You can't make the steel sludge directly at the furnace. You need to find a "Smith Table" (it's a table that's usually nearby forges and furnaces), throw the items within and then press the "Combine" slot.
After you get the sludge mixed at the table, you just need to throw it into the furnace, wait until it's molten, then throw it into the stock casting. Read the books more carefully, I know they're a bit hard to look at, but it's what we have to do.