People set up businesses to make profits.
Often, profits are outcomes of judicious allocations of scarce resources to competing products and services.
It’s not always easy to make profits when a business has competing products, screaming for scarce resources. A business in such a situation has to use a reliable formula to ensure survival, continuity and growth. The most reliable formula is the one that helps the business to take appropriate optimal product mix decision.
What is optimal product mix decision?
Optimal product mix decision is following the process that helps a business to identify the appropriate product mix that maximizes total contributions to the business by the available limited resources.
The application of optimal product mix approach is determined by the nature of the constraints (scarce resources).
What are the basic constraints?
They are basically two:
1. Single constraint and,
2. Multiple constraints.
(A) A single constraint or a key limiting factor situation arises when, a resource is limited is the midst of other factors are adequately available and, are maximally contributing to the profitability of the product mix.
When this happens, the contribution margin per key limiting factor approach is used.
And the following steps are taken to reach the optimal product mix decision;
1. The appropriate identification of the key limiting factor among other factors by comparing the budgeted resources and units to available resources and units,
2. The calculation of cost per unit, contribution per unit and savings made by producing each product,
3. The division of the contribution or savings per unit by the key limiting factor per unit,
4. Ranking the results of the division in (3) above in descending order,
5. Diving the budgeted sales by corresponding selling prices to identify the maximum units required by each product line,
6. Identification of management priorities before,
7. Preparing an allocation template, allocating identified key factor among competing product lines and identifying the optimal product mix.
(B) Multiple constraints situation arises where the supply of two or more resources of a business is limited. The linear programming technique is often applied to remedy this situation.
The appropriate approach to use in a multiple constraints situation is to find out the factors that make it difficult to meet maximum demand.
After the identification of maximum sales demand for a business’s products, earning abilities of all limiting factors should be ranked (based on their contributions- the excess of selling price per unit over variable cost per unit) and the contribution that meets the sales demand unit is the maximizing.
In a situation where a business’s limiting factor on sales or production is not a scarce resource, the business would have to make available more than the level determined by contribution per unit of limiting factor ranking.
The optimal product mix must however, recognize minimum production requirements.
A business may have a situation of non- scarce resource limiting factor when it has to do all it could to maintain goodwill (incidentally a crucial intangible asset), maintain market share of some of its products and meet contractual agreements.
