Production Decisions
The management of manufacturing companies are usually faced with the challenges of making production decisions. Perhaps a manufacturing company operates in more than one production line, and the management wants to know which of the product lines brings in more profits or which product line should be scraped out because of shortage of resources.Such decisions need thorough understanding of each of the relevant costs.
When choosing between two or more product lines, the management basically evaluates how each production line or department performs. Usually, the department or product line with the least manufacturing cost and with the highest profit is a better choice. This is achieved by calculating the contribution margin of each of the production lines or departments.
Contribution margin is actually the surplus amount left after deducting the variable costs incurred. The contribution margin of each department or product line can help managers understand how much each of the choices being considered is used to cover its relevant variable costs and the amount left to cover the fixed costs.
The contribution margin is computed by subtracting the variable costs from the revenues/sales.
Contribution margin = Sales − Variable costs
To better understand how to go about this, we are going to have an example of a situation in a production setting that requires an incremental analysis decision.
Example of Production Problem - Scenario
Kimberly Manufacturers is a company that specializes in three lines of production. Currently, the company is facing hard economic times and the management have got no option except to either drop one product line or file for bankruptcy. The management have decided to drop one of their product lines in order to avoid bankruptcy. The following is the information of Kimberly's financial information for the three product line in the latest year.
| Production Line | Sales | Variable Costs | Units Produced |
|---|---|---|---|
| Production line 1 | $2,000,000 | $800,000 | 600,000 |
| Production line 2 | $1,500,000 | $400,000 | 500,000 |
| Production line 3 | $2,500,000 | $1,200,000 | 400,000 |
Solution - Incremental Analysis Approach
The solution to find the product line to drop is to find the product line with the lowest contribution margin per unit. This means that the product line with the least amount of money left after deducting the relevant variable costs, should be dropped.Contribution margin = Sales − Variable costs
| Production Line | Total Contribution Margin | Unit Contribution Margin |
|---|---|---|
| Production line 1 | $1,200,000 | $2.00 |
| Production line 2 | $1,100,000 | $2.20 |
| Production line 3 | $1,300,000 | $3.25 |
From the calculations above, production line 1 has the lowest contribution margin per unit and can be dropped if there are no any other factors that may prove otherwise.