why do many people claim that high volume products "subsidize" low-volume products?

Question

allocating overhead based on the volume of output, such as direct labor hours or machine hours, seem fair and equitable. why do many people claim that high volume products "subsidize" low volume products?

Answer 1

One way that high volume products subsidize low volume products is in the absorption of changeover costs. If the amount of time it take to changeover a production process is relatively high, and that "lost" production time gets spread across the volume produced on the line, then the high volume products will pick up most of the cost of the changeover, even if the lower volume items where the ones that required the line to be taken out of production for the changeover.

A related way that high volume products subsidize low volume products occurs when the allocation base does not match the drivers of cost on the line. For example, in batch processing operations, the time required to produce a small batch could be essentially the same as the time required to produce a large batch. Imagine if you had to produce one batch of 10,000 gallons of ink, and another batch of 100 gallons of a different color ink. Each batch might take essentially the same amount of time to produce, as the time spent to blend the ingredients and some colorings to dissolve might be the same regardless of batch size, and might be much higher than the difference in time of dumping more ingredients into the tank. If the cost of the batching process were split on hours used, the cost might be split roughly 50/50, but if it was split on gallons produced, the high volume ink would absorb nearly all the cost, even though the low volume ink used the asset nearly as much.

If you look at the process companies use to justify investment in capital equipment, it is generally based on some measure of return or payback (net present value, internal rate of return, payback period, etc.). Assuming similar manufacturing contributions of the products, higher volume products would make it much more likely that you could justify the investment in capital than low volume products. A high volume product could justify the investment in capital, then "subsidizing" the lower volume products which could be produced on slack time on the asset. So some people might say lower volume products get a "free ride" on the capital.

The critical point about all this is that if the process in question is not capacity constrained (you aren't limiting the production of the high volume product to make the low volume product) and the marginal contribution of the low volume product is positive (you make more money on the low volume product than the incremental cost of producing it) then producing low volume products is probably a net positive for a company. The complicating factor would be the elusive "cost of complexity"- the difficult to quantify incremental cost a company would incur because it has more products. Adding a significant number of low volume products can complicate processes like order capture, order fulfillment, warehosuing and distribution, production scheduling, purchasing, etc. However, the incremental cost of complexity caused by one single low volume product is often negligible.

Answer 2

Well lets think about overhead for a moment. Some examples are executive salary at the corporate level. Say you make 3 products, Product A, Product B and Product C. Product A is high volume and Product B and C are low volume. However, all products make the same amount of profit, Product B and C make up the lack of volume with more profit per widget. So the CEO spends his time equally across the three products since they all make the same amount.

However, in terms of direct labor or machine hours, Product A will be charged with a majority of his salary.

Now that doesnt seem as equitable, right?

Answer 3

Need not necessarily to follow the rule quoted by you. Normally overheads are allocated to all products based on the basic cost and not on the volume. As such subsidizing does not arise.
If the low volume products basic costs is very high to high volume, how subsidizing will help?
VR

Answer 4

I'm not certain the "subsidize" is accurate. Usually slow to produce low-volume products soak up extra hours that would otherwise be unpaid or lost. Such as full time labor not being fully utilized. These products can either have a better profit margin but sell slowly, or have a worse profit margin, but can always be done. This question is so general though, I'm not sure exactly what you mean.

Answer 5

Because high volume products tend to pay the bills on inputs such has capital items and labor. You usually have high profit margins on low volume products but you usually dont make enough of it to keep your production lines running constantly. High volume products you make a lot of usually have low profit margins, but they keep production lines operating constantly. The high volume products pay for the capital items needed to make the low volume products and the low volume products produce the profits that add to the bottom line

Answer 6

The low-volume products may be "prestige" products that give distinction to the brand-name and help sell the higher-volume products. Depends on the company and industry.

By themselves, the lower-volume products may not make money, or may not cover their full allocation of fixed costs.

Answer 7

high volume normally forces down marginal costs per item and also absorbs a larger share of the fixed expenses than low volume products

Answer 8

Not sure which direction you're intending to go with this (financial products, manufactured goods), but in financial nomenclature, asset subsidies fall under asset allocation and diversification. Resource provided to help you understand.