COST AND MANAGEMENT

UNIT 2 SECTION 3 PRODUCT MIX DECISIONS

ACCOUNTING Unit 2, section 3: Product mix decisions

One of the more common decision-making problems is a situation where

there are not enough resources to meet the potential sales demand, and so a
decision has to be made about what mix of products to produce, using the
resources available as effectively as possible.

By the end of the section, you should be able to:

 define product mix
 choose optimum product mix when faced with one constrained resource
 choose optimum product mix when faced with multiple constrained
resources

Now read on.......

Most organisations have wide flexibility in choosing their product mix.

Decisions about product mix can have a significant impact on an
organisation’s profitability. Each Mix represents an alternative that carries
with it an associated profit level. A manager should choose the alternative
that maximises total profit. Since fixed costs do not vary with activity level,
the total fixed costs of a firm would be the same for all possible mixes and,
therefore, are not relevant to the decision. Thus, a manager needs to choose
the alternative that maximises total contribution margin.

For example, assume that Kwansash Company produces two types of gears:
X and Y, with unit contribution margins of GHC75 and GHC30,
respectively. If the firm possesses unlimited resources and the demand for
each product is unlimited, then the product mix decision is simple – produce
an infinite number of each product. Unfortunately, every firm faces limited
resources and limited demand for each product. These limitations are called
constraints. A manager must choose the optimal mix given the constraints
found within the firm.

Assuming that Kwansash can sell all that is produced, some may argue that
only Gear X should be produced and sold since it has the larger contribution
margin. However, this solution is not necessarily the best. The selection of
the optimal mix can be significantly affected by the relationships of the
constrained resources to the individual products. These relationships affect
the quantity of each product that can be produced and, consequently, the
total contribution margin that can be earned.

Single Constrained Resource

The assumption above with Kwansash Company is an example of once
constrained resource. It must, however, be noted that the presence of only
one constrained resource may not be realistic in most large organisations.

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Example 3.1
Kwansash Company produces two types of gears, X and Y, with unit
contribution margins of GHC75 and GHC30 respectively. Each gear must
be notched by a special machine. The firm owns eight machines that
together provide 40,000 hours of machine time per year. Gear X requires
two hours of machine time, and Gear Y requires 0.5 hour of machine time.
There are no other constraints.

You are required to

 determine the contribution margin per hour of machine time for each
gear.
 determine the optimal mix of gears.
 determine the total contribution margin earned for the optimal mix.

Solution 3.1
a.
Gear X Gear Y
Contribution margin per GHC 37.5 GHC60
Hour of machine time (75 / 2) (30 / 0.5)

b.
Sine Gear Y yields GHC60 of contribution margin per hour of machine
time, all machine time should be devoted to the production of Gear Y.

Units Gear Y = 40,000 total hours / 0.5 hour per Gear Y = 80,000 units.

The optimal mix Gear Y – 80,000 units and Gear X – 0 units.

c. The total contribution margin of optimal mix = (80,000 units Gear Y) x

GHC30 = GHC2400,000

Multiple Constrained Resources

Organisations face multiple constraints: limitations of raw materials,
limitations of skilled labour, limited demand for each product, and so on.
The solution of the product mix problem in the presence of multiple
constraints is considerably more complicated and requires the use of a
specialised mathematical technique known as linear programming, which is
reserved for advanced cost management courses.

Exercise
Kwansash Company produces two types of engines, Snowmobile engine
and Boat engine, with unit contribution margins of GHC25 and GHC10
respectively. Each engine must be notched by a special machine. The firm
owns eight machines that together provide 20,000 hours of machine time
per year. Snowmobile engine requires 8 hours of machine time, and Boat

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ACCOUNTING Unit 2, section 3: Product mix decisions

engine requires 2 hour of machine time. A maximum of 50,000 units of each

engines can be sold.

Required
a. What is the contribution margin per hour of machine time for each
engine?
b. What is the optimal mix of engines?
c. What is the total contribution margin earned for the optimal mix?

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