If you run a small business in the manufacturing sector, you often face a time during the manufacturing process when you can either sell a product as is or produce it further to create a different product. For example, a brewery can make beer to sell on tap. However, with additional resources such as bottles and bottle caps, the brewery can create a new product. In both situations, the brewery creates a viable good for sale in different markets. How should a company decide whether to sell or process further? Keeping some vital pointers in mind may help you make the right decision aimed at maximizing profit.
Sell or Process Further Example
Say you own a farm that grows apples. Upon harvesting the apples and preparing them for sale, you know the incurred expense and potential sale price. But you have a decision to make. Your farm could also purchase equipment, put forth labour, expand marketing, and produce applesauce for sale. Your analysis at this decision point focuses on whether the benefits you receive from selling the apples outweighs the benefits of producing a new good to sell later.
The relevant information to include in the analysis includes only the costs related to the further production process. You incur costs related to growing apples with either decision; these costs are sunk costs, because you incur them no matter which path you take.
In all, you need three pieces of information to decide whether to sell or process further. The first question to ask is: How much do apples cost in Canada? Calculate the total revenue your company expects to earn by selling the unprocessed product. In this example, your farm should calculate how much money you would earn by selling apples, making sure to discount for inevitable spoilage. Second, how much revenue can you earn by selling the processed goods? This represents the total anticipated revenue from applesauce, and factors in profits from apples that would be lost to perishing if not further processed. Finally, calculate the incremental additional costs associated with processing the goods further.
There are three methods of making your sell or process further decision based on the data you collect: the differential method, opportunity cost method, and project method.
The Differential Method
If you choose the differential method, you only consider incremental items. With this approach, it doesn’t matter what the unprocessed goods sell for. For example, your farm can raise an additional $35,000 selling applesauce by incurring an additional $25,000 in costs. Because the incremental profit is $10,000, it’s worth producing the apples further.
The Opportunity Cost Method
Another approach is to consider the opportunity cost of both courses of action. An opportunity cost is the potential cost of leaving money on the table by not pursuing the opportunity. In this example, let’s say you could earn a total of $80,000 by turning the apples into applesauce. The additional processing costs total $25,000, and you give up revenue of $45,000 from selling the apples as is. The opportunity cost for not selling the apples is $45,000, but the opportunity cost for not producing applesauce is $55,000 (or $80,000 minus $25,000). Because the opportunity cost is $10,000 more for not selling applesauce, it makes sense to process the apples further.
The Project Approach
Finally, you can make your decision by analyzing the individual projects. With this method, you compare the net revenue from the decision point to the net revenue of further processing. For example, the revenue of the apples in the above example is $45,000. If you choose to produce the apples further, total revenue earned is $80,000 and costs are $25,000. This project would produce profits of $55,000 in net income. This difference ($55,000 – $45,000) of $10,000 once again shows that you should take on the project.
Understanding the various approaches you can take when deciding whether to sell or process further is a key step toward maximizing profits. Having the tools you need to track your profits can help reassure you that you made the right decision. Using an accounting system, such as QuickBooks Online, you can generate a Profit and Loss statement automatically. Learn how today.