Question

You have been hired as a consultant for ABC Corporation which produces models X, Y, and Z. The CEO tells you that their cost system indicated that they were losing money on their highest end model, which is model X. Due to that information, ABC Corporation dropped model X the previous year. During the current year, ABC Corporation is only producing models Y and Z. However, the preliminary numbers are showing that the profit for ABC Corporation is actually lower after dropping model X and now the cost system is indicating that they are losing money on model Y even though the prices, volumes, and direct costs are the same. Explain to the CEO some of the possible reasons that dropping model X caused a reduction in profits. Also, explain some of the possible actions the company should take going forward. Would dropping model Y benefit the company in any way? Is it possible that producing a product that is unprofitable by itself actually beneficial to the company overall?  

Answer 1

There are mainly Two costing systems adopted by the companies.

1. Applied overhead rates
2. Activity Based Costing (ABC)

The company was using applied overhead rates based on Labour hours or machine hours or anything which was used to apply overhead rates and as a result, Product X was showing losses.

Let us break it down with an example. Assuming company applies its overhead cost based on how many Direct Labour hours are used in manufacturing of a product. Product X was consuming far much Direct labour hours than product Y and Z and as a result, more overheads were being allocated to product X as they were based on Direct Labour hours consumed. After a study we found that whereas product X requires only a few no pf setups as compared to product Y and Z, hence setup cost should have been allocated on the basis of set up done, not on basis of Direct Labour hours used. Had been Activity Based Costing Applied, the cost allocated to X were much lower than in Overhead rate using Labour hours. Therefore product X was not a loss making product as per ACtivity based costing, but was a contribution making product. The company stopped production of a contributory product and thus company saw a reduction in profits.

Hence the possible reason for which company faced low profits although price and volume for product Y were same, is because of using Predetermined Overhead Rates for allocation of overheads.

In future, the company should move from predetermined overhead allocation system to Activity based Costing System which allocated cost on the basis of cost drivers such as setups, labour hours, machine hours etc and not on the basis of single item such as Labour hours.

The preliminary results showing that product Y is not profitable. The results are also based on predetermined overhead rates and not on ABC. Hence dropping product would not benefit the company. Company needs to ascertain various overhead cost and their cost drivers and then ascertain the real profitability of products, only then a decision could be made which product should be stopped snd which to be continued.

Sometimes it happens a product is non profitable. Example product A which sells for $10 having Variable cost of $5 and selling 1000 units a year and allocaed fixed cost of $10,000. Now the net income from product A arrives at loss of $5,000 which is non profitable. However it is not advised to shut the product because it is providing positive contribution to the company. Had it been stop manufacturing, we shall still incurr loss pf $10,000 ie fixed cost, hence a positive contribution can reduce such loss. Therefore its actually overall benefecial for company despite a loss making product.