[gskang]

I have a practical problem to which I need the suggestions. Supoose in a company, a product (say product A) is manufactured. This product is obviously also absorbing some overhead costs as well. Now after manufacturing the product, we have some by-products which are used to manufacture another products (say Product B and Product C) in company. These new products are also absorbing some overheads. However after few months, the company realize that these products (Product B and Product C) which were made by by-products are continuously giving the loss. My question is: is it a good idea to stop manufacturing those products (Product B and Product C)? Because if the company do so, the overheads cost (which were earlier absorbed by these products) will go to another products (say D, E , F.. ) and may make some other products look bad too and so on. If not, what can company do in this case?

[ArcSine]

First determine if total overhead would remain unchanged if production of B and C were discontinued (usually the case).

Then, if B's and C's selling price exceeds their direct production costs (i.e. those costs which would go away if their production was discontinued) then B and C are making a positive contribution to profit (or equivalently, helping to reduce an overall loss).

Making a go/no-go decision on a single product solely on the basis of its P/L numbers after allocating a piece of nondiscretionary overhead, can be misleading.

[gskang]

Thanks ArcSine, I really appreciate your answer.

Now can you please let me know what do you mean by direct production costs? Because I can think of only one direct production cost which is cost of raw materials. As these products B and C are made only by using the by-products of product A, their raw material cost includes the overhead costs of Product A and how can I calculate the real raw material cost for these products? This is why it it difficult for me to proceed in the right direction. Any idea?

[ArcSine]

Think "with and without". Anything that changes as a result of discontinuing production of B and C is relevant to the analysis; anything that doesn't change is irrelevant.

Not knowing the specifics of the manufacturing process and the company itself, I can only offer examples.

It appears at first glance that the raw materials for B and C are zero-cost, as they are produced as a consequence of producing A. But if those byproducts could instead be sold (say, for $1 per unit) in the scrap market, if they weren't used in producing B and C, then the forgone scrap revenue is a valid "cost" of producing B and C.

Since those byproducts don't magically assemble themselves into B and C while the factory is away for the weekend, there's some kind of 'conversion' costs being incurred (labor, machine time, etc.). To the extent that any of those costs could be curtailed if B and C were discontinued, such costs also are relevant "costs" of producing B and C.

Perhaps, for example, discontinuing B and C would idle a couple of machines (such machines having no other use) which could be sold in the used market. And the insurance on those machines could be dropped. Or maybe plugging the plug on B and C would free up a couple of assembly-line workers.

Just examples, but you get the idea. Think of anything that would change as a result of taking B and C out of production. The cost savings of any such changes are the relevant costs of choosing to continue producing B and C. And it's this total that needs to be compared to the revenue B and C brings in for the company.