Profit Maximization with Throughput

Profit Maximization with Throughput

1.    Increasing Throughput

Profit can be maximized by increasing throughput, because all other cost are fixed, therefore increase in throughput would have direct impact on profit. In this regard key constraint should be identified & removed.

2.    Reducing Operating Expenses

Profit can also be improved by reducing the operating expenditures. Each and every item is falls under the operating expenditure other than direct material. These items could be analyzed in depth for control purposes.

3.    Reducing Investment

Inventory is treated as investment and there is lot of cost associated with investment. Capital tied up cost, storage cost etc. This investment should be reduced for profit maximization.

Theory of Constraint & throughput

Theory of Constraint & throughput

1.    Maximum Profit with Maximum throughput

Throughput accounting reveals that profit can be maximized by increasing throughput i.e. sales- variable cost (material).

2.    Maximization is not possible for constraint

Unlimited maximization is not possible due to different constraint. Constraint is a factor which limit to a something. Constraint of sales orders, constraint of production capacity.

3.     Removing Constraint

Profit can be improved by identifying & removing a key constraint. Key constraints should be identified, and then effort should be made to remove that constraint.

4.    One constraint is replaced by another

Theory of constraints says that one constrains is replaced by another constraint. It means once you remove one constraint, it will improve your profit, but soon a new constraint will appear.

5.    Always a Constraint

There is always a constraint that limits the throughput; otherwise the throughput would be unlimited.

Advantages of product life Cycle

Advantages of product life Cycle

1.    Understanding profitability

Product life cycle costing helps in understanding & predicting the profitability of the product during the different stages and as whole (during the life cycle).

2.    Cost analyses

Product life cycles break down the cost at different stages. This provides a better understanding of cost to be incurred at different  stages. These costs understand helps management to adopt appropriate strategy for controlling those costs.

3.    Pricing

Product life cycle costing is very helpful to adopt appropriate pricing strategy for different phases. It explains that each stage require price reconsideration.

4.    Future planning

Product life cycle costing is a kind of future planning for the product. Therefore product life cycle costing may be used as planning tool for the future. Product life cycle costing itself provides grounds for product planning. b

Stage of Product Life Cycle

Stages of Product Life Cycle

1.    Research & Development Stage

During this stage product is developed, most of the cost in this stage is capital in nature.

2.    Introduction Stage

Next stage is launching of product in the market. At this stage a lot of advertising activity is required. At this stage product is being produced at low quantity, therefore unit cost will be high, while profitability will be on lower side.

3.    Growth Phase

At this stage the large production will be made to meet the customer demand. Large production will lower the unit cost and therefore profitability would be at higher side.

4.    Maturity Phase

At this stage organization will try to maintain its market share. The product will be still making good profits at this stage.

5.    Decline phase

In this stage demand for the product start to fall and therefore profit will be shrinking. The firm will start preparation for exist and existing inventory will be sold. Firm continue to produce the product till the point selling price is more than variable costs.

6.    Withdrawal Phase

In this stage organization stops producing the product and incur necessary cost for the withdrawal.

Types of product life Cost

Types of product life Cost

1.    Acquisition or Development Cost

Cost which incurred for the development to product is regarded as development costs. These include all costs which incurred till the product is ready for sales.

2.    Operational costs

These are cost incurred during the life of product i.e. (number of year it remained in market).

3.    End of life cost

These costs include the withdrawal cost of product.

Product Life Cycle Costing Concept

Product Life Cycle Costing Concept

Product life costing the cost of an asset or product is determined for a whole period i.e. product life cycle. Therefore product life costing is also termed as whole life costing.

Product life Costing objective

Product life costing is basically the depth analyses of the costs of product at different stages of its life. These cost analyses helps management to decide the pricing, profitability of the product.

Product life costing suitability

1.    Product

Product life costing is suitable for a product which is introduced, sold for several years and eventually left from the market.

2.    Asset

Product life cycling is suitable for a construction of an asset, which cost changes with the period.

Techniques of Reducing Cost Gaps

Techniques of Reducing Cost Gaps

1.    Product Re-Design

First method of filling the cost gap is to re-design the product. Some features may be removed from the design of product. Usually features which add no value to the customer are removed.

2.    Review Supply Chain

Second method of reducing gap is reviewing the chain supple. This includes negotiation with supplier for reducing the cost of the supplied material. Direct purchases from the producer of material may also reduce cost. Supplier may be ready to offer a bulk discount for large amount of purchases.

3.    Economies of Scale

Third method of reducing gap is to produce large quantity of product. It will reduce the unit fixed cost and thus the total product cost will also reduce, which would ultimately reduce the Cost gap.

4.     Advance Methods of production

Fourth method of reducing gap is to use advance production techniques. It is believed that modern techniques are more cost efficient.

5.    Improve Efficiency

Fifth method of reducing gap is to improve efficiency of staff. The staff efficiency can be improved by training and introducing the incentive based remuneration packages

Target Costing Process

Target Costing Process

1.                            Design

First step target costing is to study the Design and customer requirement are in detail. A product design is selected as per requirement of the customer. New feature are incorporated as per requirements of customers.

2.    Target Cost is set

Target cost is set for product keeping in view the price & profitability .it means target cost is calculated by subtracting profit from the selling price i.e. Target cost= selling price – desired profit level.

3.    Initial Development

Produce is initially developed keeping as per designed. The first designed is ordinarily not the final product and number of adjustment is required.

4.    Initial Development Cost & target cost

Initial development cost of product is compared with set target cost for identification of any gap in cost. If development cost exceeds the target cost, then there is cost Gap.

5.    Cost Gap is removed

Cost gap is removed by number of ways including changing the design, reviewing the supply chain, economies of scale, efficient method production.

Target Costing Steps

Target Costing Steps

Target Cost establishment consist of three steps. Target cost establishment may also be referred as target cost setting or target cost calculation.

1.    Price Determination

In First place the price of a product is decided. The product price is decided keeping in view the target market and competitive prices of close product.

2.    Profitability

Second step for establishing the target cost is to determine desired level of profit. Every business is operated for the profit and therefore a desired level of profit is to be incorporated for calculating target price.

3.    Target Cost

In third step target cost is set. The target cost is set by simple mathematical calculation i.e. selling price minus desired profit or profit rate.

Disadvantages of ABC Costing

Disadvantages of ABC Costing

Disadvantages of activity based costing may be explained in terms of complexity, cost driver identification & selection, all cost coverage, and number of activities;

1.    Complex System

First disadvantage of ABC costing is its complexity. Activity based costing is a complex system of identification of activities and cost drivers and require extensive business experience and deep understanding of the business.

2.     Cost Driver Identification & Selection

Activity based costing implementation requires technical knowledge and extensive business experience. A number of factors are to be considered while deciding the appropriate cost driver. There may be more than cost driver for single activity, which may further complicate the selection of cost driver.

3.    Extension of absorption costing

Activity bases costing are just a complex extension of absorption costing and basic technique of absorption rate is still applicable in the activity based costing. There is more than one absorption rate in activity based costing as compared to single absorption rate in absorption costing.

4.    All Costs Coverage

In activity based costing, Identification of activities to cover all cost is difficult process. There are number of single costs in the organization. For example factory rent, and therefore identification & selection of activities of all those single costs are neither practical nor rational.

5.    Activities Number

In activity based costing, how many activities will cover the cost is difficult task. Too many activities will complex the absorption process, while too little number will not cover all the cost. A lot of experience and working is required to determine the exact number of activities.

Advantages of ABC Costing

Advantages of ABC Costing

Advantages of activity based costing can be explained in terms of improved business knowledge, identification of key areas, and fair allocation of overhead, accurate product costing.

1.    Depth knowledge of business

Activity based costing provides detail knowledge of different types of activities in the organization and their contribution to a core cause of the organization i.e. profit maximization. The depth knowledge about activities and their role improves management overall understanding about business.

2.    Identification of Key Business Areas

Second advantage of activity based costing is its identification of key areas of the organization. This provides management useful information for controlling & planning. If management wants to control cost, it must focus on the areas responsible for major cost.

3.    Fair Allocation of Cost

Third advantage of activity based costing is fair allocation of cost.ABC costing is based on more fair allocation of resources especially in case of product cost. This vary reason that it activity based costing is preferred over absorption costing, which offers very general absorption methodology.

4.    Accurate Product Costing

ABC costing is more realistic allocate the absorption cost to the product. Each product is charged with the cost with level of activity used for its production. It is helpful to determine the accurate cost of a product

Conditions for ABC Costing

Conditions for ABC Costing

1.    Valuation at Full Cost

Activity based costing may be an option, when inventory is to be valued at full cost. Only activity based costing and absorption costing can be used for such stock valuation (full product cost valuation).

2.    Product Differ

Activity based costing is suitable, where product substantially differ from each other. This methods is also preferred, when product are produced as per customer specification. It is appropriate that different product is charged overhead on the bases of resource utilization.

3.    Low Labour Cost

Activity based costing is preferred for products, which have lower labour cost as compared to overhead costs.

4.    Production Value Differ Substantially

Activity based costing is also preferred for businesses, where production volume of different goods differ substantially, therefore activity based costing can be used for more appropriate absorption.

ABC Activities Identification

ABC Activities Identification

1.    Activities Generate cost

All activities which are responsible for creating or generating cost are identified. These activities include production process, material handling, etc. it is important that all major cost generating activity are identified, otherwise, this costing will not work.

2.    Production is key area

It is important to remember that production will remain the key area for identifying the activities. Many activities would be relating to production. However, some activities may fall outside the production area.

3.     Number of activities

A reasonable number of activities will be identified to cover all the cost. What is the reasonable number, it depends on the nature of business. General criteria are to identify all major activities which are responsible for major costs.

4.    Too many activities are complex

Identifying too many activities will make the absorption process complex and time consuming. It would be difficult to use too many cost centers for accumulation of cost and then absorption of such accumulated costs.

5.    Too little activities will not cover the cost

Identifying too little activities will not cover the cost and therefore purpose will not be served. Business knowledge and experience of the business and industry is key factor for deciding right number of activities

Advantages of Marginal Costing

Advantages of Marginal Costing

Advantages of marginal costing may be explained in terms of basic economic decision of profit maximization, decision making, profitability manipulation, and controlling of costs.

1.    Basic Economic Decision

First advantage of marginal costing is its offered explanation for continued production until marginal cost is less than marginal profit. Thus entity can maximize its profit or reduces losses till marginal cost equal to marginal revenue.

2.    Decision Making

Second advantage of marginal costing is its support for basic decision making. Marginal costing facilitates break even analyses, margin of safety analyses, desired profitability etc.

3.    Link between Sale Price, Volume, Cost

Third advantage of marginal costing is its linkage creation between sale price, variable cost and volume of sales. Marginal costing explains that how these factors contribute to the profitability of the organization.

4.    Profitability cannot be manipulated

Fourth advantage of marginal costing is its limited role in profitability manipulation. In marginal costing stock value cannot be easily manipulated, because fixed costs are not part of stock valuation. Therefore profitability cannot manipulate with stock valuation manipulation.

5.    Controlling of Costs

In marginal costing cost are divided into variable costs (controllable) and fixed cost (uncontrollable). This classification helps management to focus on the cost, which can be controlled.

Disadvantages of Marginal Costing

Disadvantages of Marginal Costing

Limitation of marginal costing may be explained in term of total cost & price setting, preparation of financial statement, fixed cost ignorance.

1.    Total Cost & Pricing

In marginal costing full cost of the product may not be determined. Therefore price cannot be set on the bases of marginal costing. If fixed costs are major cost, then wrong pricing decision may result in heavy losses.

2.    Financial Statement Preparation

Marginal costing does not support preparation of financial statement, because financial can only be prepared with accurate stock valuation.

3.    Fixed cost cannot ignored

In marginal costing fixed cost is not taking into account for product cost. This methodology is not rationale, because in many industries fixed cost forms a major portion of product cost.