Lehigh Steel was founded in 1913 and it manufactures specialty steels for high strength, high use applications. In 1975 it was acquired by Palmer due to its ownership of Continuous Rolling Mill, a specialized equipment that convert steel intermediate shape to wire for Palmer’s bearing. The industry as a whole is highly competitive, even a small change in price could alter customers’ consumption decision greatly, keeping costs down is therefore, one of the most important targets Its financial performance was always remarkable because of the high quality of products and loyalty of customers. However, severe downturn performances could be identified since 1991 as the business condition was in recession and the industry started to decline. In order to resurrect the financial performance, Mark Edwards, Director of Operations was eager to change the traditional way of manufacturing. He suggested to adopt toyota’s lean, pull-based manufacturing concepts which could reduce stock piling up and therefore, reduce inventory costs, however this management theory was not perfectly suitable to Lehigh, due to the incapability of current technology to produce small orders efficiently. Although the theory did not apply to Lehigh efficiently, it successfully attracted many new customers who ordered in small quantities, along with the market recovery in 1992, Lehigh faced an increase in demand and it had to decide to emphasize in a few most profitable products in order to create a good product mix and improve the financial performance. As it should be, identifying profitability of products require accurate cost analysis of each product and compare them with their selling prices. The company had a tradition of using standard cost accounting for decision making and this method showed that Alloy was the most profitable product, however, management started to doubt this result as evidence proved that sales of Alloy did not actually have a positive relation with total profits, this lead to an alternative thinking in costing, which are Activity Based Costing (ABC) and Theory of Constraints (TOC).
Activity Based Costing (ABC)
‘Activity based costing is a methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities, then activities are assigned to cost objects based on their use Activity based costing recognizes the causal relationships of Cost Drivers to activities. Instead of measuring the cost of what goes into your item, you measure how you make and deliver your items. By understanding the activities and processes, cost drivers that influence the cost of activity, and whether the activity is needed at all, you can analyse the cost of how you make your items and how you may eliminate unnecessary steps’ (Oracle Inventory Reference Manual)
1) Improve estimation of cost
2) Improve planning and controlling of overheads
3) Encourage management to evaluate the efficiency and cost-effectiveness of program activities.
Steps to implement ABC
1) Identify activities – Conduct an in depth analysis of the processes that products need to go through and identify them as activities. 2) Assign resource costs to activities – In ABC, we assume that activities consume costs associated with resources and therefore, we trace the costs of resources to each activities. 3) Identify outputs – Identify all of the outputs for which activities are performed and resources are consumed. 4) Assign activity costs to outputs – activity drivers will be used in this step to determine activity costs to outputs, based on each output’s consumption of activities. 5) Analyse costs – In the final step, the company should carefully look at the costs allocated to each product and the activities that consume majority of costs. The company can use the analysis as a tool to improve the control of costs and product mix.