The objective of this memo is to recommend you a product mix for Lehigh in the year of 1993 based on profit calculations and other business considerations.
Recommendation: 1993 product mix should include only High Speed Based on an approach resultant from the combination of ABC plus Theory of Constraints (TOC), I recommend that the company include only the High Speed (machine coil) in its mix. The table bellow contains the unitary cost for Standard and ABC and the throughput per unit of the constrained resource ($/min), calculated diving the unitary ABC cost ($/lb) by the machine time for the rolling process (lb/min):
The following paragraphs present a deeper analysis to allow comprehension of the logical steps that led to this recommendation.
Rationale: ABC and TOC combined approach
The major idea behind combining ABC and TOC approaches is to come up with a fourth method of calculating profits that overcomes the shortcomings of the other three methods (Standard, ABC and TOC). Based on the ABC model (see description of this model in the next section of this report: Alternatives Rejected), I calculated the unitary operating profit per product. This operating profit eliminates the major issue concerning the Standard Costing system: to average uneven resource consumption across products. The next step was to incorporate the concept of time as a factor used in Lehigh’s decision-making. First, by obtaining information from the operations staff, I defined the CRM as the constraint of the plant. Then, I calculated the throughput per unit of the constrained process (Rolling – CRM) by diving the unitary ABC cost ($/lb) by the machine time for the rolling process (lb/min).
Exhibit 1 presents the results for these calculations. According to this approach, alloys, roller wires and chipper knives present losses, while only high speeds and round bars showed profits: respectively $4.84 and $0.08 per minute of rolling machine (CRM) used. However, considering this small profit per minute for round bars and that Die Steel market is broad and requires that its participants offer a full product line to maintain share (this means that Chipper Knives should also be produced), I recommend that Die Steel products be removed from product mix. Consequently, high speeds are the only products that I recommend be kept in Lehigh’s product mix in 1993.
It is important to mention that with demand recovering in 1993 and Lehigh’s superior product performance, it may be possible that the company command a price premium for its alloys high enough to turn it profitable in this method and, consequently, to include it in its product mix. Alternatives rejected: Standard, ABC costing and TOC approach
Analyzing the scenario, Lehigh had 3 other possibilities for calculating its profit per product:
The product weight was considered the primary driver of resource consumption, so the indirect manufacturing and administrative costs were allocated to products based on pounds produced. As a result, this approach considers that each of the five products uses manufacturing and administrative overhead equally (their unitary costs are all $0.64 per pound). Moreover, direct manufacturing costs were allocated based on machine hours and materials and direct labor were allocated based on the bill of materials and routings. The calculations for this first alternative are presented in exhibit 2. According to this approach, all products but alloys present operating losses. However, standard costing is averaging the diverse resource use by products and that one it points as the most profitable (alloys) is already promoted by marketing and sales teams, but Lehigh is not showing profits during this period. Therefore, this alternative is not recommended.
In this second approach, I considered Utilities, Maintenance and Depreciation as direct manufacturing costs and allocated them based on machine hours. Number of skus was considered driver for Technical Support. The product weight was considered driver of resource consumption only for General & Administrative costs. Moreover, materials and direct labor were allocated based on the bill of materials and routings (exactly the way they were allocated in Standard Costing system). Finally, Material Handling & Setup, Order Processing and Production Planning were driven to products using number of orders. Consequently, ABC solves the major issue regarding the Standard Costing system: the assumption that all overhead costs can be included into one cost pool.
All the drivers are summarized in exhibit 3. Exhibits 4 and 5 present respectively the ABC drivers and allocation rates. The calculations for this alternative are presented in exhibit 6. According to this approach, alloys, roller wires and chipper knives present operating losses, while only high speeds and round bars showed operating profits: $0.15 and $0.01 per pound. However, ABC does not take into consideration how smoothly material flowed through the plant and product profitability should reflect this kind of difference in resource consumption. This is the reason why this alternative was not selected.
In this third approach, it was proposed a simple operational measure to orientate the decision-making process within the company: Throughput. It was calculated as sales less material cost (“contribution margin”) per unit of the constrained resource. As already mentioned, the rolling process (CRM) is the bottleneck of the plant. TOC approach considers that the efficient management of the constrained resource is the key factor to increase profitability. The calculations for this alternative are presented in exhibit 7.
According to this approach, high speeds and alloys were the products that showed higher “contribution margins”: $25.00 and $17.70 per minute of rolling machine (CRM) used. However, TOC approach only takes into consideration the material costs, leaving aside all the other relevant costs that could be allocated to each product according to ABC approach. In other words, TOC method does not reflect the real operating profits. Considering this point, this alternative was discarded.