This chapter introduces how managers use incremental analysis to assess short-term 'keep or drop' decisions. These decisions involve whether or not to continue a product, product line, service, service line, or other component of a company. Just like other types of short-term decisions, 'keep or drop' decisions can be made most efficiently using incremental analysis. The incremental approach also helps managers focus on the relevant parts of a decision.

 


Keep or Drop What?


Keep or drop decisions evaluate whether a product, product line, service, or segment of a company should be dropped. This may include disposing of an entire corporate division, closing a single McDonald's store, or doing away with frozen foods at a grocery store chain. A product refers to an item that a company offers for sale. A service that is offered by a company, such as installing software on a computer, remodeling homes, or renting DVDs may also be dropped. A product line pertains to a number of related products that are offered or produced by a particular company, generally sharing a homogenous characteristic such as men's shoes, ice cream bars, or breakfast offered by a restaurant. A service line is a group of homogeneous services, such as textbook rentals at college bookstores, tax returns prepared by accountants, divorce cases handled by attorneys, etc. A segment is a subset of a business operation and may include geographical divisions, major customer groups, wireless cellular services, etc. This chapter uses the generic term, 'product' to include any segment, product, service, product line, or service line of a company that the company is considering to drop.

 


Incremental Analysis Components


The decision is based on whether or not the product’s revenue exceeds the costs directly traceable to the product, including any direct fixed costs.

 

Incremental Revenue

Incremental revenue is the difference in revenue between the original sales revenue and the new revenue that is expected to result due to dropping a product. The revenue to be earned if the product is dropped is zero. If the decision is made to drop a product, incremental revenue will be reduced by the amount of revenue that would have been generated by the product to be dropped. This drop in revenue reduces profit. If dropping a product will cause an increase in demand for another product, the additional revenue for the other product is incremental, and has an increase in profit.

 

Incremental Cost Savings

Variable costs associated with a product to be dropped are incremental cost savings that cause profit to increase. Incremental cost savings also result from direct fixed costs. Direct fixed costs are fixed costs that pertain only to one product. For example, if JC Penney eliminates its furniture product line, the reduction of the salary of the purchasing manager of the furniture product line will result in a cost savings, since the manager will be terminated. Direct fixed costs related to a product being dropped are avoidable if that product is dropped because they can be eliminated if the product is dropped.

   

Opportunity Costs

Opportunity costs are common in keep or drop decisions. They often arise due to rental of production space that will become vacant if the decision is made to drop a product. Opportunity costs are always incremental.

 


Amounts That Are Not Relevant in Keep or Drop Decisions


Allocated fixed costs, often called common costs, are costs that are not traceable to a particular product, service, product line, or segment. They are never relevant because the costs are assigned to a number of products. The total allocated fixed costs will remain the same total costs regardless of whether the product is dropped or not, and as such, are not avoidable. If a product is dropped, total common fixed costs must be reallocated to remaining products or segments.

 

The sales revenue. variable costs, and direct fixed costs of other products are not incremental, except if there is an expected demand change for a different product as a result of dropping a product.

 


Evaluating Keep or Drop Decisions


Companies should generally not drop products when overall company products are expected to decline. If there is no expected change in demand of other products, the company's overall profit will always be less if a product is dropped than if the product is kept in operations. This is due to allocated fixed costs that are not avoidable. Soft-benefits, also known as qualitative issues, should be considered as well.

 

Accept or Reject?

If incremental cost savings exceeds incremental revenue lost, the product should be dropped, unless qualitative characteristics overwhelmingly impact the decision. This occurs only if a significant increase in demand is expected for other products.

 

If incremental revenue lost equals incremental cost savings, qualitative effects must be used to make the decision.

 

If incremental cost savings is less than incremental revenue lost, the product should not be dropped, unless qualitative characteristics overwhelmingly impact the decision.

 

Qualitative concerns related to keep or drop decisions often include considerations of employees that will be terminated if the product is dropped, the effect a lay off might have on employees that are not terminated, effects of suppliers from which the materials needed for the product will no longer be purchased, and the effect of customers who previously purchased the product being dropped.

 


Cost Allocation Death Spiral


Allocated fixed costs often make a segment look unprofitable. However, most often, the company's total profit will decrease when a product or segment is dropped because allocated fixed costs must be absorbed by other products. When demand of other products is not affected by dropping a product, dropping the product will always lead to a second product appearing to have larger losses. If the second product is then dropped, the additional allocated common costs will cause profit of the remaining products to decline. Profits continue to erode until the company has spiraled out of business. Each additional product drop causes the company to be worse off due to allocated fixed costs that continue to be a cost for a company. This process is called the cost allocation death spiral.

 


Walk Through Problem


Sugartown, Inc. has three product lines in its retail stores: cookies, cakes, and candy. The allocated fixed costs are based on units sold and are unavoidable. Results of June follow:

 

  Cookies Cakes Candy Total
Units sold   2,400     1,600  2,000        6,000 
 Revenue  25,000 50,000 75,000 150,000
 Variable department costs   12,000 37,000 41,000       90,000
 Direct fixed costs     6,200      8,000 19,000 33,200
 Allocated fixed costs    5,000      6,500  7,000    18,500
 Operating income (loss)  $1,800 ($1,500) $8,000 $8,300

 

Demand of individual products is not affected by changes in other product lines. Prepare an incremental analysis of the effect of dropping the cakes product line. Determine the operating income or loss for Sugartown after the cakes product line is dropped.

Solution

Total cake revenue will drop by $50,000 if the cakes product line is eliminated, resulting in a decline in total profit. The $37,000 of variable costs associated with cakes will be avoided if this product line is dropped. This decrease in variable costs is a savings which increases profits, so the $37,000 cost savings is added in the incremental analysis. The $8,000 of direct fixed costs are directly associated with cakes, and will be avoided if cakes are dropped. This decrease in direct fixed costs is a savings which increases profits, so the $8,000 is added. The allocated fixed costs must be absorbed by the other two products if cakes are dropped, so in total, there will be no change to allocated fixed costs for the entire company.

 

Incremental revenue ($50,000)
Incremental savings:  
    Variable costs 37,000
    Direct fixed costs     8,000
Incremental decrease in profit if the 'cakes' product line is dropped ($5,000)

Dropping the cakes product line will result in a drop in operating income for the entire company from $8,300 to $3,300. This amount can be calculated without recreating the income statement by combining the original profit with the incremental change in profit as follows:

 

New profit = Original operating income +/- Change in operating income =

$8,300 - $5,000 = $3,300

Insight into the Effect on Profit

As you have learned, incremental analysis enables you to make a number of short-term decisions without creating new income statements. However, creating new statements for the remaining segments is helpful in allowing you to see how the cost allocation death spiral works. If the cakes product line is dropped, the costs directly associated with cookies and candy will remain the same as follows:

 

 

Cookies

Candy

Total

Units sold

 2,400

2,000

       4,400

 Revenue

$25,000

 $75,000

 $100,000

 Variable department costs

12,000

41,000

      53,000

 Direct fixed costs

        6,200

19,000

    25,200

 

Just before the cakes product line is dropped, the total fixed allocated costs are $18,500. Just after the cakes line is dropped, total allocated fixed costs remain at $18,500. The total does not change because fixed costs in total always stay the same---unless there are specific circumstances indicated which render some of these costs avoidable.

 

Assume that management has decided that $8,250 of the total allocated fixed costs is now assigned to the cookies product line, with $10,250 allocated to the candy line. Because the allocated costs are not avoidable, both product lines must now absorb a larger portion of the total allocated costs.

         

 

Cookies

Candy

Total

Units sold

 2,400

2,000

       4,400

 Revenue

 $25,000

 $75,000

 $100,000

 Variable department costs 

 12,000

41,000

      53,000

 Direct fixed costs

          6,200

19,000

    25,200

 Allocated fixed costs

   8,250

 10,250

   18,500

 Operating income (loss)

($ 1,450)

$ 4,750

$  3,300

 

Now there is a second product with a loss--the cookies product line. This new income statement may appear to some managers as if dropping cookies will improve the company's overall profits. Constructing an incremental analysis to drop the cookies product line brings more bad news. Revenue of $25,000 will decline for cookies causing profits to decline by the same amount. Variable costs of $12,000 and direct fixed costs of $6,200 will become cost savings which increase profits for the company. No change occurs to allocated fixed costs because the total allocated cost remains at $18,500. Dropping the cookies product line results in an additional $6,800 decline in product.

 

Incremental revenue ($25,000)
Incremental savings:  
    Variable costs 12,000
    Direct fixed costs     6,200
Incremental decrease in profit if the product line is dropped ($6,800)

 

Combining the $6,800 decline with the previous overall profit of $3,300, profitability drops to a loss of $3,500. The income statement of the sole remaining product verifies the new operating loss for the entire company as $3,500:

 

 

Candy

Units sold

2,000

 Revenue

 $75,000

 Variable department costs 

41,000

 Direct fixed costs

19,000

 Allocated fixed costs

 18,500

 Net income (loss)

($ 3,500)

 

All of the allocated fixed costs must now be allocated to the only remaining product, candy. leaving candy with $18,500 of allocated fixed costs and a loss of $3,500.

 

Should Sugartown drop cakes? No way!  The cost allocation death spiral exists when you forget that allocated fixed costs are not avoidable. As product lines are dropped, the company spirals into bigger and bigger losses; hence, the cost allocation death spiral exists.

 


This page was last edited on Monday January 05, 2015 02:24 PM
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