Question

How do you determine how to allocate constrained resources to maximize income?

How do you calculate the effects on operating income of keeping or eliminating operations?

Answer 1

In order to maximize profits when resources are limited, a company must produce the product(s) with the highest contribution margin per unit of limited resource. There are two steps involved in selecting the most profitable use of the limited resource.

Step 1: The contribution margin (CM) per unit of the scarce resource is calculated for each product by dividing the amount of resource required for each unit of product into the contribution margin.

CM per limited resource =	Contribution margin per unit of product
	Resource needed per unit of product

Step 2: Rank the products and select the product with the largest contribution margin per unit of limited resource. This is the product for which the company will produce the most units.

Companies should generally not drop products when overall company products are expected to decline. If there is no expected change in demand of other products, the company's overall profit will always be less if a product is dropped than if the product is kept in operations. This is due to allocated fixed costs that are not avoidable. Soft-benefits, also known as qualitative issues, should be considered as well.

If incremental revenue lost equals incremental cost savings, qualitative effects must be used to make the decision.

If incremental cost savings is less than incremental revenue lost, the product should not be dropped, unless qualitative characteristics overwhelmingly impact the decision.