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Lehigh Steel

Harvard Business School Case: 9-198-085

Prof. K. M. Padmanabhan

Submitted By
Section E, Group 8
Aravind Ganesan 2011PGP448
Gadkhel Rohit 2011PGP629
Gokulnath R 2011PGP638
Kartik Shrivastava 2011PGP685
Sumit Prakash 2011PGP907
Upasana Mukherjee 2011PGP922
Vemb V 2011PGP932

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
Executive Summary

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 Steels 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 (TOC) 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 Steels 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. It also operated a small distribution division which
served certain market segments by offering a broad product line comprising of products from
multiple manufacturers.

Lehigh Steel was acquired by The Palmer Company in 1975. The Palmer Company was a
global manufacturer of bearings and alloy steels with revenues of $1.6 billion in 1992. Palmer
believed that long-term specialization developed knowledge and innovation, the true source
of competitive advantage. Palmers corporate objective was to increase penetration in
markets providing long-term profit opportunities by taking a long-term view in decision
making by strategically managing (the) business, and emphasizing the fundamental
operating principles of quality, cost, investment usage and timelines. The acquisition of
Lehigh Steel gave Palmer speciality in Continuous Rolling Mill (CRM) that could convert
steel intermediate shapes to wire for Palmers bearing rollers.

Lehigh operated under a matrix organization structure. Reporting to the company president
were the General Managers of Primary Operations, Finishing Operations, and Marketing and
Technology; Vice President of Sales; Director of Operations Planning and MIS; and CFO.
Their performance was measured by product contribution margin calculated using standard
costs: revenue less materials, direct labour, and direct manufacturing costs such as utilities
and maintenance; other overhead was considered beyond their control.

Lehigh had 7 product lines Alloy, Bearing, Conversion, Corrosion, Die Steel, High Speed
and high Temp. Out of this Alloy, Die Steel and High Speed comprised 70% of the sales,
Lehigh also carried niche product lines Bearing, Corrosion and High Temp are whose
volume fluctuated with market conditions.

Conversion involved the processing of non-Lehigh owned material on equipment such as the
PFF or the CRM that was not economical for some products to own. Conversion was subtly
complex, as the breadth of the end customers product line translated into multiple rolling
specifications, and multiple setups.

Industry Analysis

Speciality steel comprised roughly 10% of the total US steel industry, and like other high-
tech, speciality industries, and offered growth and profit opportunities to firms who targeted
specific applications and developed unique technical competencies. Speciality steel was
characterized by variations in metallic steel composition and manufacturing processing which
enhanced the properties of basic carbon steel.

Steel products were defined by several attributes which determined the product application
and defined quality. Grade described the metallic (chemical) composition of the steel, or the
elements added to the basic recipe of iron and carbon to create the desired properties. Product
described the shape of the product, including semi-finished shapes (blooms, billets and bars)
and finished shapes (wires and coils). Surface finish described the smoothness and polish that
could be applied to the materials surface to enhance presentation. Size described the
latitudinal and longitudinal dimensions of the product. Structural quality described the
absence of breaks in the inner metallic structure. Surface quality described the absence of
cracks or seams on the surface. Because specific applications called for specific attributes,
many products were customized along one or more attributes for the customer. However, of
all attributes, customers valued most the grade, which determined product performance.

Producers typically focussed on a portfolio of product shapes within a single segment to

carve niches in a broad industry. This focus strategy protected capital investments in a capital
intensive industry. The industry was capital intensive because (i) lumpy and expensive
capacity additions, (ii) cost structure was significantly changed only by generational,
expensive new technologies (like Lehighs Precision Forging Facility (PFF)) and finally, (iii)

knowledge work performed by metallurgists and other technical specialists was a significant
portion of the cost structure.

Economics and focus also divided the industry into manufacturers and finishers/developers.
Manufacturers were the ones who melted, refined, moulded and rolled steel into basic shapes.
Finishers/Distributers were the ones who broke semi-finished steel orders and shapes down to
specific products for metalworking shops and original equipment manufacturers (OEMs).
Manufacturers and Distributers worked closely together, often as separate divisions within a

Conduct and Performance

Maintaining high standards of product quality while keeping costs competitive were essential
to compete in the specialty steel industry. Quality differences between manufacturers meant
that products were not perfectly substitutable. Differentiation also benefitted buyers, who
enjoyed a range of choices within a product category, and could pay for the precise version of
quality required. Technical services also differentiated suppliers while benefiting buyers, and
were becoming increasingly important. Over time customer had become sophisticated about
the value of the product, and the price they would pay for it.

Producers of speciality steel were small, fragmented price takers in the market dominated by
powerful, sophisticated customers. Market share could be bought or sold by pricing slightly
below or above the market price. Niches provided some protection for the providers.
Reputation for excellent quality and technical services also earned producers some price
premium. Manufacturers exited themselves quietly out of non-profitable products, sourcing
those critical to their product lines from other firms. Cost, therefore, was a 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 would select high volume orders which allowed
continuous operations at high setup time workstations. In low demand times, firms chase low
volume niche businesses to fill plants, rationalizing the poor margins as volume that would
contribute against fixed-cost while adding little variable cost.

Steel performance trended with the economy. Industry profitability fluctuated widely, ranging
from -16.7% to 5% in the late 1980s. Industry capacity utilization peaked in 1988 at 89.2%,
plummeted to 74.1% in 1991, and recovered partially to 82.2% in 1992.

Problem Statement
Industry wisdom stated that steel profits were a function of prices, costs and volume. Volume
was available at market price, though in form of niche specialities and small orders, but
virtually disappeared at premium prices. Costs failed to decline with price or volume:
shrinking operating rates drove up unit costs, and broader customer bases and product lines

bred complexity and increased labour resources, particularly in scheduling. Profit could not
be generated by simply working the traditional levers of price, cost or volume.
In 1992, Lehigh CFO Jack Clark hired Bob Hall to implement activity based costing at
Lehigh. On the other hand, Mark Edwards, Director of Operations Planning and MIS
explored Theory of Constraints (TOC) based costing system for Lehigh Steel.
Clark has to base his costing decision based on the reports of these two costing systems as
well as the outcome of standard costing system.

Evaluation of Alternatives
Standard Costing
Lehigh Steel along with the rest of steel industry has followed standard costing method. But
this method did not seem completely accurate as the company showed record profits in 1988
and record losses in 1991. In this costing method, profits from steel sales were a function of
prices, costs and volume. Product weight (pounds) was taken as the primary cost driver for
the measurement of standard cost, which included materials, labour, direct manufacturing
expense and overhead cost categories. Direct manufacturing costs such as maintenance and
utilities were allocated to products based on machine hours. Indirect manufacturing and
administrative costs were allocated to products on the basis of pounds produced, since weight
was assumed to be the primary driver of resource consumption.

From the context of this strategy, Alloys was the most profitable product and was extensively
promoted by the company. In spite of this, Lehigh witnessed record losses in 1991. The
calculation of costs by standard costing is shown below.

Standard Costing

Standard Cost Alloy : Die steel : Die steel: High speed:
Condition Chipper Round Machine
($/lb) Roller wire
round knife bar coil

Price 2.31 0.77 1.02 0.93 2.33

Materials 0.54 0 0.12 0.21 1.58

Direct labour 0.29 0.07 0.28 0.18 0.14
manufacturin 0.24 0.06 0.23 0.16 0.12
g expense

1.24 0.64 0.39 0.38 0.49
margin ($)
53.70% 83.10% 38.20% 40.90% 21%
margin (%)
Contribution( 593562 1332188 941187 2545119 1239970

g & Admn. 0.64 0.64 0.64 0.64 0.64

0.6 0 -0.25 -0.26 -0.15
profit ($)
26% 0% -24.50% -28% -6.40%
profit (%)
Operating 287207 0 -603325 -1741397 -379583
profit ($)

Total Profit($) -$2,437,098

Activity-Based Costing
In 1992, Lehigh CFO Jack Clark decided to try out alternatives to standard costing. In order
to find the correct product mix to maintain profitability even in recessionary periods, he
decided to implement Activity Based Costing in the company. As a manufacturer of
thousands of SKUs that shared the same production processes,, Lehigh was ideal for
implementing ABC.

Implementing ABC was a 2-stage process, (i) identifying activates and their cost-drivers and
(ii) allocating activities to products and customers using appropriate cost drivers. The results
of implementing ABC were unexpected: Company profitability was found to be highly
dependent on high volumes of High Speed and Die Steel sales which was a departure from
their earlier stance of making more Alloys.

However, there were some results which were counter-intuitive. For example, high temps
showed a similar profitability to high speeds, even though high speeds could be processed
across the CRM at a 6 times faster rate.

Lehigh Activity Cost Pools

Driver Cumulative
Activity Driver Amount ($) Rate
volume Rate

Melt machine
Melting - Dep 51,45,632 21,39,865 0.415860481
Melting - Melt machine
51,45,632 975130 0.189506362 1.001134943
Maintenance minutes
Melting - Melt machine
51,45,632 2036477 0.3957681
utilities minutes
Refining - Dep machine 56,91,042 1711892 0.300804668
Refining -
machine 56,91,042 780104 0.137075776 0.744599495
Refining -
machine 56,91,042 1745551 0.306719051
Mold machine
Molding - Dep 42,26,965 427973 0.101248295
Molding - Mold machine
42,26,965 390052 0.092277083 0.262351356
Main minutes
Molding - Mold machine
42,26,965 290925 0.068825978
Utilities minutes
Roll machine
Rolling - Dep 82,58,382 2995811 0.362760042

Roll machine
Rolling - Main 82,58,382 975130 0.118077609 0.586521306
Rolling - Roll machine
82,58,382 872776 0.105683656
Utilities minutes
Finishing -
machine 40,57,311 1283919 0.316445794
Finishing -
machine 40,57,311 780104 0.192271187 0.72382891
Finishing -
machine 40,57,311 872776 0.21511193
G&A Pounds 5,02,99,420 5400955 0.107376089 0.107376089
Mat Handling
orders 57,147 4936068 86.37492782 86.37492782
& Setup
orders 57,147 3953709 69.1848916 69.1848916
orders 57,147 3339500 58.43701332 58.43701332
SKUs 6,642 5766579 868.199187 868.199187

ABC Costing

ABC Cost Alloy : n: Die steel : Die steel: High speed:
Condition Chipper Round Machine
($/lb) round Roller wire knife bar coil

Price($) 2.310 0.770 1.020 0.930 2.330

Materials($) 0.540 0.000 0.120 0.210 1.580

Direct labor($) 0.290 0.070 0.280 0.180 0.140

Margin($) 1.480 0.700 0.620 0.540 0.610

Melting 0.200 0.000 0.090 0.090 0.090
Refining 0.156 0.000 0.074 0.074 0.074
Molding 0.031 0.000 0.018 0.021 0.018
Rolling 0.059 0.088 0.194 0.053 0.018
Finishing 0.043 0.014 0.051 0.058 0.036
G&A 0.107 0.107 0.107 0.107 0.107
Mat handing, setup 0.173 0.173 0.115 0.043 0.035
Order processing 0.138 0.138 0.092 0.035 0.028
Production planning 0.117 0.117 0.078 0.029 0.023
Tech support 0.564 0.197 0.150 0.022 0.035

Total 1.589 0.835 0.970 0.533 0.465

Operating Profit -0.109 -0.135 -0.350 0.007 0.145

Operating profit % -4.738 -17.546 -34.339 0.761 6.238
Total Operating profit -52386.495 281218.895 -845267.107 47427.417 367778.317

Total Profit = - $763666.7616

Theory of Constraints
Another thing that caught the managements attention (apart from ABC results) was that
despite the decrease in demands, Lehighs lead times had not decreased comparably. Excess
material could be found on the shop floor despite the reduced process batches. The Theory of
Constraints argued that in the short run the only costs that were variable were the operating
costs and advocated that management should focus only on the constraint. To increase the
throughput through the constraint was to increase throughput for the entire system. Time was

the only resource that mattered in TOC but time was not typically a factor used in Lehighs
decision-making. The key to profitability was to send only the most profitable products
(higher gross margins) through the constraint. The results were again very different from
what was expected.

TOC Costing

TOC Cost Alloy : Conversion : Die steel : Die steel:

Condition Chipper Round Machine

($/lb) Roller wire
round knife bar coil

Price 2.31 0.77 1.02 0.93 2.33

Materials 0.54 0 0.12 0.21 1.58

1.77 0.77 0.9 0.72 0.75
Contribution ($)
Time taken in
Bottleneck stage 0.21 0.15 0.33 0.1 0.1

Throughput/min 8 5 3 7 8

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 ABC TOC

All indirect costs
are related to the
product through a
Weight is taken as
causal Time taken by a process
1 Cost Driver primary cost
relationship, so the is the main cost driver
cost drivers are
different for
different activities
Independent of Long term
2 Time orientation Short Term Oriented
Time Oriented
The overhead costs are
Major Component Major Component
fixed and cannot be
3 Application of Cost is direct of Cost is
altered over given time
Variable Cost Overhead Cost

Only matrial costs

included, hence only
Linearity of Cost pool not Cost pools are
4 economies/diseconomies
Variable Costs homogeneous homogeneous
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 Managements 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,

Z ( pi ci ) X i s j qij X i (1)
i i, j

According to the TOC system,

Z ( pi ci ) X i s j Q j (2)
i j

Where pi= Price of the ith product

ci = 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 Z ( pi ci ) X i s j ( N j R j ) (3)
i i, j

Where Nj = Portion of labour and overhead costs that do not depend upon the management

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 most profitable products among the five sample products are High Speed: Machine Coil
and Die Steel: Round Bar. The quantity of production of each is obtained by solving an
optimization problem where the constraints are the resource capacity constraints.

The amount of the products that should be produced is given in the table:

Die Steel : Round Bar(lbs) High Speed : Machine Coil(lbs) Profits(RS)
54,05,248.70 72,41,510.20 10,87,855.72
Thus based on the data given in the case the above product mix is the most optimal one as
obtained by integrating ABC system and TOC system.

1) Cost Accounting: A Managerial Emphasis, Horngen, Datar, Foster, Rajan and Ittner,
Thirteen Edition
2) A comparative analysis of utilizing activity-based costing and the theory of constraints for
making product-mix decisions, Robert Kee, Charles Schmidt, Int. J. Production
Economics 63 (2000) 1}17