Question

In deciding which product to make in the context of a Product Mix, The "Theory of Constraints suggest that.  a) The company should produce the product with the highest contribution margin b) The company should produce the item with the highest gross profit c) The company should produce the item with lowest costs d) The company should produce the item with highest contribution margin per the unit of constraints.

Answer 1

Answer)

The theory of constraints is applicable in cases where availability of resources (Like, Raw Materials, Labor hours, Machine hours, etc.) is less than its requirement to fulfill the maximum demand of each product and additional resources cannot be arranged in that given period (Say a month). It is applicable where an organization is engaged in production of more than one products.

The correct answer is: (d) The Company should produce the item with highest contribution margin per unit of constraint.

The same can be explained with the help of following illustration:

For example, if a company produces 2 products Product A and Product B. next suppose Product A has a contribution margin of $ 100 per unit and that of Product B is $ 80 per unit. Material used in production of both products is available in limited quantity so that the maximum demand of both products can’t be fulfilled. Product A uses 2 kilograms of Material and Product B uses 1 Kilogram of Material. In the given scenario, it can’t be concluded just on the basis of contribution margin per unit. Though the contribution margin per unit of product A is higher than that of Product B, but it uses more raw material in comparison to Product B.

In the given scenario contribution margin per Kilogram of raw material should be used to ascertain profitability of both products.

Product A:

Contribution margin per Kilogram of raw material for Product A = Contribution margin per unit of product A / Raw material consumed in each unit of product A

                                                                                                        = $ 100 per unit/ 2 Kilograms

                                                                                                        = $ 50 per Kilogram

Product B:

Contribution margin per Kilogram of raw material for Product B = Contribution margin per unit of product B / Raw material consumed in each unit of product B

                                                                                                        = $ 80 per unit/ 1 Kilograms

                                                                                                        = $ 80 per Kilogram

Thus product B having higher contribution margin (i.e. $ 80 per kilogram) should be produced first and balance resources should be utilized in production of Product A.

JUSTIFICATIONS:

(A) The company should produce the product with highest contribution margin: This option is incorrect as it does not include the limiting factor in calculation of profitability.

(B) The company should produce the Item with the highest gross profit: This option is incorrect as gross profit is calculated by reducing cost of goods sold from Sales and since several fixed costs are also included in the cost of goods sold, the same can’t be used as it may give distorted results.

(C) The company should produce the item with lower costs: This option is incorrect as it does not include Selling price per unit (and thus contribution margin per unit analysis is eliminated) and limiting factor in eligibility calculation.

(D) The Company should produce the item with highest contribution margin per unit of constraint: This option is correct as an evaluation based on contribution margin per unit of constraint/ Limiting factor will result in optimum utilization of resources by giving priority in producing the product having higher contribution margin per unit of limiting factor over the ones having lower contribution margin per unit of limiting factor and thus the overall contribution margin will be maximized (refer illustration above).