Business — Banking — Management — Marketing & Sales

Product portfolio optimization and pricing models

Category: Financial Control Management

Product Portfolio Optimization (PPO) includes the following elements:

— Determination of the rational composition of the product portfolio;

— Analysis of customers demand for individual products;

— Consideration of limits on production capacity, working capital, and customer demand;

— Choice of optimal prices and production volumes with regard to market demand;

— Cash flow forecast to develop optimal product mix.

Optimal product mix

Often a company may improve its financial condition by changing the composition of its manufactured product mix, even if the current output levels are above the Break-Even Point. This becomes especially critical when a company has limited production capacity and resources. The optimization can be achieved by an increase in sales of products that are most profitable. At the same time, the profitability of one product can not be the only criteria for output increases, since it only reflects the existing structure of production.

The first step in PPO is the determination of the Contribution Margin for each product. An increase in production output must be adjusted to market demand. Contribution Margin provides reliable information for decisions regarding production output increases. The Contribution Margin Ratio (Contribution Margin to Sales) indicates what share of revenue can be used to cover Fixed Costs and Profit. The higher the ratio is, the more preferable it is to produce them.

The second step in PPO is considering the limitation and constrains of the business in respect of Production Capacities, Working Capital, and of market demand for the enterprises products. The importance of the optimization becomes crucial when the company encounters these limitations and it can be attained through the enlargement of the share of more profitable products and reducing the share of the less profitable or even unprofitable ones or even by a total exclusion of those.

The comparison of the product profitability ratio and contribution margin ratio for a company’s products is illustrated. The rating the attractiveness of the particular product based on Product Profitability is different from the one based on the Contribution Margin approach. The first option is the commonly applied one in Moldovan companies, which is not the appropriate one, due to the distortions in the Indirect Costs area, which will be explained further in this section. The calculation of the Product Profitability by products is based on the accounting information which is available in the accounting department, while the calculation of the Contribution Margin Ratio could be performed only by re-categorization of costs in Variable and Fixed, which is a managerial approach. As a conclusion, in order to improve the production plan, products having the highest Contribution Margin Ratio should be favored. This procedure is applicable when the products are produced using different production lines or they are not competitors among them and the market demand has no restrictions in respect of each item produced.

The comparison of the contribution margin ratio and contribution margin ratio per machine hour for a company’s products is illustrated. This is the second step of analysis which is applicable when the products are being produced using the same machines or are competitors among them. As it is seen on the chart, the rating of attractiveness is different for the two ratios presented. In this case the most attractive products are those having the highest Contribution Margin per Machine Hour used. The same comparison is required when analyzing the limitation of Working Capital or Limited Marketing Demand for a particular product.

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