Q1. Compute profits for the
Q1. Compute profits for the five sample products under ABC and TOCfive sample products under ABC and TOC Standard Costing:
Standard Costing: Lehig
Lehigh h Steel had Steel had been traditibeen traditionallonally y doindoing g stanstandard costing and had dard costing and had beenbeen recording profits when in 1991, it suddenly reported losses. In this costing recording profits when in 1991, it suddenly reported losses. In this costing te
techchniniquque, e, ststeeeel l prprofofitits s wewere re a a fufuncnctition on of of prpriciceses, , cocoststs s anand d vovolulumeme.. Product weight (pounds) was the primary unit of measure for standard Product weight (pounds) was the primary unit of measure for standard cost, which included materials, labour, direct manufacturing expense and cost, which included materials, labour, direct manufacturing expense and o
oveverrhehead ad cocost st cacattegegoorrieies. s. DDirirecect t mmananufufacactuturrining g costcosts s ssuuch ch asas maintenance and utilities were allocated to products based on machine maintenance and utilities were allocated to products based on machine hours. Indirect manufacturing and administrative costs were allocated to hours. Indirect manufacturing and administrative costs were allocated to products based on pounds produced, since weight was assumed to be the products based on pounds produced, since weight was assumed to be the primary driver of resource consumption. The results indicated alloys to be primary driver of resource consumption. The results indicated alloys to be the most profitable product which was already being promoted by the the most profitable product which was already being promoted by the company. Yet, profits were not
company. Yet, profits were not increasing.increasing. Activity-Based Costing
Activity-Based Costing
In 1992, when Lehigh realized that standard costing had failed to help the In 1992, when Lehigh realized that standard costing had failed to help the company find the correct product mix, they decided to shift to company find the correct product mix, they decided to shift to activity-based costing. Lehigh was a perfect application for
based costing. Lehigh was a perfect application for ABC as a manufacturerABC as a manufacturer of thousands of SKUs
of thousands of SKUs that shared the same production processes.that shared the same production processes.
ABC followed a 2-stage methodology of identifying activates and their ABC followed a 2-stage methodology of identifying activates and their cos
cost-dt-drivrivers ers and and thethen, n, allallocaocatinting g actactiviivitieties s to to proproducducts ts and and cuscustomtomersers us
usining g cocost st drdriviverers s apapprpropopririatate e fofor r ththat at acactitivivityty. . ThThe e reresusultlts s wewerere un
unexexpepectcteded: : CoCompmpanany y prprofofititababiliility ty wawas s hihighghly ly cocorrrrelelatated ed wiwith th hihighgh volumes of High Speed and Die Steel sales which were a departure from volumes of High Speed and Die Steel sales which were a departure from their earlier stance of making more Alloys.
their earlier stance of making more Alloys. Ho
Howewevever, r, sosome me reresusultlts s reremmaiainened d cocoununteter-r-inintutuititivive. e. FoFor r exexamamplple,e, high temps showed a similar ABC profitability to high speeds, even though high temps showed a similar ABC profitability to high speeds, even though high speeds could be processed across the CRM at a rate
Profits of five products under ABC Standard Cost($/lb) Alloy: Condition Round Conversion: Roller Wire Die Stel: Chipper Knife Die Steel: Round Bar High Speed: Machine coil Price($) 2.31 0.77 1.02 0.93 2.33 Materials($) 0.54 0 0.12 0.21 1.58 Direct labor($) 0.29 0.07 0.28 0.18 0.14 Contribution Margin($) 1.48 0.7 0.62 0.54 0.61 Manufacturing Expenses Melting 0.20 0.00 0.09 0.09 0.09 Refining 0.16 0.00 0.07 0.07 0.07 Molding 0.03 0.00 0.02 0.02 0.02 Rolling 0.06 0.09 0.19 0.05 0.02 Finishing 0.04 0.01 0.05 0.06 0.04 G&A 0.11 0.11 0.11 0.11 0.11 Order processing 0.14 0.14 0.09 0.03 0.03 Production planning 0.12 0.12 0.08 0.03 0.02
Mat handing, setup 0.17 0.17 0.11 0.04 0.03
Tech support 0.56 0.20 0.15 0.02 0.03
Total Expenses 1.59 0.83 0.97 0.53 0.46
Operating Profit -0.11 -0.13 -0.35 0.01 0.15
Total Operating profit -51423 -277030 -842029 50798 368797
Theory of Constraints
Apart from ABC figures, what was more intriguing was the fact that despite a decrease in demand, Lehigh’s lead times had not decreased comparably. Excess material could be found on the shop floor despite the reduced process batches. TOC advocated that management should focus only on the constraint. To increase the throughput through the constraint was to increase throughput for the entire system. Time was the only resource that mattered in TOC but time was not typically a factor used in Lehigh’s decision-making. The key to profitability was to send only the most profitable products through the constraint. The results were again very different from what was expected.
Profits of five products under TOC
($/lb) Alloy: Condition Round Conversion: Roller Wire Die Stel: Chipper Knife Die Steel: Round Bar High Speed: Machine coil Price 2.31 0.77 1.02 0.93 2.33 Materials 0.54 0 0.12 0.21 1.58 Throughput(Contribution $) 1.77 0.77 0.9 0.72 0.75
Max. Time taken in Bottleneck
stage (mins) 0.21 0.15 0.33 0.1 0.1
Q2. Identify the differences in assumptions between Standard Costing, ABC and TOC.
Standard Costing
ABC
Costing
TOC
1Cost
Drivers
Standard costs are calculated using engineering estimates of standard quantities of inputs, and budgeted prices of those inputs. For example, for an apparel manufacturer, standard quantities of inputs are required yards of fabric per jean and required hours of sewing operator labour per jean. Activity-based costing looks at resources and activities as cost generating Dependent events exist that result in interactions between resources and products 2
Time
Orientati
on
Independent of Time ABC has a long run horizon TOC has a short Run impact 3Linearity
of
Variable
costs
Cost pools are nothomogeneous.Cost pools are homogeneo us Within every manufacturing environment statistical fluctuations and random events occur 4
Applicati
on
Actual variance are measureagainst standard costProducts or customers consume activities Throughput is defined as revenue minus the variable cost of materials and energy. 5 Model is consumptio n rather than spending. There is always at least one constraint on each product that limits the firm’s revenue. 6 Resources consumed have numerous causes There are
three types of resources: scarce bottleneck resources, non-bottleneck resources,
and capacity constraint resources (CCR). 7 Activities of wide array can be identified and measured The optimized production technology system is implicitly stable—at any given time bottlenecks are identified, and the order mix is stable with respect to given resources.
Q3. Identify a fourth method of calculating profits that corrects assumptions identified above that are inappropriate to Lehigh’s business situation.
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. The TOC method of 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.
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.
However, 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.
In order to maximize profits, the product mix decisions are an important factor for consideration for ABC and TOC under the constraints of resource capacity and demand
Applying ABC TOC mix method to Lehigh Steel
The costing system of using both ABC and TOC method can be applied to the Lehigh Steel to 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.
Q4. Based on profit calculations and other business considerations, make recommendations for Lehigh’s product mix in 1993
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 Coiland 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.
