So it would seem that you can remove all but one item from a loot bag, And still use it for crafting the next tier items. Not sure if this was meant to be like this or not.

Yes, that's intended.

Pretty much, alternatively you can increase the number of bags needed to upgrade up as compensation.

ok so I guess limiting the amount of items per bag to 1 is the only way to basically make this less op?

Resolved with the "Prevent Merging Opened Bags" config option.