Lehigh Steel: The Case for Activity Based Costing and The Theory of Constraints
Lehigh Steel is a steel and alloy production company with a huge range of products. It was able to reach a record profit in 1988, but went down to a record loss by 1991. Lehigh is owned by a parent company, The Palmer Company who’s a global manufacturer of alloy and steel and were interested in Lehigh’s specialised equipment to allow them to gain a competitive advantage.
Palmer had acquired Lehigh in 1975 not for synergies with its own speciality steels businesses, but for the Continuous Rolling Mill (CRM). CRM is specialized equipment that can convert steel intermediate shapes to wire for Palmer’s Bearing rollers. There are only 6 mills in the US.
The specialty steel industry composes 10% of the US steel industry. The quality of steel products is determined by the product application and the grade of the steel. Since the steel market is in a very competitive sector, firms must maintain a high standard of quality and keep its costs to its minimum. For non-profitable products to exit the market, the manufacturers can do this silently by raising their price above the competitive price so there’ll be no customers remaining and allow the manufacturer to stop making these products.
Lehigh Steel has a huge range of products but 3 of these products comprise 70% of Lehigh’s total sales, these three products are: Alloy, Die Steel and High Speed. In order to analyses each of these products, we will need to do some costs analysis to find out whether these products are profitable or whether these products are the causes for the loss in Lehigh Steel. To do this, we will focus mainly on ABC and TOC analysis to analyse the cost and therefore different profits due to the different methods of cost allocation, for each product using the two different methods, then compare the results arising from the two analyses, and finally draw a conclusion.
The main aim of this report is to identify the true resource consumption of resources from each product using the two main techniques of costing ABC and TOC, in an attempt to highlight the best product value mix for Lehigh to help the company to maintain market share in the steel industry.
ABC was first introduced by Cooper and Kaplan in late 1980s. Its purpose is to identify cost pools or activity centres and allocate the costs to the products based on the amount of resources used to create a certain product. It implicitly assumes that all overheads allocated are variable some time in the future. It is a good tool for planning and control as it identifies each products cost, based on the activity used to make the product. The costs allocated to each product is a realistic figure as it allocates the costs according to the amount of time spent or the amount of resources used in each of the activities, but to acquire these data, it requires a lot of research and monitoring to give a reasonable estimate of the time or resources spent.
Traditional systems often allocate service costs to production centres. ABC however tends to establish separate cost driver rates for support centres and assigns the cost of support activities directly to the cost objects without any allocation to production centres. With the more accurate results for each product, companies can make lots of decisions, for instance, dropping unprofitable products, raising prices for low-volume orders. Also information from ABC can encourage companies to redesign products and process technologies to be more efficient and cost less. This was why Bob Hall was called upon at Lehigh – to introduce the case for ABC and thus help Lehigh to highlight the best value product mix.
In an ABC analysis, we will firstly need to identify the different activities that are required to make each product rather than costs incurred in different departments. In Lehigh, the different activities identified are:...
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