Variable Costing in Action
The preceding illustration highlights a common problem faced by many businesses. Consider the plight of a typical airline. As time nears for a scheduled departure, unsold seats represent lost revenue opportunities. The variable cost of adding one more passenger to an unfilled seat is quite negligible, and almost any amount of revenue that can be generated has a positive contribution to profit! An automobile manufacturer may have a contract with union labor requiring employees to be paid even when the production line is silent. As a result, the company may conclude that they are better off building cars at a "loss" to avoid an even "larger loss" that would result if production ceased. Professional sports clubs will occasionally offer steeply discounted tickets for unpopular games. Obviously, the variable cost of allowing someone to watch the game is nominal. Countless such examples exist in business. Likely, variable costing information is taken into account in making the decisions relating to the examples just cited. Each decision is intended to be in the best interest of the entity, even when a full costing approach causes the decision to look foolish.
A Double-Edge Sword
A typical textbook illustration of decision making based on variable costing data looks simple enough. But, such decisions are actually very tricky. Considerable business savvy and discipline are necessary, and there are several traps that must be avoided. First, a business must ultimately recover the fixed factory overhead and all other business costs; the total units sold must provide enough margin to accomplish this purpose. It would be easy to use up the full manufacturing capacity, one sale at a time, and not build in enough margin to take care of all the other costs. If every transaction were priced to cover only variable cost, the entity would quickly go broke. Second, word gets around ... if a company offers special deals on a selective basis, other regular customers may become alienated or start to hold out for lower prices as well. The key point here is that variable costing information is useful, but it should not be the sole basis for decision making.
Avoiding a Downward Spiral
Variable costing data is quite useful in avoiding incorrect decisions about product discontinuation. Many businesses offer multiple products. Some will usually be more successful than others, and a logical business decision may be to focus on the best performing units, while discontinuing others.
Consider the data below. This company offers three products (A, B, and C). Each is being produced in equal proportion, and the company is fully able to meet customer demand from existing capacity (i.e., producing more will not increase sales). The company is not incurring any other variable costs relating to selling, general, and administration efforts. From the absorption costing data shaded in tan, it appears that Product A is yielding a negative gross profit. Logically, a manager may target that product for discontinuation. However, if that decision is reached, Products B and C will each have to absorb more fixed factory overhead. The revised cost data (in rose shading) show that eliminating Product A will actually reduce overall profitability!
The decline in overall profits from discontinuing the "loser" occurs because the "loser" was absorbing some fixed cost of production. The $15 selling price for Product A at least covered its variable cost ($6 + $5 + $3 = $14). The lesson here is that a company must be very careful in eliminating "unprofitable" products. This decision can often result in a series of successive shifts in overhead to other remaining products. This, in turn, can cause other products to also appear unsuccessful. A downward spiral of product discontinuation decisions can ultimately destroy a business that was otherwise successful. This illustration underscores why a good manager will not rely exclusively on absorption costing data. Variable costing techniques that help identify product contribution margins (as more fully described in the following paragraphs) are essential to guiding the decision process.