Here again, are five basic questions to address as you contemplate segments with regard to the sales mix:

1. Does the segment have a positive contribution margin?
2. What happens to fixed costs if we eliminate a segment?
3. How will dropping a product or segment affect other areas of the business?
4. What can the company do with freed-up capacity?
5. What are the qualitative (non-financial) considerations?

We looked at what would happen to the company if it dropped the HighLine model, but we did not take into account what might happen with fixed costs.

Question 2: What happens to fixed costs if we eliminate a segment?

We have this information with regard to fixed costs per month:

Let’s say we decide to allocate sales salary and SG&A based on the number of units of each model sold, and production facility rent based on the number of square feet each model occupies. You have this information:

The Midline production operation takes up half of the available space in the production facility, so we allocate half of the rent to that segment, and 4,000/10,000 of the rent to HighLine, and so on.

For rent and sales salaries, we have decided to allocate costs based on units sold. We would choose whatever base made the most sense for a particular business, and that was cost-effective to collect the data on. In this case, we can get the units sold very easily and we can make a logical argument that fixed costs could be allocated on that basis.

Allocating based on these assumptions, and rounding to the nearest whole dollar, we get the following:

This then gives us this revised CVP analysis:

Notice that when we allocate fixed costs, although the LowLine shows a positive contribution margin, it shows an operating loss. Total contribution margin based on sales of 20 units per month does not cover that model’s allocated fixed costs.

Let’s see what happens if we eliminate the HighLine and fixed costs do not change:

We have to reallocate rent on the production facility. For purposes of this analysis, let’s assume the 4,000 square feet HighLine production space either remains vacant or the MidLine and LowLine production lines spread a bit and take up that space. In either case, we have to reassess the amount of rent we will allocate to each segment, assuming the rent can’t go down just because we aren’t using that space:

Let’s also, for now, assume that SG&A and sales salaries remain the same, but are now allocated over less units:

Fixed costs allocated over two segments instead of three look like this:

Notice that total fixed costs remain the same in this analysis, as does the bottom line, but the LowLine model fares even worse:

Now let’s re-run this analysis with the assumption that by eliminating the HighLine model, which was sales-intensive, we could lay off one of the two salespeople, saving the company $5,000 per month, and cut SG&A by $10,000. Our fixed costs now look like this:

And our CVP analysis looks like this:

Let’s look at this using differential analysis:

Eliminating the HighLine and cutting costs increase the bottom line by $25,500 per month. That’s $306,000 per year.

However, we still have three questions left to answer.

Before we address those last three considerations, check your understanding of how changing the product mix affects fixed costs.