2011

Lehigh Steel Case Study- CA

Assignment

Submitted by
Group 6, Section D

Name

Roll No

Abhishek Suryawanshi
2011PGP913
Aditya Kiran Nori
2011PGP514
Pankaj Gupta
2011FPM09
Abhishek R Pai
2011PGP508
Snehal
Jogdand
2011PGP667of bearings and alloy
The Palmer Company, Lehighs
parent,
is a global manufacturer
Someswar Basak
2011PGP891
steels with 1992 revenues ofShriraman
$1.6 billion.
that long-term specialization
S Palmer believed
2011PGP879

Company Overview

developed knowledge and innovation, the true source of competitive advantage. Palmers
2011PGP913

corporate objective was to increase penetration in markets. Palmer had acquired Lehigh
2011PGP514

in 1975 for Continuous Rolling Mill (CRM), specialized equipment that could convert
2011FPM09

steel intermediate shapes to wire for Palmers bearing rollers. As a manufacturer of

speciality steels for high strength and high2011PGP508
use applications it enjoyed a niche position. It
2011PGP667
enjoyed a premium market position because
of its ability to produce superior quality

products by integrating clean materials which

were customized for specific applications.
2011PGP891
It also operated a small distribution division
which offered a broad product line from
2011PGP879
08/08/2011

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multiple manufacturers to cater to different market segments. Only 6 such mills existed in
the US.
The years 1988 and 1989 had been great ones for the company when it had posted record
profits during a period of general industry growth as reflected in shipments, operating
rates and prices. But, broad recessionary business conditions drove a severe industry
decline in 1991, reducing shipments, operating rates and prices. Lehigh posted record
losses in 1991.

Products
Tool and die, structural, high temperature, corrosion resistant and bearing steels in a
variety of shapes and grades. Markets for these products included aerospace, tooling,
medical, energy and other performance industries.Lehigh operated under matrix
organisation. Marketing managers assumed product line responsibilities that crossed
functional boundaries. They developed marketing strategies, determined product
offerings, established minimum order quantities, selected order and set price all with the
goal of building volume at strong prices. Their performance was measured by product
contribution margin calculated using standard costs. Manufacturing staff executed the
orders brought by marketing managers and were measured on variances from standard
cost for the output produced. Their goal was to provide quality product within specified
lead time at lowest cost.
Steel products were defined by several attributes like
Products

Attribute description

Grade

Metallic composition of the steel

Product

Shape of the product- semi finished and finished shapes

Surface Finish

Smoothness and polish

Size

Latitudinal and longitudinal dimensions

Structural Quality

Absence of breaks in inner structure

Surface Quality

Absence of breaks on the surface

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Industry Conduct and Performance:

Maintaining high standards of product quality while keeping costs competitive was
essential to compete in the steel industry. Not a commodity like carbon steel, which was
sold primarily on a price and delivery basis, specialty steel, was nonetheless highly price
competitive. Market share could be bought or sold by pricing slightly below or above
market price. Cost, was the most 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 could select high volume orders
which allowed continuous operation at high-setup time workstations. In low demand,
firms chased low- volume niche business to fill plants, rationalizing the poor margins as
volume would contribute the fixed-cost while adding little variable cost. Steel
performance trended with the economy. Industry profitability fluctuated widely, ranging
from -16.7% to 5.0% in the late 1980s. Industry capacity peaked in 1988 at 89.2%,
plummeted to 74.1% in 1991, and recovered partially to 82.2% in 1992.

Markets and Products

The customers of Lehigh Steel ranged from large forge shops to OEMs, from distributors
to tiny metalworkers and also depending on the product size. So in order to cater to this
diversified customer base, Lehigh classified them in 33 market segments whose
requirements for grade specificity, technical support and shipping varied.

Recession Period
In 1991- 92, economy went into recession. This affected the profit margins of Lehigh
Steel as well.

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-

The average order size declined from 1600 pounds in 1988 to less than 1200

pounds in 1991.
Lehighs sales distribution broadened
Customer sales ranged from $5.9 million for 2.7 million pounds of steel, to
$84 for 8 pounds with an average customer buying 36,635 pounds of steel for

$ 63,407.
18 customers spent more than $ 1.0 million, 130 spent more than $ 100,000
and over 420 customers spent more than $ 1,000.

Lehigh had 7 product lines-

Alloy

Bearing

Conversio
n

Corrosion

Die steel

High
Speed

High
Temperat
ure
Alloy, Die steel and High Speed comprised 70% of the sales.

Production Operations:

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Melt

Refine

Mold &
Breakdo
wn

Roll

Finish

Lehighs Production Process Flow

Melting:

Scrap purchased for $114.20 per ton was melted in Electric Arc

Furnace.
Refined:

Steel was further refined by Argon Oxygen Decarbeurization

(AOD), in which oxygen or argon was bubbled through molten
metal to further burn off impurities.

Mold & Breakdown: Molten steel was teemed from ladles into octagonal Molds,
forming ingots which were Broken down into semi-finished shapes
such as billets and bars.
Roll:

The intermediate billets and bars were transformed by rolling into

finished shapes.

Finishing:

The products were annealed a final time to improve formability

and make surface more durable, and rough turned, or straightened.

Support activities were also critical to production. Maintenance, depreciation and utilities
were basic costs required to run the plant, and comprised 21% of the revenues.

The Case for Change:

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Industry wisdom stated that steel profits were a simple function of prices, costs and
volume. However, 1991 presented challenges in all three fundamental profit drivers.
Market prices declined sharply to near or below product cost while the costs failed to
decline with price or volume.
Mark Edwards, Director of Operations Planning and MIS believed that pull based
manufacturing concepts would lead to reduced inventory costs. However, under the
current technology, it proved difficult to eliminate the steps in setups and changeovers
critical to efficient small order throughput. As a result, Lehigh targeted a high value
product mix that would lever profits in strong demand, and cushion it in low demands
with greater contributions to fixed cost per unit volume. Product weight was the primary
unit of measure for standard cost which included materials, labour, direct manufacturing
expense and overhead cost categories

Activity based costing (ABC)

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Brief overview of ABC
Activity-based costing (ABC) is a special costing model that identifies activities in an
organization and assigns the cost of each activity with resources to all products and
services according to the actual consumption by each. This model assigns more indirect
costs (overhead) into direct costs compared to conventional costing models.
With ABC, an organization can soundly estimate the cost elements of entire products and
services. It can help the organisation in two ways
1. To identify and eliminate those products and services that are unprofitable and
lower the prices of those that are overpriced (product and service portfolio aim).
2. To identify and eliminate production or service processes that is ineffective and
allocates processing concepts that lead to the very same product at a better yield
(process re-engineering aim).

Introduction of ABC in Lehigh steel

In 1992, after attending a seminar on ABC Clark decided to adopt ABC in the company
as he believed that as discrete manufacturer of thousands of SKUs that shared the same
production process Lehigh was the perfect application of ABC.
The standard costing was averaging the diverse resources used by different products
leading to under costing and over costing of products.
In view of implementing ABC Bob Hall was hired as an ABC expert. The goal was to
arrive at a clearer sense of product and customer profitability. This would have helped
them to choose the right product mix and do away with non-profitable products.
After the initial regression study Hall found that profitability of the company was highly
co-related with the high volumes of high speed and die steel sales. Whereas under
standard costing the marketing managers thought that alloys were the profitable product.
This finding can be explained- under standard costing the uneven resources used were
perhaps averaged out. But when ABC was implemented it made proper allocation of
resources and actual profitability came out.
According to ABC different activity costs and cost drivers are listed in exhibit 6 along
with relevant values.
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Taking these into account we can restructure the manufacturing and administrative
overhead costs in exhibit 5 into different cost pools as mentioned in exhibit 6. We also
take help of the exhibit 4 to ascertain the per pound requirement of resources for each
kind of product.

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Calculations are shown as below.

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Although the Hall was pleased with the results of the ABC but reaction from the
company was mixed for the following reasons1. Although the ABC was correcting the distortions created by the standard costing
model yet managers were not ready for the shift.
2. He further tried to refine the allocation of resources but it did not yield substantial
changes.
The production department was, however, pleased with the results as they felt that the
model confirmed some of the intuitions they had about profitable and unprofitable
products.
Although results were definitely better than the standard costing yet some results were
counter-intuitive.
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For example, high temperatures showed a similar ABC profitability as high speeds even
though high speed could be processed at least 6 times faster than the high temperatures.
This was really uncanny as product profitability should reflect such vast differences in
resource consumption.

Theory of constraints (TOC) Brief overview of TOC

The theory of constraints (TOC) adopts the common idiom "A chain is no stronger than
its weakest link" as a new management paradigm. This means that processes,
organizations, etc., arevulnerable because the weakest person or part can always damage
or break them or at least adversely affect the outcome.
The analytic approach with TOC comes from the contention that any manageable system
is limited in achieving more of its goals by a very small number of constraints, and that
there is always at least one constraint. Hence the TOC process seeks to identify the
constraint and restructure the rest of the organization around it, through the use of five
focusing steps.
1. Identify the constraint (the resource or policy that prevents the organization from
obtaining more of the goal)
2. Decide how to exploit the constraint (get the most capacity out of the constrained
process)
3. Subordinate all other processes to above decision (align the whole system or
organization to support the decision made above)
4. Elevate the constraint (make other major changes needed to break the constraint)
5. If, as a result of these steps, the constraint has moved, return to Step 1. Don't let inertia
become the constraint.

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The theory of constraints has three underlying assumptions:
Convergence - Inherent Simplicity;
The more complex a system is to describe, the simpler it is to manage.
Consistency - There are no conflicts in nature;
If two interpretations of a natural phenomenon are in conflict, one or possibly
both must be wrong
Respect - People are not stupid;
Even when people do things that seem stupid they have a reason for that
behaviour

TOC in Lehigh steel

The counter-intuitive results from the activity based costing could be explained by the
lean or synchronous manufacturing process summarized as the theory of constraints
(TOC). This theory advocated proactive management of constraint in a business system.
Throughput: Quantity of money that the business system generates through a specified
period of time.
Throughput = sales price direct variable cost
It is generally represented as
= sales price material cost
It is roughly comparable to the contribution margin.
Profit of the system is increased by maximizing throughput per unit of the
constrained resource.
Calculations are as follows

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Product costs do not play any role in this method as it leads to sub-optimal decision
making as it ignores the constraint of time in a process.
Throughput is not measured in terms of units produced, but in gross profit realized from
units produced that are sold. Emphasis is placed on getting products through the
manufacturing process and sold in the least possible time.
On proper investigation it was found that batch of steel would wait at the rolling mills for
several days. So naturally it was the constraint in the whole batch process.
TOC advocated that management should solely focus on the constraint as it choked the
entire operation. The capacity of the constraint determined the capacity of the entire
system. They had to increase the throughput for the constraint.
The key to profitability was to send the most profitable products through the constraint.
They identified CRM as the constraint of the plant.

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Assumptions
Standard Costing

There is one ideal cost for any product

All overheads need to be assigned to the product and that these overheads relate to
the amount of labour required to make the product. It leads to over costing or

under costing of Products.

These costs mislead people and cause them to make wrong decisions relating to

pricing, profitability and so forth.

It is assumed that the company traces actual costs at each stage of production to
allocate the costs. It might lead to complicated data flow which generates huge
quantities of wasteful and confusing transactions.

Activity Based Costing :

Activities consume resources

Resources consumed have numerous causes
Activities of wide array can be identified and measured
Cost pools are homogeneous
Costs in each pool are variable

Theory of Constraints:
There is always at least one constraint on each product that limits the firms
revenue
Within every manufacturing environment, statistical fluctuations and random
events occur
The optimized production technology system is implicitly stableat any given
time bottle necks are identified and order mix is stable with respect to given
source

Analysis of different types of costing:

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Standard costing 1. In the standard costing method manufacturing and
administrative overheads were allocated on the basis of quantity.
But in reality each kind of products consumed different amount
of resources. So this kind of costing was definitely faulty.
2. According to this method only alloy: condition round in
profitable and all other product lines are loss making.
3. But this does not reflect the true picture as the costing here is
faulty. So we moved to activity based costing.

Activity based costing 1. In this method we allocated the manufacturing and

administrative overheads according to the resources consumed
by each of the activity.
2. We found out the driver for each activity and allocated costs to
them in proportion of the resources consumed by each activity.
3. Results were very different in this case. As we found that some of
the products were under-costed hence were showing more profits
(alloy, conversion, die steel- chipper knife) and others were overcosted hence were showing losses (die steel-round bar, high
speed).
4. In ABC we found that only high speed is showing profits and
all other product lines were showing losses. So if we go by this
method of costing they should go for high speed only.
5. We have also keep in mind that Lehigh might have decided on
the prices of their product lines according to the costs so they
could contemplate on changing the prices of the loss making
product.
6. They could easily increase the price as they were dealing with
speciality steel and in these kinds of customized products one
could easily charge a premium depending upon the demand of
the product and competitors.
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7. The industry was quite price-competitive. Although niches
provided some protection it was sonly reputation of exceptional
quality and technical services gave the producers leverage in
charging a premium.
8. However cost was a significant competitive weapon in
determining share and profits.
9. Although results were definitely better for ABC than the standard
costing yet some results were counter-intuitive.
10.
For example, high temperatures showed a similar ABC
profitability as high speeds even though high speed could be
processed at least 6 times faster than the high temperatures.
11.
This was really uncanny as product profitability should
reflect such vast differences in resource consumption.
12.
So we moved on to the concept of lean or synchronous
manufacturing- theory of constraints (TOC).

Theory of constraints 1. We first found out that the CRM was the constrained resource.
2. The objective of TOC is to maximize throughput and minimize
investments and operating costs.
3. According to the TOC analysis alloy and high speed were
the most profitable products.
4. As these products generated more throughputs per unit of
constraints.
5. They should try to keep the bottleneck operation busy by
continuously running the bottleneck operation. It should not be
waiting for jobs.
6. They can also take actions to improve the efficiency and capacity
of the bottleneck operation.

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Recommendation 1. Standard costing method is not applicable in this kind of industry

of speciality steels as here the amount of customization and
resources used by each product are different.
2. According to ABC high speed is the most profitable product.
3. According to TOC alloy and high speed have greater profitability
than others.
4. In terms of ABC and TOC die steel chipper knife is the least
profitable product.
5. Also it takes the most of the constrained resource CRM.
6. So according to ABC and TOC we recommend that Lehigh should
do away with this product to trim the product line.
7. Trimming the product line will lead to longer production runs and
greater efficiency.
8. Die steel round bar is making great losses. So Lehigh could do
away with this product or try to rework its price to become
profitable.
9. So according to ABC and TOC analysis their new product line
would only have 3products alloy, conversion and high speed.
10.
But before making any decision we should go through
exhibit 2.

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Exploring the Alternatives It is quite evident that ABC is not giving proper results. It can be seen
that most of products are making loss so there should be some other
method that can be used for costing. Various other alternatives which
can be used are

Process based costing

Job Costing
Hybrid costing

Process costing
It cannot be used as company is not producing huge no. of different
products rather it is producing only few different varieties of products.
These products are sold in small as well as very large quantities so it
does not make much sense of doing process costing here.

Job costing
A job order costing system is used when a job or batch
is significantly different from other jobs or batches. Cost accounting is
usually fairly simple in these systems. Labour and materials are
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entered on a job ticket. Overhead is usually added to the amount the
customer will be charged for labour and materials.

Hybrid Costing
Allocating Overhead using ABC Costing Overhead is a large mixed
group of costs that can't be directly traced to products. There are
several methods of allocating overhead costs in a cost accounting
system. ABC costing is one method. We will learn other, simpler
methods as well.
Activity-based costing (ABC) - used
overhead
activities

costs
that

are

primarily

for

allocating

tracked overhead that is hard to track to

consume specific productsdepartments

resources.
ABC Costing is a little more sophisticated that the single-driver
method. But it is really not much more difficult.

Two-Stage Overhead Allocation

Stage 1- Allocate Total Cost to Pools
Stage 2- Allocate pools to products or services
3 cost pools can be identified, each with a relevant driver. It can trace
total overhead costs as follows.

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Product A
Product B

Cost pool A

Product C
Product A
Total Overhead
Cost

Cost pool B

Product B
Product C
Product A

Cost pool C

Product B
Product C

Using separate cost pools and drivers, total overhead costs can be
allocated more accurately to the products that consume those costs.
Using separate pool cost in ABC would give us a better picture in term
of resources used as given in case different pool of resources are used
differently by different products so by using a little variation of ABC we
would get a clear picture of how cost of different resources used is
affecting overall cost of product.

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