Accounting: The Language of Business - Vol. 1 (Part 153)

If Jesus Christ were to sit down with us and ask for an accounting of our stewardship, I am not sure He would focus much on programs and statistics. What the Savior would want to know is the condition of our heart. He would want to know how we love and minister to those in our care, how we show our love to our spouse and family, and how we lighten their daily load. And the Savior would want to know how you and I grow closer to Him and to our Heavenly Father.

Dieter F. Uchtdorf

Differential Analysis and Product Pricing (Part H)

by

Charles Lamson

Product Profitability and Pricing Under Production Bottlenecks

An important consideration influencing production volumes and prices is production bottlenecks. A production bottleneck (or constraint) occurs at the point in the process where the demand for the company's product exceeds the ability to produce the product. The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on a process.

Product Profitability Under Production Bottlenecks

When a company has a bottleneck in its production process, it should attempt to maximize its profitability, subject to the influence of the bottleneck. To illustrate, assume that Snap-Off Tool Company makes three types of wrenches: small, medium, and large. All three products are processed through a heat treatment operation, which hardens the steel tools. Snap-Off Tool's heat treatment process is operating at full capacity and is a production bottleneck. The product contribution margin per unit and the number of hours of heat treatment used by each type of wrench are as follows:

The large wrench appears to be the most profitable product because its contribution margin per unit is the greatest. However, the contribution margin per unit can be a misleading indicator of profitability in a bottleneck operation. The correct measure of performance is the value of each bottleneck hour, or the contribution margin per bottle neck hour. Using this measure, each product has a much different profitability when compared to the contribution margin per unit information, as shown in Exhibit 11.

The small wrench produces the most contribution margin per bottle neck (heat treatment) hour used, while the large wrench produces the smallest profit per bottleneck hour. Thus, the small wrench is the most profitable product. This information is the opposite of that implied by the unit contribution margin profit.

Product Pricing Under Production Bottlenecks

Each hour of a bottleneck delivers profit to the company. When a company has a production bottleneck, the contribution margin per hour of bottleneck provides a measure of the product's relative profitability. This information can also be used to add just the product price to better reflect the value of the product's use of a bottleneck. Products that use a large number of bottleneck hours per unit require more contribution margin than products that use few bottleneck hours per unit. For example, Snap-Off Tool Company should increase the price of the large wrench in order to deliver more contribution margin per bottleneck hour.

To determine the price of the large wrench that would equate its profitability to the small wrench, we need to solve the following equation:

$90 = Revised price of large wrench - $40 / 8

$720 = Revised price of large wrench - $40

 $760 = Revised price of large wrench

The large wrench's price would need to be increased to $760 in order to deliver the same contribution margin per bottleneck hour as does the small wrench, as verified below.

At a price of $760, the company would be indifferent between producing and selling the small wrench or the large wrench, all else being equal. This analysis assumes that there is unlimited demand for the products. If the market were unwilling to purchase the large wrench at this price, then the company should produce the smaller wrench. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1,008-1,009*

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