CHAPTER 5 MEASU,RING THE COST OF RESOURCE CAPACITY 265
LEmGUSTEEL
Lehigh had gone from record profits to record losses in
less than 3 years.
- Bob Hall, ABC Projec;tMa"ager
Bob Hall studied the product profit report prior to the
1993 First Quarter Financial Review.The report was the
culmination of a year's effort calculating and analyzing
customer and product profitability using Activity-Based
Costing (ABC). Hall had been hired to implementABC
to restore profitability at Lehigh Steel. which had re-
ported record losses in 1991 after posting record profits
in 1988. Not uncommon in an industry characterized by
cyclic demand and large capital investment, such losses
could not be long sustained. Lehigh was under pressure
to return to profitability.
The goal of this Quarterly Financial Review- and
the ABC program itself- was to rationalize Lehigh's
product mix. Management felt that the decline from
record profits to record losses was only partially ex-
plained by the traditional profit driver, volume. Another
factor was the product mix running through the cost
base. The recession of 1991had presented a very differ-
ent demand profile offering limited contributions to
profit. With demand recovering in i993, the ABC profit
reports would enable marketing managers to identify
profitableproducts, and select the 'right' mix.
Although the ABC model was running smoothly, the
results were puzzling. Not only were product profits
significantly different from those under standard cost-
ing, but they were counterintuitive to operations staff,
who believed that products that tied up critical re-
sources in the production process should reflect higher
costs. and lower profitability. They were advocating a
different approach called Theory of Constraints (TOe)
to enhance profitability. Quickly Hall ran through the
ABC model in his head. Which approach was right?
Leltigh and Specialty Steel
The Palmer Company, Lehigh's parent, was a global
manufacturer of bearings and alloy steels with 1992
revenues of $1.6 billion. Palmer took pride in its long-
Professor V. G. Narayanan and Research Associate Laura E. Donohue pre-
pared this case.
Copyright ~ 1998 by the President and Fellows of Harvard College. Har-
vard Business School case 198-085.
term decision-making that concentrated corporate re-
sources on delivering superior performance for specific
products and markets. Palmer believed that long-term
specializationdeveloped knowledge and innovation, the
true source of competitive advantage. Palmer's corpo-
rate 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 funda-
mental operating principles of quality, cost, investment
usage and timeliness."
Founded in 1913, Lehigh Steel enjoyed a niche posi-
tion as a manufacturer of specialty steels for high
strength. high use applications. Products included high-
speed, tool and die, structural, high temperature. corro-
sion-resistant and bearing steels, available in a wide
range of grades in a variety of shapes and finishes. Mar-
kets included aerospace, tooling, medical. energy and
other performance industries. Lehigh enjoyed a pre-
mium market position because of its superior ability to
integrate clean materials with precision processing to
produce high quality products, which were often cus-
tomized for specific applications. and bundled with
metallurgy and other technical services. Primarily a
manufacturer.Lehigh also operated a small distribution
divisionwhich served certain market segments by offer-
ing a broad product line comprising products from mul-
tiple manufacturers.
Palmer had acquired Lehigh in 1975 not for syner-
gies with its own specialty steel businesses, but for the
Continuous Rolling Mill (CRM), specialized equip-
ment that could convert steel intermediate shapes to
wire for Palmer's bearing rollers. Only 6 such mills ex-
isted in the US.
Lehigh's financial performance trended with but
generally outperformed the industry as a whole. driven
by the superior quality that had earned it numerous
awards from customers. The years 1988 and 1989 had
been banner ones for Lehigh, which posted record prof-
its during a period of general industry strength as re-
flected in shipments. operating rates and prices. But,
broad recessionary business conditions drove a severe
industrydecline in 1991, reducing shipments, operating
rates and prices. Lehigh posted record losses in 1991.
Lehigh operated under a matrix organization struc-
ture. Reporting to the company president were General
 266 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY
. Managers of Primary Operations. Finishing Operations,
and Marketing and Technology;Vice President of Sales;
Director of Operations Planning and MIS; and CFO.
Marketing managers assumed product line responsibili-
ties that crossed functional boundaries. They developed
marketing strategies, determined product offerings, es~
tablished minimum order quantities. selected orders 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:
revenue .less materials. direct labor, and direct manufac-
turing costs such as utilities and maintenance; other
overhead was considered beyond their control. Manu-
facturing staff executed the orders brought in by the
marketing managers, and were measured on variances
from standard cost for the output mix produced. Their
goal was to deliver quality product within the specified
lead time at the lowest cost.
Industry Structure Specialty steel comprised
roughly 10% of the total US steel industry, and like
other high-tech, specialty industries. offered growth and
profit opportunities to firms who targeted specific appli-
cations and developed unique technical competencies.
Specialty steel was characterized by variations in the
metallic composition and manufacturing processing
which enhanced the properties of basic carbon steel.
For example. adding nickel and chromium to carbon
steel created 'stainless' steel, which resisted corrosion,
Tungsten and molybdenum combined to strengthen.
harden and temper carbon steel for cutting applications.
Several industry segments evolved reflecting basic
metallic combinations, which required different equip-
ment and knowledge bases for'manufacture,
Steel products were defined by several attributes
which determined the 'product application and defined
quality. Grade described the metallic (chemical)compo-
sition of the steel, or the elements added to the basic
recipe of iron and carbon to create the desired proper-
ties. Product described the shape of the product, includ-
ing semi-finished shapes, such as blooms, billets and
bars; and finished shapes, such as wires and coils. Sur-
face finish described the smoothness and polish that
could be applied to the material's surface to enhance
presentation. Size described the latitudinal and longitu-
dinal dimensions of the product. Structural quality de-
scribed the absence of breaks in the inner metallic struc-
ture. Surface quality described the absence of cracks or
seams on the surface. Because specific applications
called for specific attributes. many products were cus-
tomized along one or more attributes for the customer.
However. of all attributes, customers valued most the.
grade. which determined primary product performance.
Producers typically focused on a selected portfolio
of product shapes within a single segment, carving
niches out of the broad, industry. The. focus strategy
helped to protect volume and capital investments. The
industry was capital intense in several areas. First, ca-
pacity additions were 'lumpy' and expensive. with
equipment scaled in 100,000 tons of annual production,
costing $10-$100- million, and requiring 18-24
months to install. Second, the cost structure was signifi-
cantly changed only by new technologies, such as
Lehigh's Precision Forging Facility (PFF), which were
expensive, risky. generational ventures. Finally, knowl-
edge work performed by metallurgists and other techni-
cal specialists was a significant portion of the cost
structure. Hall summarized the 'focus' strategy: "You
choose to make product which ~'OU can make better [han
the competition."
Economics and 'focus' also divided producers into
manufacturers, who melted, refined, molded arid rolled
steel into basic shapes; and finisher/distributors. who
broke semi-finishedsteel orders and shapes down to spe-
cific products for metalworking shops and original
equipment manufacturers (OEMs). Manufacturers and
distributorsworked closely together,often as separate di-
visions within a firm. The manufacturing process fo-
cused largely on the materials science, in which metal-
lurgistssupervisedthe careful blending of alloy additives
with carbon steel to create the precise properties required
in a product application. Formerly mere warehousing.
distribution had assumed the industry marketing role,
creating product lines across materia) segments and
shapes, enabling a firm to serve a diverse metalworking
market while maintaining focused manufacturing
processes. Both manufacturers and distributors provided
technical services for everything from material composi-
tion to design to installationof the finishedproduct.
Industry Conduct and Performance Maintaining
high standards of product quality while keeping costs
competitive were essential to compete in the specialty
steel industry. Quality differences among manufactur-
ers meant that products were not perfectly substi-
tutable. Considerable value differentiation across pro-
ducers within product classes had actually been
confirmed and quantified by the International Trade
 CHAPTER 5
Commission during trade case investigations. Intended
to protect suppliers, differentiation also benefited buy-
ers, who enjoyed a range of choices within a product
category, and could pay for the precise level of quality
required. Technical services also differentiated suppli-
ers while benefiting buyers, and were becoming in-
creasingly important. Over time, customers had become
sophisticated about the value of the product, and the
price they would pay for it.
Not a commodity like carbon steel, which was sold
primarily on a price and delivery basis, specialty steel
was nonetheless highly price competitive. Producers
were small, fragmented price takers in a market domi-
nated by powerful, sophisticated customers. Market
share could be bought or sold by pricing slightly below
or above market price. Niches provided some protection
for producers. Reputation for exceptional quality and
technical services also earned producers some price
premium. However, when cost and price were notice-
ably out of alignment, manufacturers exited, pricing
themselves quietly out of non-profitable products,
sourcing those critical to their product line 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 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 mar-
gins as volume that would contribute against fixed-cost
while adding little variable cost. Unfortunately, this
business required short production runs if Lehigh were
to avoid inventory buildupof customized products.
Steel performance trended with the economy. Indus-
try profitabilityfluctuatedwidely,ranging from -16.7%
to 5.0% 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.
Markets and Products Customers ranged from large
forge shops to original equipment manufacturers
(OEMs), from distributors to tiny metalworkers, many
of whom added further value by cutting down the prod-
uct or the order size. Lehigh classified its customers
into 33 market segments whose requirements for grade
specificity. technical support and shipping varied. See
Exhibit l for a market summary.
During the recession, Lehigh pursued marginal busi-
MEASURINC THE COST OF RESOURCE CAPACITY 267
ness to fill the plant, attracting many new customers in
1991- 2. Under standard costing this business looked
potentially profitable. However, specialized products re-
quired specialized processing and were ordered in
smaller quantities. The average order size declined from
1600 pounds in 1988 to less than 1200 pounds in 1991.
Accordingly, Lehigh's sales distribution broadened:
customer salep ranged from $5.9 million for 2.7 million
pounds of steel, to $84 for 8 pounds, with the average
customer buying 36,635 pounds of steel for $63.407.
Only 18 customers spent more than $1.0 million, and
only 130 spent more than $100,000; over 420 customers
spent less than $1,000.
Lehigh had 7 product lines-Alloy, Bearing, Con-
version, Corrosion, Die Steel, High Speed and High
Temp-of which three-Alloy, Die Steel and High
Speed-comprised 70% of sales. Die Steel was steel
hardened and strengthened for use in machine dies and
molds. The Die Steel market was broad, ranging from
ingots to semi-finished and finished parts, and market
participants felt the need to offer a full product line to
maintain share, High Speed products served endurance
applications. such as metal cutting and punching, and
were narrower in focus. Production of High Speed and
Die Steel products was relatively simple, requiring little
technical or process support. By contrast, Alloy prod-
ucts were complex. Their applications in aerospace
frames, landing gears, missile cases and fasteners re-
quired steel precisely graded by metallurgists within
tighter-than-standard ranges. super-cleaned by a double
melt, and precisely rolled to narrow tolerances. By
virtue of its superior product performance. Lehigh was
able to command a small price premium for its alloys.
Lehigh also carried niche product lines - Bearing,
Corrosion and High Temp-whose volume fluctuated
with market conditions. Bearing steels were designed
for a broad range of aircraft bearings and similar highly
stressed parts whose grade precision required a triple
melt. Corrosion-resistant steels were designed to oper-
ate in challenging environments in markets such as oil
and gas exploration and medical implants. High Tem-
perature steels were designed to withstand sustained ex-
posure to temperatures from 800F to 1300F, such as in
jet engines. These product lines were highly complex.
requiring significantly higher levels of support from
metallurgy, for making very clean steel, and process en-
gineering, for testing and certification. For example,
steel for artificial limbs had to pass stringent require-
ments for purity, for which each part had to be certified.
268 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACllY
.Almost 80% of metallurgists' time was spent on the
niche product lines.
Conversion involved the processing of non-Lehigh
owned material on equipment such as the PFF or the
CRM that was not economical for some producers to
own. The primary 'product' was the conversion of billet
to roller wire for Palmer. Conversion was subtly com-
plex, as the breadth of the end customer's product line
translated into multiple rolling specifications, and mul-
tiple setups.
Lehigh's product hierarchy was structured as fol-
lows: product lines were broken down into grades,
which were subdivided into product shapes, and further
into skus, which reflected variations in size and finish.
In anyone year, Lehigh produced over 100 grades of
steel, 500 individual products, and over 7,000 individ-
ual stock-keeping units (skus). Over multiple years, ac-
tual production could span over 10,000 skus. See Ex-
hibit 2 for a product line summary.
Production Operations Specialty steel producers
used steel scrap as the primary raw material. and essen-
tially recycled rather than manufactured steel. Produc-
tion involved six steps, whose complexity varied by
product. See Exhibit 3 for a summary of the production
process.
Hauled in with magnets and cranes, scrap purchased
for $114.20 per ton WaS pre-processed, or combined
with iron-based compounds to achieve the low compos-
ite residual (contaminant) levels required by Lehigh's
high-grade products. The scrap compound was Melted
in the Electric Arc Furnace, where high-powered (80
megawatts) electrical charges heated the solid metal by
zapping it with arcs of electricity emanating from car-
bon electrodes. Synthesized fluxes containing limes re-
fined the hot metal by binding with phosphorus and
other impure elements, which were skimmed off.
The steel was further Refined by Argon Oxygen De-
carbeurization (AOD), in which oxygen or argon was
bubbled through the molten metal to further burn off
impurities. Alloys were then added to achieve the spe-
cial properties. The Melting and Refining processes
constituted chemical reactions between various ele-
ments which created the desired material. As tempera-
ture was an essential factor in generating the appropri-
ate chemical reaction, the hot metal processes were
carefully monitored and controlled by metallurgists to
achieve the precise grade.
The molten steel was teemed from ladles into octag-
onal Molds, forming ingots. Once solidified, ingots
were stripped and left to soak in a storage furnace to
maintain malleability and prevent damage. Molding
was a relatively laborious process, as each 2500-pound
ingot had to be handled and moved manually. Some in-
gots were then remelted to meet stringent purity re-
quirements at either the Vacuum Arc Remelt Furnace or
the Electro Slafo Remelt Furnace, which cleansed the
steel in solid form. Ingots were then Broken down into
semi-finished (rectangular) shapes such as billets and
bars. The Mesta press hot-worked bars over 12/1ill di-
ameter, a small percentage of overall output. Most in-
gots were routed to the PFF. The PFF was $40 million
of relatively new technology in which an ingot was
heated and forged by 4 hammers progranuned to pro-
duce intermediate billets or bars. After being worked.
the solid steel underwent a thermal treat called anneal-
ing, or slow cooling, to prevent shrinking and cracking
caused by air cooling.
Rolling transformed intermediate billets and bars
into finished shapes. A hot rolling mill had a soaking
furnace to heat the steel, followed by a series of stands
with progressively narrower rollers that pressed the hot
steel into progressively thinner sizes until it achieved its
final shape, such as a wire. A mill contained several sets
of stands to roll different shapes; however. only one
shape could be rolled at a time. Unique product shapes
were rolled manually on the Hand Mill.' 95% of inter-
mediates were rolled on the CRM into one of 4 prod-
ucts: rods, flats, coils and bars. Shape changeovers were
time-consuming events which dictated continuous 3
shift production, as well as a set production schedule
with dedicated windows rotating within a 4 week cycle.
One out of four weeks was dedicated to the conversion
of billet to coil for Palmer. At $50 million, the CRM
represented a capital investment that could not be dupli-
cated in less than five years. Labeling it the plant bottle-
neck, Hall described the CRM as "the one manufactur-
ing process that has the most impact on Lehigh . . . in
terms of the resources used and the schedule it drove."
The final step was Finishing, which included a vari-
ety of treatments. Most products were annealed a final
time to improve formability and make the surface more
durable, and rough turned, or straightened. Other treat-
ments included pickling (dipping in acid to clean off
scaling) and polishing (grinding to produce a shiny,
buffed finish). Pieces were tested or inspected if cus-
tomer requested special tolerances in grade or shape.
Finished product was shipped directly to customers.
 CHAPTER '5
Support activities were also critical to production.
Maintenance, depreciation and utilities were basic costs
required to run the plant, and comprised 21% of rev-
enues. Production support activities such as material
handling/setup, production planning and order process-
ing ebbed and flowed with order volume.Technical sup-
port-metallurgy and engineering-was considered
the lifeblood of Lehigh's reputation. Around the indus-
try it was rumored that Lehigh had more metallurgists
per ton of steel than anyone in the world. General & ad-
ministrative included company-wide activities such as
management, finance and research and development
(R&D). R&D combined raw research in materials sci-
ence with applied research in production technologies.
The Casefor Chang~
Industry wisdom stated that steel profits were a simple
function of prices, costs and volume. However, 1991
presented challenges in all three fundamental profit dri-
vers. Market prices declined sharply to near or below
product cost, lower in real terms than 1982 levels. Vol-
ume was availableat market price, though in the form of
niche specialties and small orders, but virtually disap-
peared 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 labor resources, particu-
larly in scheduling.Profit could not be generatedsimply
by working the tradition levers of price, cost or volume.
Particularly pressing were the simultaneous decline
of the' average order size and shortening of lead times,
which had left volume-drivenLehigh flush with inven-
tories and cost. In an effort to meet these demands and
eliminate inventory 'waste', Mark Edwards,Director of
Operations Planning and MIS, drove the 1991 move to
synchronous flow manufacturing.Edwardsbelieved that
Toyota's lean, pull-based manufacturing concepts were
key to reducing inventory cost., and pushed for their
adoption at Lehigh. The new approach appealed to the
marketing managers, who could broaden their customer
base by offering smaller orders. However, under the
current technology, it proved difficult to eliminate the
steps in setups and changeovers critical to efficient
small order throughput, and production staff observed a
dramatic decline in efficiency.
In late ·1992,Lehigh was reprieved somewhat by a
slow but steady market recovery. Facing an increase in
demand, Lehigh now had to choose which products to
MEASURlNG THE COST OF RESOURCECAPACITY 269
emphasize to convert sales into profits. Following its
market strategy, Lehigh targeted a high value product
mix that would lever profits in strong demand, and
cushion it in downturns with greater contributions to
fixed costs per unit volume. CFO Jack Clark suggested
a firm-wide product profitability analysis, which would
enable market managers to rationalize unprofitable
products and focus resources on high value ones.
Clark reviewed the products' standard costs, which
were used for both inventory valuation and decision-
making. Product weight (pounds) was the primary unit
of measure for standard cost, which included materials,
labor, direct manufacturing expense and overhead cost
categories. Standards for materials and direct labor
were based on the bill of materials and routings, and in-
cluded yield factors for scrap and rework. Scrap pre-
processing was handled as a material burden rather than
a routing step. Direct manufacturing costs such as
maintenance and utilities were allocated to products
based on machine hours. Indirect manufacturing and
administrativecosts were allocated to products based on
pounds produced, since weight was assumed to be the
primary driver of resource consumption.
The results were not news: the most profitable prod-
ucts-alloys-were already heavily promoted by mar-
keting and sales. If these products were truly profitable,
where were profits?
The Case for ABC In 1992, Clark attended a seminar
on Activity-BasedCosting. He realized that Lehigh was
a perfect application for ABC as a discrete manufac-
turer of thousands of skus that shared the same produc-
tion processes, serving a diverse customer base with a
wide range of support needs. They knew that individual
customers and products made different demands for re-
sources, and that their standard cost system was likely
averaging the diverse resource use by products and cus-
tomers. Resources were heavy on his mind: support re-
sources had increased through the recession. The num-
ber of production planners alone had increased by 25%
to handle the increased scheduling complexity of the
extra business.
Believing that ABC presented an opportunity to un-
derstand the drivers of profitability, Clark hired Bob
Hall from Armco Steel. A steel industry accountant,
with undergraduate and MBA degrees in Accounting &
Finance, Hall had spent a year developing an activity-
based product costing application at Armco. As Man-
ager for Operations Accounting, Hall was assigned to
270 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY
implement ABC at Lehigh. with the goal of arriving at a
clearer sense of the product and customer channels that
were profitable to the company.
Hall investigated the issue by performing a regres-
sion analysis between the various product mixes and
overall company profitability over time. The results
were curious': company profitability was highly corre-
lated with high volumes of High Speed and Die Steel
sales. Under standard costing. the marketing managers
had only tolerated these products, since they con-
tributed against fixed costs, but believed that the real
generators of profits were Alloys. Familiar with the the-
ory of ABC as well as the specialty steel business, Hall
agreed with Clark that standard costing was probably
averaging uneven resource consumption across prod-
ucts, and that resources thought to be benefiting the
whole business were in. fact only benefiting a subset.
The full ABC analysis would highlight the resource
consumption of individual products.
The.ABC model encompassed all customers, prod-
ucts and operations. Hall followed the two stage
methodology of assigning general ledger account bal-
ances ('resource costs') to activities, using the resource
driver 'percentage of time or effort expended'. and allo-
cating activities to products and customers using cost
drivers appropriate to that activity. The activity pools
and cost drivers reflected a 4 level ABC cost hierarchy
of unit, batch, product and facility costs. The model in-
cluded 50 business processes and 270 activities. Activ-
ity pools ranged from $5,017 for secretarial support to
$1,096,952 for direct sales, with most covering $50,000
to $200,000.
As with standard costing, material costs were based
on the bill of materials structure (i.e. 14" ingot to 4 5/16/1
billet to 0.71" rod product), and included a burden rate
for material pre-processing, as well as a scrap yield fac-
tor. Labor costs were based on the routing and standard
labor rates, and included a rework yield factor. Overhead
. activities were driven to products using cost drivers that
defined the causal relationship between the product and
the activity, such as number of orders, machine hours, or
number of skus per product (a measure of product com-
plexity). For activities that were environmentally re-
quired, such as administrative activities, costs were allo-
cated by the generic driver, 'pounds produced'.
The results were as. Hal! expected, and he was
pleased with the study. However, responses by the rest
of the organization were understandably mixed. Antici-
pating small changes in profits, managers were not pre-
pared for the magnitude of the shift. Hall argued that
the ABC model was correcting distortions created by
standard costing, and that the ABC data was a true re-
flection of resource consumption. To facilitate accep-
tance, the project team refined some allocations to more
accurately reflect the consumption of certain activities
and resources. The refinements did not substantively
change the resu)ts.
Support for the ABC model began to grow. In partic-
ular, production operations staff felt that the model con-
firmed some of their intuitions about profitable and un-
profitable products, which were based on how smoothly
material flowed through the plant. Certainly, it was felt
that ABC was an improvement over standard costing.
However, some results remained counter-intuitive. For
example, high temps showed a similar ABC profitabil-
ity to high speeds, even though high speeds could be
processed across the CRM At a rate 6 times faster.
Surely product profitability should reflect such vast dif-
ferences in resource consumption.
The Case for TOe Edwards thought he understood
why the ABC profit figures did not make sense. He had
thoroughly researched recent manufacturing theories in
his effort to reduce order planning and inventory costs,
and had become a convert to lean manufacturing. He
had read all of Eli Goldratt's books on synchronous
manufacturing, summarized as the Theory of Con-
straints (TOe). TOC advocated proactive management
of the constraint in a business system, and vilified ab-
sorption accounting as the driver of unprofitable deci-
sion-making. It was intriguing that a theory of produc-
tion and operations management incorporated a theory
of management accounting. Perhaps the key to the
profit puzzle would be found in TOC.
Edwards reread his notes on the principles of TOC
accounting, which proposed a simple operational mea-
sure to guide an organization toward the goal of making
money. Throughput was defined as the quantity of
money which the (business) system generated through
sales over a specified period of time. Generalized as
sales tess direct variable cost, it was most commonly
calculated as sales less material cost, and was roughly
comparable to contribution margin. Profit for the system
was increased by maximizing throughput per unit of the
constrained resource. Interestingly. product costs played
no part in TOC accounting. In fact, TOC proponents ar-
gued that product costing of any kind led to suboptimal
decision-making because it ignored the constraint of
 CHAPTER
time in a process. Edwards focused on a phrase he had
underlined several times that contradictedevery thing he
had ever been taught about cost accounting:
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 time possible.
Edwards often walked through the plant as he rumi-
nated. The ABC figures were not the only seemingly
contradictory results at that time. Despite a decrease in
demand during the recession, Lehigh's lead times had
not decreased comparably.Excess material could easily
be found on the shop floor despite the reduced process
batches, which were supposed to facilitate the rapid
flow of material through the plant. and the reduction of
inventories. Had the reality of Lehigh's synchronous
manufacturing fallen short of the vision? Or was the tra-
ditional accounting system contradicting the concepts
of synchronous flow. impeding its full implementation
and the realization of results? He decided to investigate
one batch of steel as it traveled through the plant. He
paused with his batch at rolling, where it would wait
several days for its scheduled run. and reviewed what
he had seen.
He observed that some WIP piles were Jarger than
others, and his batch had waited longer at some work-
stations than at others. He considered the possibility of
a constraint in the process. TOC advocated that man-
agement attention be focused exclusively on the con-
straint, which acted as the drum that set the pace for the
entire operation. The capacity of the constraint deter-
mined the capacity of the entire system. To increase
throughput through the constraint was to increase
throughput for the entire system. Alternatively, to ig-
nore the constraint was to lose control of the process.
He also noted that products had moved at vastly differ-
ent rates across workstations. Thinking of throughput,
5 MEASURING THE COST OF RESOURCE CAPACITY 271
he imagined the 'faster' products flowing smoothly
through the plant, out the door to a customer. Other
products seemed to crawl through the plant, requiring
slower machine speeds, and routing promptly to inven-
tory. He began to visualize the slowpokes at the bottle-
neck, tying up that critical resource, constraining
throughput and profits. 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. Operations
staff would unequivocally identify the CRM as the con-
straint in the plant. Edwards abandoned his production
batch and returned to his desk to calculate Throughput
for Lehigh's products. The results were almost as shock-
ing as the ABC results, though for different reasons.
Accuunting for Change Edwards called Clark before
the next Quarterly Financial Review,eager to share his
results. Concerned by the contradictions between the
three accounting theories--standard costing, ABC and
TOC-Clark asked Hall and Edwards to present their
theories in the meeting. The managers would agree on
one and use it to target products. To simplify the ac-
counting for the other managers, Hall and Edwards
agreed to model five products that were representative
of the major product lines. Exhibit 4 contains product
data for the sample products. Exhibit 5 contains their
standard costs used in the initial analysis. Exhibit 6 con-
tains activity cost pools prior to Stage 2 cost allocation,
The managers were equally confused by the differ-
ent results. Surely calculating profits was a straightfor-
ward exercise. They preferred to focus on the decision
at hand: which products to rationalize. Following
either set of recommendations would likely have sig-
nificant impact on Lehigh's product portfolio, not to
mention profits.
272 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY

EXIUBIT 1 Lehigh Market Summary

No. of 1992 Sal.. 1992 Sates
Market Segment
Cuatome ... ~Ibs) (S)
Auto Die 2 9,394 $30,595
Bar 16 966,896 $1,631,655
Bearing 8 130,714 ' $600.398
Billet 2 1,598,041 $556,615
Coil 7 981.341 $2,044,536
Cold Head 25 332,531 $876,704
Core Pin 7 1.044.121 $2,688,430
Die Cast 13 1,026,699 $1.487.216
Distributor 154 10.533,749 $15,585.553
Extrusion 28 5,667,407 $5,042,492
Fastener 10 148,345 $2,259,677
r:orge Billet 9 396.945 $395,515
Forge Die 6 323.131 $357,229
Forge Shop 34 7,416,347 $10,716,024
Gauge 3 10,274 $34.687
Ingot I Electrode 2 251.897 $56,269
Intercompany 1 431,672 $433,369
Knife 18 2,637,048 $2,893.755
Label Die 11 108,665 $153.991
Large OEM 92 7.576,997 $19,995.673
Mandrel Bar 19 19,452 $263.544
New 841 6,373.893 $12,811,325
Other 5 16..922 $39.651
Plastic Mold 6 51.906 $105,433
Punch 23 952,428 $1,967,775
Rock Bit 1 35,192 $33,784
RC>a1Form 8 291,928 $406,876
Special Machinery 11 3,725 $149,986
Spring 3 3,609 $118.992
Thread 3 614.882 $1.681,541
Wheel Mold 1 6,074 $8,204
Wire 1 5.074 $10,758
Z-Mill 3 332,021 $619.269

Total 1373 50,299.420 $87,057,521

 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY 273

EXHmlT 2 Lehigh Product Summary

No. of No. of 1992 Sales 1992 Sat..
ProductUne
Grades Products (Ibe) ($)

Alloy 21 153 11,836,227 $17,494,283

Bearing 7 24 329.816 $1,541.070
Conversion 16 16 5,516,107 $6,878,068
Corrosion 4 20 762,448 $1,327.111
Die Steel 49 156 22.336,768 $29,046,569
High Speed 24 97 9,375,129 $26,298.139
High Temp 3 16 142,925 $4,472,281

Total 124 482 50,299,420 $87,057.521

Proc ... Flow

Mold &
Melt -----+ Refine ~ Roll Finish
Breakdown

.-

WorbtatloD.

Electric Arc: Argon Oxygen Ingot Molda Continuoua Rolling Annealer

Furnace De<:arbuerlzer MUI(CRMI
(AOOI Precision Forging Bar Straightener
Facility (PFP) Hand Mill
Vacuum Arc B2 Turner
Remelt Melita Pre..

Electro Slag
Rem.elt Inspection

Vacuum Induction
Furnace

EXHmIT 3 Lehigh Production Processes

 I

214 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY

EXHIBIT 4 Sample Product Data

Alloy: Ole Steel:
Converalon: Ole Steel: High Speed:
Condition Chtpper
Roller WIN Round Bar MaehineCoU
~ound Knife

Production (Jbs) 478,679 2,081,543 2,413,299 6,697,682 2,530,552

Number of skus 311 473 418 172 102
Number of orders 957 4,163 3,218 3,349 1,012

Bill of Materials (Ibs J Ib of output)

Steel scrap 1.00 0.00 1.00 1.00 1.00
AUoys 0.01 0.00 0.01 0.01 0.01
(@ $48.29 J Ib) (@ S6.29/lb) (@ $15.29/Ib) (@ 5152.29/Ib)

Machine Time (min lIb; crew = 1)

Melting (Electric Arc Furnace) 0.20 0.00 0.09 0.09 0.09
Refining (YOo) 0.21 0.00 0.10 0.10 0.10
Molding I Breakdown (Ingot I PFF) 0.12 0.00 0.07 0.08 0.07
Rolling (CRM) 0.10 0.15 0.33 0.09 0.03
Finishing (multiple) 0.06 0.02 0.07 0.08 0.05

Total time 0.69 0.17 0.66 0.44 0.34

 CHAPTER 5 MEASURING THE COST OF RESOURCE CAPACITY 275

EXHIBIT 5 Standard Cost Results

Alloy: DleS*I:
Converaion: Ole Steel: High Speed:
Standard CoM ($ lib) Condition Chipper
Roner Wire Round a.r Machine Coli
Round Knife

Price S2.31 $0.77 S1.02 $0.93 $2.33

Materials SO.54 $0.00 $0.12 $0.21 $1.58

Dlredlabor $0.29 SO.07 $0.28 $0.18 $0.14
Oirect manufacturing expense $0.24 $0.06 $0,23 $0.16 $0.12

Contribution margin $1.24 SO.64 $0.39 $0.38 $0.49

Contribution margin (%) 53.7% 83.1% 38.2% 40.9% 21.0%
Total contribution $593,562 S1,332,188 $941,187 $2.545.119 $1,239.970

Manufacturing& administrative 50.64 $0.64 $0.64 $0.64 $0.64

overhead

Operating profit $0.60 50.00 ($0.25) ($0.26) ($0.15)

Operating profit (%) 26.0% 0.0% ·24.5% ·28.0% -6.4%
Totaloe!ratlns profit $287,207 $0 ~$603,325~ ~$1.741.39n ~$379,583~
 1
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276 CHAPTER 5 "'1EASURING THE COST OF RESOURCE CAPACITY

EXHIBIT 6 Lehigh Activity Cost Pools

Driver
Activity Driver Amount
Volume

Melting: Depreciation melt machine minutes 5,145,632 $2,139,865

Melting: Maintenance melt machine minutes 5.145.632 $975.130
Melting: Utilities melt machine minutes 5,145.632 $2.036.477
Refining: Depreciation refine machine minutes 5.691.042 $1.711,892
Refining: Maintenance refine machine minutes 5,691,042 $780,104
Refining: Utilities refine machine minutes 5.691,042 $1,745,551
Molding: Depreciation mold machine minutes 4,226,965 $427.913
Molding: Maintenance mold machine minutes 4.226,965 $390,052
Molding: Utilities mold machine minutes 4.226,965 $290,925
Rolling: Depreciation roll machine minlJtes 8.258,382 $2,995,811
Rolling: Maintenance roll machine minutes 8.258,382 $975,130
Rolling: Utilities roll machine minutes 8.258.382 $872,1'/6
Finishing: Depreciation finish machine minutes 4,057,311 $1,283,919
Finishing: Maintenance finish machine minutes 4,057.311 $780,104
Finishing: Utilities finish machine minutes 4.057,311 $872,776
General & Administrative pounds 50.299,420 $5.400.955
Material Handling & Setup* orders 57.147 $4,936,068
Order Processing orders 57,147 $3,953.709
Production Planning orders 57,147 $3,339,500
Technical Support skus 6,642 $5.766,579
~
Total $41,675,296

·Material Handling & Setup includes Depreciation for setup hours

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