discontinued locations

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.

Make more money now! Try our JOB search.

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.

Keep or Drop1

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?

Keep or Drop 2

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?

keep or drop 3

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.

Keep or drop 4

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.

Final Thoughts

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.

Related Video

Keep or Drop Decision Making

Share This:


Related pages


bond valuation formula exampleallowance for doubtful accounts iscosting and cost accountingshare based payments journal entriesexample of trial balance worksheetwhat is the present value of an annuitydepartmental overhead ratesjournal entry interest expenseaccounting discontinued operationsis accumulated depreciation a liabilityfavorable variancesinventory accountant salarytexas net pay calculatoroverhead rate formulaaverage variable cost calculationdefine merchandising companypv factor formulacost method of accounting journal entriesis accumulated depreciation a contra accounthow to calculate direct materials used in productionprepare adjusting journal entriesdiscount on notes payable is charged to interest expenseestimated manufacturing overhead costdepreciable cost formulapercentage of sales methodexample of trial balance worksheetdisposal of asset journal entrypv of annuity factorfactory overhead formulaannual simple interest formulass and medicare tax ratesis unearned revenue a liabilitythe balance of an unearned revenue accountaccounts receivable occur from credit sales to customersvaluation allowance journal entryhow to calculate ending inventory fifotraditional costing system formulaformula for depreciable costpaycheck tax calculator washingtondiscount allowed journal entrycalculating overhead rateadjusting entries worksheet exampleswhat goes on the debit side of a trial balancean example of deferred revenue is unearned rentcredit sales accounting entryjournal entry accrued interestwhat are examples of current liabilitiesexamples of journal entries in tallydebit credit analysis examplehow to find merchandise inventorydifference between bad debts and provision for bad debtsincome statement from trial balancefifo cost of goods soldbasics of accounting entriesaging schedule of accounts receivableincome statement explained for dummiesjournal entry for accounts receivable collectedwages deductions calculatorllc balance sheet templatenote payable journal entryhow to calculate a simple interest loanfifo examplespayroll expense journal entryaje journaljournal entries for accrualspremium bond certificateswrite off accounts receivablemanagerial accounting budget examplespresent value of annuity chartwhat is included in cogsbeginning inventory plus the cost of goods purchased equalsformula of cost of good soldwip sheetfifo income statementfederal payroll tax calculator 2014journal entry for accrued salariessale of fixed asset journal entrybreak even point and contribution marginhow do you prepare a trial balancehow to construct a balance sheetaccounting for merchandising businessestraditional costing definition