Learning Outcomes
- Identify the data needed to support an add or drop decision
Adding, retaining or dropping a product or service can be a tough decision. Before we get back to Hupana Running Company and their situation with the water bottles, let’s take a look at Jen’s Sweaters:
Mary, the production manager, is contacted by her boss. He says, “Mary, we are thinking about dropping the recovery sandal line we are currently producing. We would love you to sit down with us and look at the data to decide if this is a decision that makes good sense or not. When can we meet?”
Mary sets up a time to meet with management and they show her the following income statement information.
Let’s further assume the following:
- All of the salaries assigned to each product line, belong to that product line, and will go away if the product line goes away.
- The advertising is an avoidable cost. If the product line is dropped, those ads won’t be needed any longer.
- The utilities is the total for the entire company and is merely allocated by space. It won’t change if we drop a product line.
- The depreciation is on the displays for the particular product line. We just got them, but they are custom made, so they won’t have any resale value if we drop the line.
- The mortgage interest won’t change, we will just need to reallocate it if we drop the line.
- The insurance is company wide, and will simply be reallocated.
- The general administrative expenses are for accounting, order entry and general management. Currently, these costs are allocated based on sales dollars for each product line, but they won’t go away if a line is dropped.
What does Mary do now? How do we determine which costs will be avoided if we drop the recovery sandal line?
| Fixed Expenses | Totals Assigned to Recovery Sandals | Not Avoidable | Avoidable |
|---|---|---|---|
| Salaries | $22,500 | $22,500 | |
| Advertising | $5,000 | $5,000 | |
| Utilities | $1,000 | $1,000 | |
| Depreciation | $1,000 | $1,000 | |
| Interest expense (mortgage) | $2,000 | $2,000 | |
| Insurance | $500 | $500 | |
| General administrative | $2,000 | $2,000 | |
| Total fixed expenses | $34,000 | $6,500 | |
| Net operating income (loss) | $18,500 | $13,000 | $27,500 |
The recovery sandals were bringing $18,500 to our operating net income. The contribution margin for the sandals is $52,500, but some costs will be avoidable if we discontinue the line.
- Contribution margin that is lost if we discontinue the line: ($52,500)
- Fixed Expenses that will be avoided if we discontinue the line: $27,500
- Decrease in our overall net operating income: $25,000
Should we discontinue the line? It is still contributing $25,000 to our net operating income.
Mary suggests keeping the line, unless a more profitable line is located. Might they want to look at discontinuing the water bottle line?
Practice Questions
