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 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

1.24 53.70% 593562

0.64 83.10% 1332188

0.39 38.20% 941187

0.38 40.90% 2545119

0.49 21% 1239970

0.64

0.64

0.64

0.64

0.64

0.6 26% 287207

0 0% 0

-0.25 -24.50% -603325

-0.26 -28% -1741397

-0.15 -6.40% -379583

-$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

21,39,865 975130 2036477 1711892

0.415860481 0.189506362 0.3957681 0.300804668 1.001134943

0.137075776

0.744599495

56,91,042 42,26,965 42,26,965 6

0.306719051 0.101248295 0.092277083 0.068825978 0.362760042 0.262351356

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

0.118077609 0.105683656 0.316445794

0.586521306

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

Total Profit = - $763666.7616

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 8

the only resource that mattered in TOC but time was not typically a factor used in Lehighs decisionmaking. 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

Throughput Contribution ($) Time taken in Bottleneck stage (mins)

1.77

0.77

0.9

0.72

0.75

0.21

0.15

0.33

0.1

0.1

Throughput/min

Different Assumptions between Standard Costing, ABC and TOC Costing The main assumptions that go in calculation of costs in case of standard costing, ABC and TOC costing are shown below Standard Costing ABC All indirect costs are related to the product through a causal relationship, so the cost drivers are different for different activities Long term Oriented Major Component of Cost is Overhead Cost TOC

Cost Driver

Weight is taken as primary cost driver

Time taken by a process is the main cost driver

Time orientation

Independent of Time Major Component of Cost is direct Variable Cost

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

Linearity of Variable Costs

Cost pool not homogeneous

Cost pools are homogeneous

Alternate Costing Strategy 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. 10

Time Horizon of using ABC and TOC The TOC bas should 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. In practice there will be situations where the management will not have either complete or zero control over these costs and hence the cost will be a function of that particular context. It is evident that time is not a factor which determines the use of ABC or TOC based costing for product mix decisions. The ABC gives a product mix based on the resources used in production. Thus management has the liberty to redeploy these resources or completely stop the use of these resources depending on its interpretation of ABC results. Unused or excess capacity lead to suboptimal product mix and consequently profitability is affected. Conversely, the TOC system leads to an optimal product mix based on the labour and overhead resources supplied to production. If unused resources can be redeployed to productive uses elsewhere within the firm or terminated, the product mix selected with the TOC may be suboptimal and hence will lead to reduced profitability. Thus, management's control over labour and manufacturing resources determines when the TOC and ABC lead to an optimal product mix. Management's control over labour and overhead normally depends upon the time horizon selected. For example, the shorter the time horizon, the less control management generally has over labour and overhead resources. On the other hand, the longer the time horizon selected, the more control management has, or has the ability to acquire, over labour and overhead. Thus managers have to understand the context of the situation in order to determine when the TOC and ABC will lead to optimal product-mix decisions rather than focusing on the time horizon alone.

The Effect of Managements Degree of Control over Resources2 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. But in real life this is not the case. 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 11

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,

i i, j

(1)

According to the TOC system,

ij

(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 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 12

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.

Applying ABC TOC mix method to Lehigh Steel The costing system mentioned above can be applied to the Lehigh Steel 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.

Recommendations on the Product Mix 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 Coil and 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. The amount of the products that should be produced is given in the table: Total Die Steel : Round Bar(lbs) High Speed : Machine Coil(lbs) Profits(RS) 54,05,248.70 72,41,510.20 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.

13

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

14

The researchers suggested the Asset Specificity is a better way instead of the long or short run comparison to decide whether theory of constraints (TOC) or activity-based costing(ABC) is a better product mix decision for a firm in a particular period of time. Summary of Introduction In TOC, materials is one of the few variable costs in a firm while in ABC, most resources are variable costs. Besides that , in TOC , firms are advised to work hard to improve the bottleneck resource to maximize the overall throughput. In ABC, it suggested that firms should ignore the existence of the bottleneck because the unused resources are charged as cost of excess capacity. The main purpose of TOC is to optimize production by manipulating the constraints thus obtaining higher throughput. The objective of ABC is to increase the accuracy of product costs. TOC reduces the inefficiency in constraining resources to enhance the throughput hence making it through-put driven. ABC transforms the cost of most resources to product costs ignoring whether it is a bottleneck or not. In shortterm, most costs are stable and less variable. Firms choose the more suitable TOC during shortterm run, making TOC the short-term technique. In long term, most costs has become unstable causing firms to choose ABC instead of TOC because most costs are variable under ABC. Thus, ABC is the longterm technique. Although the two techniques can be used parallel, but the firms face difficulties in making the choice for product mix decision. The researchers suggest that if a product mix has one or more asset specific products, a firm is more likely to choose ABC and the choice is relevant when bottleneck do not exist in a firm. The researchers has propose the integrated TOC-ABC choice based on the need of the firms to manage bottlenecks and