R., N. P. Galambos and M. Karlsson. 1997.
Constraint-based profitability analysis: Stepping beyond the theory of constraints.
Journal of Cost Management (July/August): 6-10.
by Dennis Tichio
Master of Accountancy Program
University of South Florida, Fall 2001
ABM Main Page | Profit Analysis Main Page | TOC Main Page
Companies have determined the profitability of their products on an aggregate basis. Providing this information in the aggregate allows investors to make reasonable decisions, but provides no useful information for management. Management must determine profitability on an individual product basis.
based management (ABM) has allowed companies to determine the costs associated
with individual products. This
technique provides useful information to the company. However, this technique cannot be used alone when the company
also experiences constraints. Constraints
must be accounted for. Constraint-based
profitability analysis (CBPA) is the technique of determining a company’s most
profitable product mix with the use of ABM calculations, and constraints or
is the process of identifying the most profitable product mix across certain
capacity constraints, and then implementing a plan to obtain this higher profit
at any given time. The first step
of CBPA is to compute product profitability for each product in a company using
ABM. The ABM profitability per unit
will be used to determine the ABM profitability on an hourly basis across the
product with the highest profitability per hour shall be optimized until all of
the demand for that product is met. Next,
the second most profitable item will be optimized to meet demands.
This process will continue until the constraint or bottleneck’s
capacity is completely used. CBPA
is best used to maximize the constraint for certain products, and allowing those
products to be used in the future. CBPA
is not sufficient for order-based products.
must not only rely on the numbers when determining the most profitable product
mix. Management should also
consider qualitative factors. Management
may choose to produce a less profitable product for a major customer, or produce
products that are new to the market, or early in the product’s life cycle.
Management must also consider the flexibility within a company to change
product mix, and whether the company can alter its resource structure.
Management must also consider the market constraints, which will be
uncontrollable by the company.
ABM as a component of CBPA
provides valuable information for costing products. ABM is necessary for a successful CBPA analysis. Traditional costing systems favor low volume, highly complex products
which are a result of traditional systems allocation of overhead costs. ABM focuses on those costs that are variable with production. ABM can better identify the resources and incremental costs
associated with production.
looks at costs on a long-term basis, which is consistent with CBPA. ABM also identifies costs on a more precise basis than just variable and
fixed. ABM identifies those costs
that have an effect on production volumes and those costs management can change.
ABM also identifies excess capacity costs, and does not factor them into
product costs. This results in more
precise costs, and provides useful information to the company regarding these
CBPA in practice
simple example of CBPA can show the product producing the most profit on a per
unit basis produces the least profit hourly.
A product with the least per unit profitability may produce the highest
case study that implemented CBPA showed surprising results.
The case study was done on a steel manufacturer, and there ultimate
constraint was machine hours on one particular machine.
First, the company needed to cost their products using ABM.
The product costing results from ABM provided different information
regarding per pound profit compared to hourly profit.
Based on the bottleneck, an optimum product mix was developed.
case also provided information in regards to the industry and customers of the
company. Certain factors should be
considered when developing an ultimate product mix. By determining their hourly profits per product, the company
was able to gauge their customers’ needs.
The company was able to enter into a contract that required their most
profitable product. Determining the
costs of some of their less profitable products provided the company with
valuable information. The company
determined outsourcing the product would be more beneficial to their operations.
development of CBPA sometimes develops a related constraint based on the new
product mix. The company must
analyze the new constraint and determine changes that are necessary to increase
profits. Again, in this case the
company chose to maximize the most profitable product, and to outsource the
product they would no longer be able to produce.
CBPA analysis becomes more complex as the number of constraints increases. To handle the added constraints, linear programming must be used.
Linear programming mathematically determines the optimal mix of certain
variables based upon certain equations. There
is a maximum or minimum equation (the objective function), followed by all the equations that identify
capacity constraints. Linear
programming is then capable of determining the optimal mix of products.
CBPA is a valuable technique for companies trying to maximize profits in light of capacity constraints. CBPA allows companies to determine the optimal mix of products that will ultimately maximize the bottom line.