Sippican Corporation
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 approach provides only insight into the products profitability after variable cost deduction, but it does not show whether the profit of a particular product is still profitable after all cost deductions. This could lead to a false perception of product profitability. In addition, this approach could lead to wrong decision making in terms of pricing or expansion actions. Moreover, with this approach it is not possible to identify any cost drivers. Thus, many profitability improvement opportunities might be lost. Moreover, in particular, in the Sippican’s case the overhead costs are not really fix. They are fix only in the short term but variable in the long term as with an increase in volume of the products or the number of various products more machines and labor are required. The correct term for such cost is step-fix cost. Thus, the overhead costs in this case are not really a period expense (only in the short term). Thus, the volume of each product line does indirectly drive the overhead cost in the long term. Consequently, it is important to see how each product affects the overhead costs or, to say it the other way around, what amount of resources does a product use and how does it differ from to the usage rates other product
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 approach provides only insight into the products profitability after variable cost deduction, but it does not show whether the profit of a particular product is still profitable after all cost deductions. This could lead to a false perception of product profitability. In addition, this approach could lead to wrong decision making in terms of pricing or expansion actions. Moreover, with this approach it is not possible to identify any cost drivers. Thus, many profitability improvement opportunities might be lost. Moreover, in particular, in the Sippican’s case the overhead costs are not really fix. They are fix only in the short term but variable in the long term as with an increase in volume of the products or the number of various products more machines and labor are required. The correct term for such cost is step-fix cost. Thus, the overhead costs in this case are not really a period expense (only in the short term). Thus, the volume of each product line does indirectly drive the overhead cost in the long term. Consequently, it is important to see how each product affects the overhead costs or, to say it the other way around, what amount of resources does a product use and how does it differ from to the usage rates other product