Most businesses have limited capacity, so if you make and sell more than one product, and you are unable to completely fulfil demand for all products, how do you decide which one(s) to prioritise?
When considering this question, it's helpful to quantify the "contribution margin per hour" associated with each product.
"Contribution margin" is simply the sales price per unit of a product, less the variable cost of producing that unit (variable costs are costs that vary depending on the number of units produced; fixed costs, by contrast, do not vary according to production levels.)
Let's illustrate this by comparing two products:
- Product A sells for £100 per unit, the variable cost of production is £40, and it takes 2 hours to make one unit
- Product B sells for £180 per unit, the variable cost of production is £105, and it takes 3 hours to make one unit
The contribution margin for one unit of product A is (£100 - £40) = £60, and it takes two hours to produce one unit so the contribution margin per hour of production is (£60 / 2) = £30 per hour.
The contribution margin for one unit of product B is (£180 - £105) = £75, but it takes three hours to produce one unit so the contribution margin per hour of production is (£75 / 3) = £25 per hour.
Interesting point - product B is more profitable per unit of product, but not per hour of production! We've established that product A has a contribution margin of £30 per hour, and product B has a contribution margin of £25 per hour.
The conclusion? Making product A should be the priority where capacity is limited, because compared to product B, product A contributes more per hour of production towards covering the business's fixed costs.
Continuing our example, let's imagine that for the month ahead our hypothetical business has 300 hours of production capacity, and anticipates demand for 120 units of product A and 50 units of product B.
Prioritising product A, the business is able to make all 120 units, which uses up (120 units x 2 hours/unit) = 240 hours of production time.
This leaves (300 hours - 240 hours) = 60 hours of production capacity to make product B. Therefore the business is able to make (60 hours / 3 hours/unit) = 20 units of product B, leaving the demand for the remaining 30 units unmet.
This approach can be applied to any number of products - I've used just two products to keep the example simple, but you can use it with three, four, or even more. It's still the same principle - prioritise production according to the contribution margin per hour attached to each product, up to the level of anticipated demand.
There can, of course, be many other factors influencing production decisions. I won't pretend otherwise - but where capacity is limited, an analytical approach can result in better decision-making and, ultimately, higher profits.