- Pages: 3
- Word count: 516
- Category: Economics
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The profits are different because the costs are allocated differently in the three methods.
In the standard-cost method, steel profits were a function of prices, costs and volume. Product weight (pounds) was the primary unit of measure for standard cost, which included materials, labor, direct manufacturing expense and overhead cost categories. Direct material and direct labor are based on the bill of materials and routings. Direct manufacturing costs were allocated to products based on machine hours. Indirect manufacturing and administrative costs were allocated to products based on pounds produced. It averages the diverse resource use by different products.
The ABC followed a two stage methodology by using resource drivers and allocating activities to products and customers using cost drivers appropriate to the activity. The material costs and direct labor are the same with the standard cost method. All the indirect costs are related to the product through a causal relationship, so the cost rates are different for different activities. In the standard cost method, the cost rates for direct manufacturing expenses are the same for all the activities and manufacturing and administrative overhead is allocated evenly among different products.
TOC only involves material costs, and all the overhead costs are the same among different products and fixed.
In ABC, the product mix was decided on the basis of profitability of each product and the production of the most profitable product was maximized. It doesn’t consider the time and the opportunity cost of utilizing the bottleneck resources. TOC takes into consideration the effect of the most critical resource in finalizing the product mix. It maximizes the product which gives maximum profit on utilizing one unit of the critical resource.
In Lehigh’s case, Lehigh should not base its product mix decision on either ABC or TOC solely. In the case, the bottleneck process of each of the product line is decided based on the machine time, and the throughput per minute can be calculated based on the longest time in the bottleneck resources. For example, the Die Steel Round bar, the throughput is 0.72, the time it stays in refining is 0.1 minutes. The throughput per minute is 7.2. When the bottlenecks exist, we must take measures to optimize because a bottleneck occurs when the demand for a resource, in a given time period, outweighs the plant’s ability to deliver it. In the short run, the production capacity is fixed and cannot be changed.
To accommodate those constraints, the best way is to use TOC, because ABC system doesn’t consider constraints and time resources. A product that consumes a large quantity of the bottleneck resource is not penalized. But some of the products which give maximum throughput are not profitable according to the ABC system. ABC shows the profitability of the products. With both TOC and ABC information, we can identify the constraint resources and send the most profitable products through the constraint to maximize the profits. In the long run, we need use the information to take measures to increase the capacity of the bottleneck to optimize the system.