Product Gross Margin Calculation vs. Product Contribution Margin Calculation
Assigning the overhead costs to the products shows how profitable the products are after deducting all cost. However, it is important to find the appropriate method of overhead cost allocation. In Sippican’s case the traditional accounting method is used, which does not reflect the real resource usage of the different product lines. The correct method in this case would be to apply the time-driven ABC approach for cost allocation. Such method apart from showing the actual profitability after all cost deductions also depicts the differences in resource usage rates between the products and, thus, allows for identification of cost drivers. A contribution margin…show more content… As already explained above, the high per unit cost for flow controllers across the categories are mostly due to on average small batch sizes. For the majority of activities (setup, receiving and production control, partially packaging and shipping) the costs occur independent from the volume, but they do depend on the number of batches. For these reason the total manufacturing overhead per unit cost for valves and pumps are lower than estimated via the traditional accounting method as in these product lines the average batch sizes in production runs as well as in shipments were very high (375/188 for valves and 125/125 for pumps).
Table 5: Cost per Unit
Note: For exact calculations please see the attached excel file.
Recommendations
Flow Controllers
Starting with flow controllers, there are two ways to deal with the negative gross margin. First way would be to keep on producing the flow controllers and increase the batch sizes and thereby reduce the setup- and shipping related cost. If the batch sizes for shipments and production were increased to 25 units, the gross margin would amounts to 8.6% (see excel sheet for precise calculations). To reach the target gross margin of 35% by only adjusting the batch sizes one would have to increase the batch sizes of both shipping and production to 190 units. In reality the increase in
