergraduate and MBA degrees in Accounting &
In late 1992, Irhigh was reprieved somewhat by a Finance, Hall had spent a year developing an activity-
w but steady market recovery. Facing an increase in based product costing application at Armco. As Man-
nand, Irhigh now had to choose which products to fo. Operations Accounting, Hall was assigned to
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270 CHAPTER 5 MEAsuRlNc rHE cosr oF RESoURCE cAPAclrY
time in a process. Edwards focused on a phrase he had he irnagined the 'faster' products flowing smoothly
underlined several times that conrradicted every thing he through the plant, out the door to a customer. Other
had ever been taught about cost accounting: products seemed to crawl through the plant, requiring
slower machine speeds, and routing promptly to inven-
Throughput is not measured in terms of units produced,
tory. He began to visualize the slowpokes at the bottle-
but in gross profit realized from units produced that are
sold. Emphasis is placed on getting products through the neck, tying up that critical resource, constraining
manufacturing process and sold in the least time possible. throughput and profits. Time was the only resource that
mattered in TOC, but time was not typically a factor
Edwards often walked through the plant as he rumi used in Lehigh's decision-making.
nated. The ABC figures were not the only seemingly The key to profitability was to send only the most
contradictory results at that time. Despite a decrease in profitable products through the constraint. Operations
demand during the recession, Lehigh's lead times had staff would unequivocally identify the CRM as the con-
not decreased comparably. Excess material could easily straint in the plant. Edwards abandoned his production
be found on the shop floor despite the reduced process batch and returned to his desk to calculate Throughput
batches, which were supposed to facilitate the rapid. for Lehigh's products. The resul8 were almost as shock-
flow of material through the plant, and the reduction of ing as the ABC results, though for different reasons.
inventories. Had the reality of Lehigh's synchronous
manufacturing fallen short of the vision? Or was the tra- Accounting for Change Edwards called Clark before rl:
ditional accountirrg system contradicting the concepts the next Quarterly Financial Review, eager to share his
of synchronous flow, impeding its full implementation l',
results. Concerned by the contradictions between the
and the realization of results? He decided to investigate three accounting theories-standard costing, ABC and
one batch of steel as it traveled through the plant. He TOC-Clark asked Hall and Edwards to present their il'.
paused with his batch at rolling, where it would wait theories in the meeting. The managers would agree on
several days for its scheduled run, and reviewed what one and use it to target products. To simplify the ac-
he had seen. counting for the other managers, Hall and Edwards
He observed that some WIP piles were larger than agreed to model five products that were representative
others, and his batch had waited ionger at some work- of the major product lines. Exhibit 4 contains product
stations than at others. He corrsidered the possibility of data for the sample products. Exhibit 5 contains their
a constraint in the process. TOC advocated that man- standard costs used in the initial analysis. Exhibit 6 con-
agement attention be focused exclusively on the con- tains activity cost pools prior to Stage 2 cost allocation.
straint, which acted as the drum that set the pace for the The managers were equally confused by the differ-
entire operation. The capacity of the constraint deter- ent results. Surely calculating profits was a straightfor-
mined the capacity of the entire system. To increase ward exercise. They preferred to focus on the decision
throughput through the constraint was to increase at hand: which products to rationalize. Following
throughput for the entire system. Altematively, to ig- either set of recommendations would likely have sig-
nore the constraint was to lose control of the process. nificant impact on Lehigh's product portfolio, not to
He also noted that products had moved at vastly differ- mention profits.
ent rates across workstations. Thinking of throughput,
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272 CHAPIER 5 MEASURING THE cosT oF REsoURcE CAPACITY
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274 cHAprER 5 MEAsuRtNc rHE cosr oF REsouRcE cApAcrry
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MachineTime (min / lb; creu, = 1)
Melting (Elec{ricArc Fumace) 0.20 0.00 0.09 0.09 0.09
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,l:i :i Refining (VOD) 0:1 0.00 0.10 0.10 0.10
t,ll Molding / Breakdown (lngot / PFF) o.12 0.00 0.07
l'l'r 0.08 0.07
Rolling (CRM) 0.10 0.15 o.33 0.09 0.03
Finishing (multiple) 0.06 0.02 0.07 0.08 0.05
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Total time 0.69 0.17 0.66 o.44 0-34
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CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY 275
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276 cHAprER , MEASURTNG rHE cosr oF RESoURCE cApActry
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Production Planning orders 57,147 $3,339,500
Technical Support skus 6,ilz $5,766,579
Total $41.675.296