Case Study: Managerial Accounting and Control II for Lehigh Steel, Group 4

Summary: Lehigh Steel is a company specialised in the production of specialty steels for high strength, high use applications.

In 1988 the company experienced record profits, but then in 1991, it reported record losses due to the decreasing demand as a result of recession.

After the crisis, the demand rose again, but Lehigh Steel could not transform its revenue into profits. Therefore the management at Lehigh decided to rationalize the product mix to address the issue. The company was initially using the standard costing following which they adopted the Activity Based Costing.

They believed that this would enable them to identify profitable products and hence select the right mix. Though ABC approach illustrated that the product profits were significantly different from that computed by standard costing approach the results were somewhat counterintuitive.

To address this problem the management decided to employ a new approach called Theory of Constraints which focussed on the constraint that affected the entire operation. The results of this method were different from those obtained from ABC method.

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The management was now faced with the task of assessing the pros and cons of the various methods and arrive at a method that will help them achieve the right product mix which will in turn boost their bottomline. It is recommended that the best possible option would be to employ a combination of the ABC and TOC methods.

Based on this method only high speed (machine coil) is profitable and therefore should be included in the mix. 1. 1 The Company: Lehigh Steel founded in 1913, enjoyed a niche position as a manufacturer of speciality steels for high strength, high use applications. Its products included high-speed, tool and die, structural, high temperature, corrosion resistant and bearing steels available in wide range of grades in a variety of shapes and finishes. Its market included various industries, aerospace, energy. Lehigh enjoyed a premium position because of its ability to produce high quality customized products.

Palmer a global manufacturer of bearing and alloy steels acquired Lehigh in 1975 primarily for the specialized equipment, Continuous Rolling Mill (CRM) Lehigh operated under a matrix organization structure. General Managers of different departments, Vice President of sales, Director of operation and planning and the CFO reported to the company President. Performance was measured by product contribution margin calculated using standard costs: revenue less materials, direct labour, direct manufacturing costs, such as utilities and maintenance; and other overhead was considered beyond their control.

The goal was to deliver quality product within specified lead time at the lowest cost. 1. 2 Industry Structure Conduct and Performance: Speciality steel comprised of 10% of the US steel industry and offered an excellent growth opportunity. Speciality steel varied in metallic composition and manufacturing process and were defined based on different attributes (grade, product, surface finish, size, structural and surface quality) most important of which was grade as it was a primary indicator of product performance.

The industry was capital intense due to ‘lumpy’ and expensive capacity addition, changing cost structure because of newer technologies and also the knowledge work performed by metallurgists and the other technical specialists which formed a significant portion of the cost structure. The focus strategy (You choose to make product which can make better than the completion) employed helped to protect volume and capital investments. Maintaining high quality at competitive costs was essential in the industry. Producers were small, fragmented price takers in a market dominated by sophisticated customers however niches provided some protection.

Cost was a significant competitive weapon in determining share and profits. Efficient short production runs were required in order to avoid inventory build up of customized products. Industry profitability fluctuated widely ranging from -16. 7% to 5. 0%. 1. 3 Market and Products: Customers were classified into 33 market segments ranging from original equipment manufacturers to forge shops, distributors to metal workers. Lehigh had 7 product lines – Alloy, Bearing, Conversion, Corrosion, Die Steel, High Speed and High Temp – of which three – Alloy, Die Steel and High Speed comprised 70% of sales. Die steel was steel strengthened for use in machine dies and molds. • High speed products served endurance applications, such as mental cutting and punching, and were narrower in focus. • Alloys were used in aerospace frames, landing gears, missile cases and fasteners. • Lehigh also carried niche products lines - Bearing, Corrosion and High temp – whose volume fluctuated with market conditions. Conversion process was also carried out which involved the processing the non Lehigh owned materials on the CRM. The company product hierarchy was in the following order: product lines, grades, shapes, SKUs. 1. 4 Production Operations:

Scrap steel was the primary raw material which was recycled. Production process involved 6 steps: 1. Melting: The scrap compound was melted in the Electric Arc Furnace, where high-powered (80 MW) electrical charges heated the solid metal. 2. Refining: The steel was further refined by Argon Oxygen Decarburization (AOD), in which oxygen or argon was bubbled through the molten metal to further burn off impurities. 3. Moulding: The molten steel was teemed from ladles into octagonal molds, forming ingots 4. Breakdown: Ingots were then broken down into semi-finished rectangular shapes such as billets and bars. . Rolling: The billets and bars are transformed into finished shapes like wire rods and coils. 6. Finishing: Finishing involved a variety of treatments. Most products were annealed a final time to improve formability and make the surface more durable, and rough turned or straightened. Fig. Basic Steel Making Process Other processes included pickling, polishing testing and inspection. Production and technical support activities also formed an important part of production. Maintenance, depreciation and utilities were basic costs amounting to 21% of the revenues. 1. 5 The Problem:

In 1991, recessions marked the lowering of the market price near to or lower than product cost and it was increasingly difficult for Lehigh for selling at premium prices. Cost of production remaining the same with decline in the price and volume lead to lowering of profits. This meant that Lehigh was flush with inventories and cost. In an initial attempt to reduce the inventory cost the management decided to use the pull based marketing concept which proved to be a failure as it was difficult to eliminate the steps in production and changeover. Later in 1992, the market recovered resulting in increased demand.

But even with the increase in demand the company was not able to realize the profits. To overcome this situation the management decided to identify the right product mix that would enable the company to lever profits. They now emphasised on the use of ABC method to find out the desired product mix and later on shifted to the TOC method as the former provided counterintuitive results. Now the management is in a fix to determine the best possible method that would enable them to select the right product mix. 1. 6 Strategic Analysis: The three methods employed by Lehigh to calculate its profit per product are analysed below: . 6. 1 Standard Costing: Product weight (pounds) was the primary driver for standard cost, which included materials, labour, direct manufacturing expense and overhead cost categories. 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 product lines uses manufacturing and administrative overhead equally (unitary costs = $0. 64 per pound). Standards for materials and direct labour were allocated based and included yield factors for scrap and rework.

Direct manufacturing costs were allocated to products based on machine hours. According to Standard Costing method, all products except alloys and roller wires generate operating losses. Roller wire recorded 0% profit. Standard costing is averaging the diverse resource use by products and that is the reason that ‘alloy’ comes out to be most profitable even though it is heavily promoted by marketing and sales teams. Despite the profits generated in ‘alloy’ product line, Lehigh is not able to generate profits (overall) during this period. Therefore, Standard costs method is not recommended.

Refer Exhibit 2 for calculation of standard costing calculations. 1. 6. 2 Activity Based Costing: Utilities, Maintenance and Depreciation are considered as direct manufacturing costs and are allocated based on machine minutes. For Technical Support number of skus was considered the cost driver. The product weight was considered as the driver for General and Administrative costs. The materials and direct labour have been allocated exactly the way they were allocated in Standard Costing system. Finally, Material Handling & Setup, Order Processing and Production Planning were based on number of orders as cost driver.

Consequently, ABC overcomes the major issue of the Standard Costing system i. e. the inclusion of all overhead costs in a single cost pool. According to this approach, alloys, roller wires and chipper knives and round bars present operating losses, while only high speeds showed operating profits of $0. 03 per pound. 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. Therefore, ABC method is not recommended. Refer Exhibit 3&4 for calculation of Activity Based Costing calculations. 1. . 3 Theory of Constraints: TOC proposed a simple operational measure to carry out the decision-making process - Throughput. Generally it is calculated as sales less direct variable cost and more commonly as sales less material cost which is comparable to contribution margin. According to this method profits can be increased by maximizing throughput per unit of the constrained resource. As already mentioned, the rolling process (CRM) is the bottleneck of the plant. This approach considers that the efficient management of the constrained resource is the most important factor to increase profitability.

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 (constrained resource) used. Theory of Constraints 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. Hence, this method is also not recommended. Refer Exhibit 5 for Theory of Constraints calculations. 1. 7 Recommendation

The ideal method would be a combination of the TOC and ABC methods as it has been clearly shown that all these methods suffer from certain drawbacks that can be eliminated by considering the two approaches (TOC & ABC) together. 1. 7. 1 Combined approach of TOC & ABC: This method of combining TOC & ABC overcomes the shortcomings of the other three methods mentioned above. Unitary operating profit per product is calculated based on the ABC model. This operating profit eliminates the major issue concerning the Standard Costing system as mentioned above. Incorporating time as a factor used in Lehigh’s decision-making is necessary.

Based on the information from the operations staff, CRM can be identified as the constraint of the plant. Therefore throughput per unit of the constrained process (Rolling - CRM) can be computed by dividing the unitary ABC cost ($/lb) by the machine time for the rolling process (lb/min). This process shows that only high speed (machine coil) is profitable and others are not. Therefore only this product must be included in the company’s product mix.