Financial Modeling: Important Metrics
Financial modeling can be considered to be the science of making informed decisions regarding a company based on data simulations. Most financial models pay keen attention to a variable such as revenue and expenses as well as their drivers. Data regarding these variables is extensively collated as well as analyzed. However, it turns out that […]
Scalability and Startups
Scalability is considered to be a very important factor in any start-up company. Investors all over the world are highly impressed by scalable business models and prefer investing in the same. However, many people in the start-up community still do not have a clear idea about what scalability is. In this article, we will have […]
The Financial Independence Retire Early (FIRE) Movement
In the previous article, we learned about financial freedom or financial independence. However, in the traditional financial planning world, financial freedom was only considered to be a goal that is to be reached towards the end of one’s career. The general opinion was that financial freedom has to be reached when a person has attained […]
Leasing in Infrastructure Finance
In the previous article, we have studied about how vendor financing is being used as an alternate mechanism of finance in the infrastructure financing community. Similarly, leasing is also being used as a method of raising finances for infrastructure projects. Leasing is primarily used because this method allows conserving capital as well as provides many […]
The Role of Government in Financial Systems
In the previous articles, we have already established that the financial system of any country is the key to its economic prosperity. It is for this reason that these financial systems need to be appropriately maintained. The government is the party that is most suited to this maintenance of financial systems. However, too much government […]
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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