Can profits increase when overall volume goes down?

Product X
D-1 5 min/unit

Product Y
D-2 29 min/unit

RM R5-00 Unit

C-1 5 min/unit

C-2 12 min/unit

B-2 5 min/unit

A-1 5 min/unit

B-1 17 min/unit

A-2 27 min/unit

RM R5-00 Unit

RM R15-00 Unit

1. One of each resource; cannot substitute for each other 2. Each resource available for 2400 minutes per week 3. Fixed cost is R5 000-00 per week for the four resources

The correct way to solve this problem: 1 Calculate the load on each resource (to determine whether the constraint is internal not enough capacity to meet demand or external the market does not have enough capacity to buy leading to having excess capacity internally) A = 84 (5) + 66 (27) = 2202 min B = 84 (17) + 66 (17 + 5) = 2880 min C = 84 (5 + 12) + 66 (12) = 2220 min D = 84 (5) + 66 (29) = 2334 min B is the constraint, not having sufficient capacity to meet demand. 2 Calculate the most profitable product using the throughput rate
Product X R50-00 per unit R10-00 per unit R40-00 per unit 17 minutes R2-35 per constraint min Product Y R75-00 per unit R20-00 per unit R55-00 per unit 22 minutes R2-50 per constraint min

Selling price True variable cost Contribution margin Constraint time Throughput rate

Y is the most profitable since it makes profits faster than X considering the limited capacity of resource B. 3 Calculate the qty of the least profitable product since we are going to maximise the qty of the most profitable one, which is Y as per calculation in step 2 above. Since B is constraining the overall volume, only Bs limited capacity will be used for this calculation. Since Y is the most profitable, we will maximise its qty namely 66. Making 66 of Y on B will require 66 (22) = 1452 minutes from B. That leaves 2400 min 1452 min = 948 minutes to produce X. Since one of X takes 17 min on B, we will be able to produce 948/17 = 55.76 units of X. Since we are paranoid times 2, but not hysterical, we round it down to 55 units. Optimum mix is thus 55 of X, 66 of Y. (Total volume = 121 units) 4 Calculate the profit NP = Vol (SP- VC) FC = 55 (50 10) + 66 (75 20) 5000 = 2200 + 3630 5000 = R830/week

NO NEED TO CALCULATE COST PER UNIT

The wrong way to do it: 1 Calculate the load on each resource (to determine whether the constraint is internal not enough capacity to meet demand or external the market does not have enough capacity to buy leading to having excess capacity internally) A = 84 (5) + 66 (27) = 2202 min B = 84 (17) + 66 (17 + 5) = 2880 min C = 84 (5 + 12) + 66 (12) = 2220 min D = 84 (5) + 66 (29) = 2334 min B is the constraint, not having sufficient capacity to meet demand.

2 Calculate the most profitable product R5000 buys 4 resources X 2400 minutes each. Cost per minute = R5000/9600 min = R0.52083333 per minute
Product X R50-00 per unit R10-00 per unit R40-00 per unit 44 minutes R32.916665 per unit R17.083335 per unit Product Y R75-00 per unit R20-00 per unit R55-00 per unit 90 minutes R66.874997 per unit R8.125003 per unit

Selling price True variable cost Contribution margin Capacity required Cost per unit Profit per unit

X is the most profitable since it is the cheapest to make and provides the highest unit profit margin.

Calculate the qty of the least profitable product since we are going to maximise the qty of the most profitable one, which is X as per calculation in step 2 above. Since B is constraining the overall volume, only Bs limited capacity will be used for this calculation. Since X is the most profitable, we will maximise its qty namely 84. Making 84 of X on B will require 84 (17) = 1428 minutes from B. That leaves 2400 min 1428 min = 972 minutes to produce Y. Since one of Y takes 22 min on B, we will be able to produce 972/22 = 44.18 units of Y. Since we are paranoid times 2, but not hysterical, we round it down to 44 units. Optimum mix is thus 84 of X, 44 of Y. (Total volume = 128 units)

4 Calculate the profit NP = Vol (SP- VC) FC = 84 (50 10) + 44 (75 20) 5000 = 3360 + 2420 5000 = R780/week

NB. Key learnings: 1 Volume does not drive profitability, throughput rate does. With a lesser volume of 121 units more profit is made R830/week than with a higher volume of 128 units, where only R780/week is made. 2 Even though Y takes longer on the constraint than X, it is still more profitable. Also, Y takes more than double the amount of capacity than X (90 min vs. 44 min). 3 Making a profit (R790/week) does not indicate optimum profit. 4 Allocating fixed costs do no change fixed costs. 5 Profit improvement is possible without spending any money. 6 Cost per unit does not exist, it is a mirage*.

* A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects or the sky. The word comes to English via the French mirage, from the Latin mirare, meaning "to look at, to wonder at". This is the same root as for "mirror" and "to admire". In contrast to a hallucination, a mirage is a real optical phenomenon which can be captured on camera, since light rays actually are refracted to form the false image at the observer's location. What the image appears to represent, however, is determined by the interpretive faculties of the human mind. For example, inferior images on land are very easily mistaken for the reflections from a small body of water. Source: http://en.wikipedia.org/wiki/Mirage Similarly, cost per unit is a real business phenomenon which can be can be calculated, since the underlying components (fixed costs and variable costs) exist in reality. The allocation of costs however distorts the actual costs to form the false perception of profitability or nonprofitability of a product/service. What the cost per unit appears to represent, however, is determined by the interpretive faculties of the human mind. For example, cost per unit is very easily mistaken for real costs incurred (or not incurred) for a given business decision. Source: Pieter Pretorius, recognising the source above as well for any similarities in wording.