- Create a report outlining the data to support an add or drop decision
Remember our Jen’s Sweaters add or drop question? Here is a review:
Managers need to decide which product lines to continue, add or drop. An add or drop decision is based only on the relevant costs involved in the process. As we have discussed earlier, some costs are not relevant to a decision, so as we look at options between our product lines, we need to decide which costs should be considered as decisions are made. It isn’t always the item we sell for the highest price! Costs can outweigh revenues, and in those cases, we need to evaluate and analyze to determine what items to manufacture, offer as services or stock on our shelves.
Let’s look at a grocery store example. We have five flavors of ice cream in our freezer, but would like to determine how to best utilize the freezer space. Our accounting department gives us the following information regarding revenues and costs for our ice cream freezer:
|Morrie’s Grocery: Ice Cream Cooler—What Should We Stock?|
|Direct Fixed Costs||100||180||90||105||105|
|Allocated Fixed Costs||150||180||135||140||157.5|
From this spreadsheet, it would look like dropping the Neapolitan would be a good idea, right?
Let’s look a little closer at this situation to determine if that is the right decision.
So, if we get rid of the Neapolitan flavor, what expenses will be relevant to our decision?
Variable costs would go away, as that cost is directly related to the Neapolitan ice cream. Direct fixed costs would also go away, as those costs are directly attributed to that flavor too. But what happens to the allocated fixed costs? Those costs would need to be distributed among the remaining flavors. Remember things like rent and utilities will occur regardless of what products we carry.
|Drop the Neapolitan?|
|Variable Costs Avoided||490|
|Direct Fixed Costs Avoided||105||595|
|Less: Sales Revenue Lost||700|
|Decrease in Net Income||105|
The variable costs and direct fixed costs are called avoidable costs. These are the costs that would go away by eliminating this flavor.
So you can see now, that eliminating the Neapolitan would have a negative effect on the net income. What if we drop chocolate?
|Drop the Chocolate?|
|Variable Costs Avoided||720|
|Direct Fixed Costs Avoided||180||900|
|Less: Sales Revenue Lost||1200|
|Decrease in Net Income||300|
So who would drop chocolate anyway, right?
So you can see the decision to add or drop a product isn’t as easy as it looks! They may increase the sales of chocolate, if they eliminated another flavor. Remember that is called an opportunity cost!
Now let’s practice: