Keep or Drop Decisions Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 23

What are Keep or Drop Decisions?  A short-term decision of whether or not to drop or continue one of the following:  Product line – such as shoes at JCPenney, home appliances at Best Buy  Product – such as breakfast burritos at McDonalds, Blue Moon beer at Hooters  Service line – such as carpet installation by Home Depot, textbook rentals at Follett book store  Service – such as rental of DVDs by Netflix, downloading of MP3s by Amazon  Segment – such as a geographical division, retail verses wholesale offerings, outpatient surgery in a hospital, 3G cellular service 2

Relevant Amounts What is not relevant  Allocated fixed costs  Often called common costs  Consists of overhead costs that a company allocates or divides up amongst several units that use the costs 3 Incremental Revenue The decline in revenue from dropping Incremental Cost Savings The variable cost savings due to dropping The direct fixed cost savings due to dropping

How to Make Keep or Drop Decisions Use qualitative characteristics to assess 4 If the decline in revenue < incremental cost savings Drop the product/product line, unless qualitative characteristics impact the decision Do not drop the product/product line, unless qualitative characteristics impact the decision If the decline in revenue > incremental cost savings If the decline in revenue = incremental cost savings

Beware of Allocated Fixed Costs 5 Because not all costs will disappear when we allocate costs to products. Our allocations can make a segment look less profitable than it really is.  Dropping a product/service/line/segment that has a net loss often creates a bigger loss  Referred to as the Cost Allocation Death Spiral Why should we keep the ice cream segment? It shows a loss?

Keep or Drop Example 6 Take Outs has three product lines in its retail stores: snacks, salads, and sandwiches. The allocated fixed costs are unavoidable. Results of July follow: Demand of snacks is expected to increase by 10% if salads are dropped. Prepare an incremental analysis. SnacksSaladsSandwichesTotal Units sold8001,2002,4004,400 Revenue$49,600$52,800$67,200$169,600 Variable costs19,20026,40033,60079,200 Direct fixed costs10,00014,00013,00037,000 Allocated fixed costs16,00018,00016,00050,000 Operating income$4,400($5,600)$4,600$3,400

Keep or Drop Example cont. 7 Data reproduced: Incremental decline in salad revenue($52,800) Incremental variable cost savings - salads 26,400 Incremental direct fixed costs savings –salads 14,000 Incremental snack revenue (10% x $49,600) 4,960 Incremental variable costs –snacks (10% x $19,200) (1,920) Incremental decrease in profit if drop salads ($9,360) SnacksSaladsSandwichesTotal Units sold8001,2002,4004,400 Revenue$49,600$52,800$67,200$169,600 Variable costs19,20026,40033,60079,200 Direct fixed costs10,00014,00013,00037,000 Allocated fixed costs16,00018,00016,00050,000 Operating income$4,400($5,600)$4,600$3,400 Original profit +/- Change in profit = New profit New profit = $3,400 - $9,360 = $5,960 loss Original profit +/- Change in profit = New profit New profit = $3,400 - $9,360 = $5,960 loss

8 The End