The question is whether the business should stop making a product when it is unprofitable, or continue making the unprofitable product?
If a business makes more than one product (produces more than one good or provides more than one service), Contribution-Costing Technique shows managers which good or service is making the greatest or the lowest contribution towards paying Indirect Costs (Overheads).
By using Full-Costing Technique, we can determine whether a product makes a profit or loss, as we will know the Total Costs (TC), or Full Cost, of making that product after all Indirect Costs (Overheads) are apportioned proportionally.
While any individual product can surely make a loss, it can still make a positive contribution towards paying Indirect Costs (Overheads). This is because contribution only includes Direct Costs and omits Indirect Costs (Overheads).
Should a firm stop making unprofitable products?
Ideally, the business wants to keep making products that both make positive contribution and are making a profit. However, this is not always the case.
When a product makes a loss, the business manager could decide to stop producing that product. The business may not want to continue producing a loss-making product forever as it will lower overall profits.
However, unprofitable products can still be making positive contribution. In this case, it is not worth ending the production of such a product in the short-term. This is because Indirect Costs (Overheads) will still have to be paid. So, this unprofitable product still contributes somewhat towards paying fixed costs although there will be reduced contribution. Ending the production of a good making a positive contribution will also reduce the overall profits of the business.
When a business no longer has the fixed costs of the product then it should stop its production.
An example when the business should not stop making an unprofitable product
The following example illustrates this principle of using marginal costing in deciding whether to stop making a product or not.
A business manufactures two different products – Product A and Product B. Product A has made a loss of USD$2,000 while Product B has made a profit of USD$17,000.
The Marketing manager thinks that the company should stop selling Product A because this product is making a loss for the business. However, the company’s Finance manager who knows about the Contribution-Costing Technique disagrees with the Marketing manager’s claim.
Here is the breakdown of the sales revenue, costs and profit for the production of those two products. Let’s take a look first.
Indirect Costs (Overheads) do not change with the level of output produced, so they will remain at USD$10,000 for Product A and USD$15,000 Product B. Total Indirect Costs (Overheads) for this business are USD$25,000.
So, even though the output produced and sold for Product A is zero, Indirect Costs (Overheads) of USD$10,000 still need to be paid by the business. So, if the company stops producing Product A, it will still have to pay those Indirect Costs (Overheads). The business will not have to pay Direct Costs of Product A of USD$12,000 any longer, and it will lose all the sales revenue from selling Product A.
When the business produces Product B only, the amended data for each product and the company in total looks like this now:
We can see that if the company decides to stop producing Product A, the total profit will fall from USD$15,000 to USD$7,000.
Therefore, the accountant is right to continue the production of Product A. It is because now all of the Indirect Costs (Overheads) will need to be covered from the sales revenue of Product B only, as there is not Product A any longer to bring any revenue.
