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 Steel’s 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 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 Steel’s 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.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 ABCTOC Cost 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 Management’s 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,
- According to the TOC system,
- Where pi= Price of the ith product i = 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
- 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 quantity of production of each is obtained by solving an optimization problem where the constraints are the resource capacity constraints.