Some product lines or business segments tend to under-perform compared to others. When deciding to add a new product line or drop an existing one, the management must consider relevant benefits and costs.
As a rule, product lines or business segments should be evaluated based on traceable revenues and costs.
Allocated fixed costs should be removed from the analysis of income since the company will incur in the entire amount with or without the product line or segment.
XYZ Company has three product lines. The company is considering dropping Product 2 because it has been operating at a loss. The following summarizes the income of the three product lines.
| Product 1 | Product 2 | Product 3 | Total | ||||
| Sales | $15,000 | $22,000 | $37,000 | $74,000 | |||
| Less: Variable Costs | 9,000 | 10,000 | 19,000 | 38,000 | |||
| Contribution Margin | $ 6,000 | $12,000 | $18,000 | $36,000 | |||
| Less: Fixed Costs | |||||||
| Traceable | 3,000 | 10,000 | 6,000 | 19,000 | |||
| Allocated | 1,000 | 3,500 | 5,000 | 9,500 | |||
| Net Income | $ 2,000 | ($ 1,500) | $ 7,000 | $ 7,500 |
Solution:
The allocated fixed costs should be removed when analyzing segment income. Hence, Product 2 should not be dropped since it has a positive segment margin.
| Product 1 | Product 2 | Product 3 | |||
| Sales | $15,000 | $22,000 | $37,000 | ||
| Less: Variable Costs | 9,000 | 10,000 | 19,000 | ||
| Contribution Margin | $ 6,000 | $12,000 | $18,000 | ||
| Less: Traceable Fixed Costs | 3,000 | 10,000 | 6,000 | ||
| Segment Income | $ 3,000 | $ 2,500 | $ 12,000 |
Why are we removing the allocated fixed costs in our analysis? Because the company would still incur the entire allocated fixed costs with or without Product 2. A portion of these costs is actually absorbed by Product 2's segment income. If Product 2 is dropped, it will result in lesser overall profits.
| With Product 2 | Without Product 2 | ||
| Sales | $74,000 | $52,000 | |
| Less: Variable Costs | 38,000 | 28,000 | |
| Contribution Margin | $36,000 | $24,000 | |
| Less: Fixed Costs | |||
| Traceable | 19,000 | 9,000 | |
| Allocated | 9,500 | 9,500 | |
| Net Income | $ 7,500 | $ 5,500 |
The allocated fixed costs are unavoidable costs. The entire $9,500 would be incurred with or without Product 2. If Product 2 is dropped, it will result in lower overall net income. Hence, the product line should not be dropped.
Add or drop decisions require the computation of segment income.
Segment income excludes allocated fixed costs, since these are not traceable to the segment and are unavoidable. The entire business will still incur them regardless.
If the product line or segment has a positive segment margin, it is recommended to keep (or add, if new) that segment.
