When a business produces different products and has limited resources, the business is faced with the problem of identifying how many of each product to produce.
Since our goal is to maximize profit, the business should prioritize producing the product/s with the highest contribution margin per unit of scarce resource. Let's illustrate that.
XYZ Company is choosing which product/s to produce and sell. XYZ has 10,000 machine hours available. The following summarizes the contribution margin and required machine hours to complete each product.
A unit of Product A requires 2.5 machine hours. Product B requires 4 machine hours and Product C requires 1 machine hour. For each product, the contribution margin per machine hour is computed.
|÷ Required hours||2.5||4||1|
|CM per machine hour||$4||$3||$6|
The company should prioritize producing Product C since it provides the highest contribution margin per machine hour. Next in line is Product A, and then Product B.
Now - assume that based on market research, the estimated demand for Product A is 2,000 units; Product B: 4,000 units; and Product C: 3,000 units. How many of each product should be produced?
1. The company should produce 3,000 units of Product C first. Based on the above analysis, it has the highest contribution margin per constraint. Producing 3,000 units will consume 3,000 of the 10,000 available machine hours. The company will have 7,000 machine hours available for Product A and Product B.
2. Between Product A and Product B, the company shall prioritize the production of Product A since it has a higher CM per machine hour. Producing 2,000 units will require 5,000 machine hours (2,000 x 2.5 hours).
3. After producing Product C and of Product A, only 2,000 machine hours remain. This will be used in producing Product B, which in this case is the least preferred. Only 500 units of Product B can be produced with the remaining machine hours.
With 10,000 available machine hours, the company should produce and sell 3,000 units of Product A, 2,000 units of Product B, and 500 units of Product C to be able to maximize profits.
When a company produces different products that are competing for resources, the business should prioritize those that will result in higher profits.
Fixed costs in most cases are irrelevant since they will be incurred no matter how many of each product is produced. Hence, the product/s with the highest contribution margin per unit of scare resource should be prioritized.