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 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 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.

Conduct and Performance

Maintaining high standards of product quality while keeping costs competitive were essential to
compete in the specialty steel industry. Quality differences between manufacturers meant that
products were not perfectly substitutable. Differentiation also benefitted buyers, who enjoyed a
range of choices within a product category, and could pay for the precise version of quality
required. Technical services also differentiated suppliers while benefiting buyers, and were
becoming increasingly important. Over time customer had become sophisticated about the value of
the product, and the price they would pay for it. Producers of speciality steel were small,
fragmented price takers in the market dominated by powerful, sophisticated customers. Market
share could be bought or sold by pricing slightly below or above the market price. Niches provided
some protection for the providers. Reputation for excellent quality and technical services also
earned producers some price premium. Manufacturers exited themselves quietly out of non-
profitable products, sourcing those critical to their product lines from other firms. Cost, therefore,
was a significant competitive weapon in determining share and profits. To manage utilization rates
and unit costs, producers sought volume and long production runs. When demand was strong,
producers would select high volume 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 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 CostAlloy :Conversion :Die steel :Die steel:High speed: ($/lb)Condition roundRoller
wireChipper knifeRound barMachine coil Price2.310.771.020.932.33

Materials0.5400.120.211.58
Direct labour0.290.070.280.180.14
Direct manufacturing expense0.240.060.230.160.12

Contribution margin ($)1.240.640.390.380.49
Contribution margin (%)53.70%83.10%38.20%40.90%21%
Total Contribution($)593562133218894118725451191239970

Manufacturing & Admn. Overhead0.640.640.640.640.64

Operating profit ($)0.60-0.25-0.26-0.15
Operating profit (%)26%0%-24.50%-28%-6.40%
Total Operating profit ($)2872070-603325-1741397-379583

Total Profit($)-$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

ActivityDriverDriver volumeAmount ($)RateCumulative Rate
Melting - DepMelt machine minutes51,45,63221,39,8650.415860481 Melting - MaintenanceMelt
machine minutes51,45,6329751300.1895063621.001134943 Melting - utilitiesMelt machine
minutes51,45,63220364770.3957681 Refining - DepRefine machine
minutes56,91,04217118920.300804668 Refining - MainRefine machine
minutes56,91,0427801040.1370757760.744599495 Refining - UtilitiesRefine machine
minutes56,91,04217455510.306719051 Molding - DepMold machine
minutes42,26,9654279730.101248295 Molding - MainMold machine
minutes42,26,9653900520.0922770830.262351356 Molding - UtilitiesMold machine
minutes42,26,9652909250.068825978 Rolling - DepRoll machine
minutes82,58,38229958110.362760042 Rolling - MainRoll machine
minutes82,58,3829751300.1180776090.586521306 Rolling - UtilitiesRoll machine
minutes82,58,3828727760.105683656 Finishing - DepFinish machine
minutes40,57,31112839190.316445794 Finishing - MainFinish machine
minutes40,57,3117801040.1922711870.72382891 Finishing - UtilitiesFinish machine
minutes40,57,3118727760.21511193 G & APounds5,02,99,42054009550.1073760890.107376089

Mat Handling & Setuporders57,147493606886.3749278286.37492782 Order
Processingorders57,147395370969.184891669.1848916 Production
Planningorders57,147333950058.4370133258.43701332 Technical
SupportSKUs6,6425766579868.199187868.199187


ABC Costing
ABC CostAlloy :Conversion:Die steel :Die steel:High speed: ($/lb)Condition roundRoller
wireChipper knifeRound barMachine coil Price($)2.3100.7701.0200.9302.330

Materials($)0.5400.0000.1200.2101.580
Direct labor($)0.2900.0700.2800.1800.140

Contribution Margin($)1.4800.7000.6200.5400.610

Manufacturing expense:
Melting0.2000.0000.0900.0900.090
Refining0.1560.0000.0740.0740.074
Molding0.0310.0000.0180.0210.018
Rolling0.0590.0880.1940.0530.018
Finishing0.0430.0140.0510.0580.036
G&A0.1070.1070.1070.1070.107
Mat handing, setup0.1730.1730.1150.0430.035
Order processing0.1380.1380.0920.0350.028
Production planning0.1170.1170.0780.0290.023
Tech support0.5640.1970.1500.0220.035

Total1.5890.8350.9700.5330.465

Operating Profit-0.109-0.135-0.3500.0070.145
Operating profit %-4.738-17.546-34.3390.7616.238
Total Operating profit-52386.495-281218.895-845267.10747427.417367778.317

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 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 CostAlloy :Conversion :Die steel :Die steel:High speed: ($/lb)Condition roundRoller
wireChipper knifeRound barMachine coil Price2.310.771.020.932.33
Materials0.5400.120.211.58

Throughput Contribution ($)1.770.770.90.720.75
Time taken in Bottleneck stage (mins)0.210.150.330.10.1
Throughput/min85378


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 CostingABCTOC
1Cost DriverWeight is taken as primary cost driverAll indirect costs are related to the product
through a causal relationship, so the cost drivers are different for different activitiesTime taken by a
process is the main cost driver 2Time orientationIndependent of TimeLong term OrientedShort
Term Oriented 3ApplicationMajor Component of Cost is direct Variable CostMajor Component of
Cost is Overhead CostThe overhead costs are fixed and cannot be altered over given time
duration 4Linearity of Variable CostsCost pool not homogeneousCost pools are homogeneousOnly
matrial costs included, hence only economies/diseconomies of scale in procurement may be
involved

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. 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 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,

(1) According to the TOC system,
(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 (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. 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: Die Steel : Round
Bar(lbs)High Speed : Machine Coil(lbs)Total Profits(RS) 54,05,248.7072,41,510.2010,87,855.72

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