direct fixed costs
Sometimes when a business sees that a product, department, or location is losing money, the first reaction is to shut it down. Discontinuing operations is a decision that should only be taken after careful consideration and number crunching.
When deciding to keep or drop a part of the company, the first thing to do is to create an income statement broken into segments. For example, if a product is unprofitable, create a product line income statement. If there is a location that is not profitable, create an income statement for that location. Use a contribution margin income statement to separate variable costs from fixed costs.
This is the kind of income statement that would make a company think about dropping a product. Overall, the company has a loss of $4,000 and it appears that Product A has a $38,000 loss. On the surface, it might look like dropping Product A and only producing Product B would result in a profit of $34,000. But is that correct?
Here are some things to consider when evaluating if a company should keep or drop a segment (product, department, or location):
1. Does the segment have a positive contribution margin?
If we look at Product A, it does have a positive contribution margin. This is important because the product is covering all of it’s variable costs and it is contributing toward foxed costs. While the contribution margin is not high enough to cover all of the fixed costs, increasing sales of Product A would increase contribution margin and lower the loss.
If the segment has a positive contribution margin, continue the evaluation.
2. Can any of the fixed costs be avoided if the segment was discontinued?
There are two types of fixed costs that should be considered, direct fixed costs and common fixed costs.
Direct fixed costs are fixed costs that can be directly traced to the segment. Just because a fixed cost is direct does not mean that it is avoidable. There may be depreciation, contractual obligations, and other costs that the company will not be able to cut even if the segment is discontinued. If the fixed costs cannot be avoided, losses will increase if the segment is discontinued because the segment will no longer be contributing to the total contribution margin.
Common fixed costs are organization sustaining fixed costs that are allocated to the segment. These fixed costs will continue even if the segment has been eliminated; they will just be allocated to the remaining segments.
Let’s say, in our example, that none of the direct fixed costs are avoidable. What happens to the loss if Product A is discontinued?
Since there are no longer sales from Product A, we eliminate the revenue and the variable costs from Product A. We also lose $85,000 in contribution margin that was helping to offset some of the fixed costs. The loss increased by $85,000 (the amount of contribution margin that was eliminated). What would happen if we could eliminate all of the direct fixed expenses?
If all of the direct fixed costs could be eliminated, now we see positive results. Notice that the common fixed cost is still $99,000.
Make sure to carefully examine fixed costs to see which, if any, could be cut.
3. Can the freed up capacity be used for another purpose?
If the segment was discontinued, could the company use the machinery and employees for another purpose? Could the company make additional units of another product or make a new product? Assessing these alternatives helps the company decide if there is something more profitable it could do instead. Idle capacity makes it less likely that fixed costs could be eliminated.
4. Will discontinuing a segment have adverse effects on the sale of other products?
Imagine that Product A is a cereal bowl and Product B is a matching plate. Do you think that discontinuing Product A would hurt the sales of Product B? I think it would. Before discontinuing a product make sure that sales of remaining products would not be adversely affected.
Let’s say that we could eliminate all the direct fixed costs from Product A but sales of Product B would fall 15%. Should we drop Product A? If we remove Product A and it’s direct fixed costs but lower the sales and variable costs of Product B by 15%, the results are not good.
The loss is larger now than it was when the company was making Product A. The negative impact on sales of Product B outweighs the savings from discontinuing Product A.
Make sure to look at the adverse effects on other segments of the company before deciding to drop a segment.
When deciding if a company should drop an unprofitable segment, the company should create a segment contribution margin income statement. If the contribution margin is positive, the company should consider direct and common fixed costs, what to do with freed capacity, and the effect on sales of other products.
Keep or Drop Decision Making