Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
Making Decisions, Determining Costs
Businesses are constantly under pressure to make the best decisions possible. However, there is never a shortage of decisions to be made. From deciding whether or not to continue a product line to deciding how to treat a joint product, companies are constantly trying to make sure that they are maximizing profits while minimizing costs.
This lesson will examine decisions regarding starting or stopping production on a good, outsourcing, using a constrained resource, and understanding how joint product costs can help companies make even more money.
Product Lines and Special Orders
A crucial rule of business is that a company can only be expected to offer a product line if it is profitable. Depending on the stage of the product, this could mean different things. For a product that is just being introduced, the money made from its sale should be enough to cover variable costs, fixed costs, and make a profit.
Meanwhile, if a good has been sold for a while and is facing discontinuation, a company should keep it around only if its sales price is greater than variable costs. That means that it is still contributing money towards fixed costs and profits.
Finally, special orders should be treated like new product lines; they should only be pursued if they are profitable.
Another decision that is driven by a desire to save money is whether to outsource, or allow another company to perform one of your business functions. Here, the analysis is pretty simple: can you save money by having someone else do it all for you?
Distribution is often outsourced. After all, many of us look for only a small number of companies to deliver our packages. Some companies have their own delivery trucks, and this is profitable for them to do so. However, for many companies, the costs of maintaining warehouses, distribution centers, and trucks is simply too much. Instead, they find it cheaper to outsource these tasks.
Using a Constrained Resource
Let's say that you run an ice cream truck. It's the middle of summer, and freezer space on board is limited. In this instance, space is a constrained resource, because it is limited in availability. Of course, your ice cream varieties have different variable costs and take up different amounts of space in your truck. For example, a box of twelve ice cream sandwiches takes up half the room as a box of twelve ice cream tacos, yet while you can make a profit of $1.00 per ice cream sandwich, you can make $2.50 per ice cream taco.
These numbers are known as the contribution margins. By dividing the contribution margin by the area taken up by each box, 1 cubic foot for ice cream sandwiches and 2 cubic feet for ice cream tacos, we can see that each cubic foot of space is most profitable when it is used to sell ice cream tacos. For an ice cream truck driver aiming for profits, that means telling kids that you're all out of ice cream sandwiches.
Joint Product Costs
Finally, we get to joint product costs. Join products are those products that share a great deal of the production process. For example, many electronic tablets are jointly produced. The point at which they are differentiated, for example with different memory capacities, is called the split-off point. This is the point where we can finally find different profit values for each.
As a rule, we should concentrate on whichever side produces the greater profit. For example, let's say that you sold a tablet with 16 gigabytes of memory for $500, and one with 128 gigabytes for $1000. The 128-gigabyte hard drive adds $600 to your base cost of $200, while the 16-gigabyte drive is free. As a result, it is more profitable for you to sell the 16-gigabyte tablet.
In this lesson, we looked at how to use cost determination to make the best business decisions. In short, businesses should always seek to maximize profits while minimizing costs. Minimizing costs can occur by outsourcing, which means to allow another company to perform one of your business functions, or through eliminating product lines that are not profitable.
Meanwhile, maximizing profits can be done by making smart use of both joint products and constrained resources. Remember that a constrained resource is one that is only available in limited quantities. Also, it is the contribution margin, or difference of price and variable cost, which helps us determine just how to make the best use of those constrained resources.
Finally, we have to be careful when analyzing products with joint product costs, when they share a great deal of the production process, in order to make sure that we keep the split-off point, or place where the products have different profit values, in mind.
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