For profit planning and perhaps as it is only reliable measure in profitability analysis, management should consider the contribution margin a product makes to joint cost after separable or individual cost are deducted from sales. The contribution margin allows management to predict the amount that a segment or product line will add or subtract from company profits.
In profitability analysis, this margin is not the product’s net profit figure. It only indicates relative profitability in comparison with other products. Net profit determined by allocating to segments an ‘equitable’ share of all costs, both separable and joint, associated with the group of segments is not a reliable guide to profit-planning decisions because these data cannot be used for predicting the outcome of decisions in terms of the change in aggregate net profit. For these reasons, attempts to allocate joint marketing costs to products and customers by time studies of salespersons’ activities often yield results which are unreliable for appraising segment profitability.
The Federal Trade Commission recently required that certain businesses furnish cost-and-profit data for a wide range of specific product categories. In 1974 the Securities and Exchange Commission began requiring that annual reports to stockholders include revenue and profit by business. The Financial Accounting Standards Board is researching possible segment reporting requirements for external financial statements.
Businessmen resist such requirements. One of their main arguments is that cost allocation today with multiple products and product lines is wrought with great danger of improper interpretation caused by arbitrarily allocated joint costs. Of course, as this topic indicates, there are acceptable ways of allocating joint product costs and even separable costs. Yet, it makes a difference which method is chosen. The decision determines the degree of profitability of the various products.
When the allocation method is applied the first time, the cost is based on the present price is the subject of the regulatory process. By means of profitability analysis, a firm can take better decision in pricing.