Disadvantages of Defined Contribution Pension Plans
Defined contribution plans have come under a lot of criticism because of the various disadvantages that they have. Many of these plans have been viewed as a covert way to absolve the government of any responsibility related to the retirement of its citizens. Given the many other socio-economic factors which are at play, defined contribution […]
Interest Coverage Ratio – Meaning, Assumptions and Interpretation
The interest coverage ratio is a number that has a lot of importance for the creditors of the firm. This number tells them how safe their investments are and how likely they are to get back principal and interest on time. Formula Interest Coverage Ratio = EBIT / Interest Meaning The interest coverage ratio tells […]
The Panaya Acquisition
If mere numbers are considered, Panaya is a small blip on the radar of the global Information technology behemoth Infosys. The deal is valued at only $316 million dollars which is not even 1% of the valuation of Infosys. However, this Panaya acquisition has shaken the company to its core. It has created a rift […]
Extrapolation: The Root Cause behind the Bubbles
They say that there is no smoke without fire. This is true of many things and one of them is asset bubbles. It is true that all asset bubbles begin their initial upward movement based on some genuinely good positive news. However, somewhere along the way, the amount of smoke far exceeds the underlying fire […]
An Introduction to Hedge Funds
The term “hedge funds” have become ubiquitous in the financial markets nowadays. This is a term which incites a strong emotional reaction from all market participants and observers. Some are of the opinion that these funds are evil and endanger the entire market with their reckless risk taking. Others are of the opinion that hedge […]
The cost volume profit analysis has a rogue assumption. This rogue assumption believes that the cost volume profit analysis is completely scalable. We know that this is not the case. We operate in a finite world and have finite resources. We show this in our analysis when we write down the relevant range within which this analysis is valid. So, while performing contribution analysis, we also have to pay attention to the constraints that we have while maximizing production. This is what this article will explain in more detail.
In real life, we cannot go on producing the products with maximum contribution margin. Our sales of this product will be limited by the size of the market. Our production will also be limited by the size of resources. What if production requires a certain number of hours on a particular machine and we have limited number of hours on that machine. We will have to optimize our contribution analysis accordingly.
In this case, we have to shift the focus of our analysis. Instead of focusing our analysis on maximizing the contribution margin, we must focus on maximizing the margin while making minimal use of the resources. This technique is fairly recent in managerial accounting. It has been introduced as an improvement over the older versions of contribution analysis.
In a single constraint contribution, we will try to maximize the output per unit of constraint. For example, A produces $100 of contribution but requires 4 hours on the machine, but B produces $70 in 2 hours on the machine. So here, we will divide the contribution margin, not by sales, but with the hours that it spends on the machine.
So A has a per hour contribution of $25 whereas B has a per hour contribution of $35. Hence, we must allocate more machine hours to B, A must only get the residual machine hours.
Firms usually work with multiple constraints. They can have constraints on sales, on capacity, on know how and many such things. In such case, the decision to optimize the production and sales mix goes beyond the purview of managerial accounting. There is a separate science called operations research which has been developed for this purpose. There are techniques like linear programming problem that help us solve this question. However, since they are beyond the scope of this course and this subject we will not delve into their details.
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