Deciding which products to produce and sell is a major managerial decision. If manufactur- ing capacity is limited, managers must decide which products to produce. If shelf space is limited in the stores, then managers must decide which products to display and sell. Also, managers must often decide whether to drop products, departments, or territories that are not as profitable as desired. Let’s look at how these decisions are made.
Dropping Unprofitable Products and Segments
Some of the questions managers must consider when deciding whether to drop a product or a business segment, such as a department or territory, include:
• Does the product or segment provide a positive contribution margin?
• Will fixed costs continue to exist, even if the company drops the product or segment?
Learning Objective 3 Make decisions about dropping a product, product mix, and sales mix
Jeff Sylvester is a sales representative for Angelfish to Zebras, a manufacturer of stuffed animals. The company sells the stuffed animals to retailers, such as department stores and toy stores. Jeff enjoys his job—he’s a good salesman, and he likes selling a product that makes children happy. Jeff recently received a request from a new customer for a special promotion. The store wants Angelfish to Zebras to manufacture a teddy bear wearing a shirt with the store’s logo. The store will sell the bears only during a three-week period coinciding with the store’s 25th anniversary and will provide the shirts. The store has asked for a special price on the bears, 20% less than Angelfish to Zebras’s regular price. The store has justified its request by stating it is a one-time deal because the store does not usually sell stuffed animals and Angelfish to Zebras will not incur any selling costs. Jeff needs to decide whether to accept the sales order. The bears would be made during the com- pany’s slow period, after the rush of the holiday season, so capac- ity is not a problem. Should Jeff accept the order?
Solution
Based on the information given, it appears fixed costs would not change if the order is accepted because the order is for a current product and the manufacturing facility has excess capacity. Addi- tionally, there would be no change in selling and administrative costs. Therefore, the only differential costs would be the variable manufacturing costs. If the reduced sales price is greater than the variable manufacturing costs, then Jeff should accept the order.
Alternative Solution
The marketing manager may have another perspective. The com- pany should carefully consider its existing customers. What if Angelfish to Zebras’s other customers find out about the deal?
Would they expect the same low sales price? If so, can the com- pany afford to sell to regular customers at such a low price? These questions should be answered before a final decision is made.
Should we accept this order?
DECISIONS
Try It!
Thomas Company makes a product that regularly sells for $12.50 per unit. The product has variable manufacturing costs of $8.50 per unit and fixed manufacturing costs of $2.00 per unit (based on $200,000 total fixed costs at current production of 100,000 units). Therefore, the total production cost is $10.50 per unit. Thomas Company receives an offer from Wesley Company to purchase 5,000 units for $9.00 each. Selling and administrative costs and future sales will not be affected by the sale, and Thomas does not expect any additional fixed costs.
7. If Thomas Company has excess capacity, should it accept the offer from Wesley? Show your calculations.
8. Does your answer change if Thomas Company is operating at capacity? Why or why not?
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S25-2 and S25-3. MyAccountingLab
• Are there any direct fixed costs that can be avoided if the company drops the product or segment?
• Will dropping the product or segment affect sales of the company’s other products?
• What would the company do with the freed manufacturing capacity or store space?
Once again, we follow the two key guidelines for short-term business decisions: (1) Focus on relevant data and (2) use a contribution margin approach. The relevant financial data are still the changes in revenues and expenses, but now we are considering a decrease in volume rather than an increase, as we did in the special pricing decision. In the following example, we consider how managers decide to drop a product. Managers would use the same process in deciding whether to drop a business segment, such as a department or territory.
Earlier, we focused on one of Smart Touch Learning’s products—the Standard Tablet. Now we focus on two of its products—the Standard Tablet and the Premium Tablet. Exhibit 25-6 shows the company’s budgeted contribution margin income statement by product, assuming fixed costs are shared by both products. The middle column shows the income for the Standard Tablets, as previously shown in Exhibit 25-4. Because the Premium Tablet product line, as shown in the third column, has an operating loss of $5,000, management is considering dropping the product.
Exhibit25-6 | Budgeted Income Statement by Product
Manufacturing Net Sales Revenue
Total
Standard Tablets
Premium Tablets
Variable Costs:
Selling & Administrative Total Variable Costs Contribution Margin Fixed Costs:
Manufacturing
Selling & Administrative Total Fixed Costs
Operating Income (Loss)
$ 1,430,000 $ 1,200,000
588,000
$ 230,000
118,000
462,000 90,000
552,000
878,000 738,000 140,000
116,000 110,000
25,000 70,000 141,000
180,000
$ 236,000 $ (5,000)
$ 231,000
226,000 95,000
321,000 172,000 706,000
150,000 22,000
SMART TOUCH LEARNING Budgeted Income Statement Year Ended December 31, 2019
The first question management should ask is “Does the product provide a positive con- tribution margin?” If the product has a negative contribution margin, then the product is not even covering its variable costs. Therefore, the company should drop the product. However, if the product has a positive contribution margin, then it is helping to cover some of the company’s
by using activity-based costing, or by using some other method. However, in the short term, many fixed costs remain unchanged in total regardless of how they are allocated to products or other cost objects. Therefore, allocated fixed costs are irrelevant except for any amounts that will change because of the decision that is made. What is relevant are the following:
1. Will the fixed costs continue to exist even if the product is dropped?
2. Are there any direct fixed costs of the Premium Tablets that can be avoided if the prod- uct is dropped?
Let’s consider various assumptions when dropping products.
Fixed Costs Will Continue to Exist and Will Not Change Fixed costs that will continue to exist even after a product is dropped are often called unavoidable fixed costs. Unavoidable fixed costs are irrelevant to the decision because they will not change if the company drops the product. Let’s assume that all of Smart Touch Learning’s total fixed costs of $321,000 will continue to exist even if the company drops the Premium Tablets. Also assume that Smart Touch Learning makes the Premium Tablets in the same plant using the same machinery as the Standard Tablets. Thus, only the contribution margin the Premium Tablets provide is relevant. If Smart Touch Learning drops the Premium Tablets, it will lose the $90,000 contribution margin.
The differential analysis shown in Exhibit 25-7 verifies the loss. If Smart Touch Learn- ing drops the Premium Tablets, revenue will decrease by $230,000, but variable expenses will decrease by only $140,000, resulting in a net $90,000 decrease in operating income.
Because fixed costs are unaffected, they are not included in the analysis. This analysis suggests that management should not drop Premium Tablets. It is actually more beneficial for Smart Touch Learning to lose $5,000 on the product line than to drop the Premium Tablets and lose $90,000 in total operating income.
Exhibit25-7 | Differential Analysis of Dropping a Product When Fixed Costs Will Not Change
Expected decrease in revenue
Expected decrease in total variable costs Expected decrease in operating income
$ (230,000) 140,000
$ (90,000)
Remember that in differential analysis, items are shown with their effect on profits. The decrease in revenues will decrease profits, so it is shown as a negative amount. The decrease in costs
will increase profits, so it is shown as a positive amount.
Notice the decrease in operating income is equal to the contribution margin for the Premium Tablets.
Direct Fixed Costs Will Change In this scenario, instead assume Smart Touch Learning manufactures the Premium Tablets in a separate facility. If the product line is dropped, the lease on the facility can be terminated and the company will be able to avoid all fixed costs except $3,000. In this situation, $92,000 of the fixed costs belong only to the Premium
Tablet product line ($95,000 total fixed costs - $3,000 unavoidable fixed costs = $92,000 avoidable fixed costs). These would be direct fixed costs of the Premium Tablets only.1 Therefore, $92,000 of fixed costs are avoidable fixed costs and are relevant to the decision because they would change (go away) if the product line were dropped.
Exhibit 25-8 shows that, in this situation, operating income will increase by $2,000 if Smart Touch Learning drops the Premium Tablets. Revenues will decline by $230,000, but expenses will decline even more—by $232,000. The result is a net increase to operating income of $2,000. This analysis suggests that management should drop the Premium Tablets.
Exhibit25-8 | Differential Analysis of Dropping a Product When Fixed Costs Will Change
Expected increase in operating income Expected decrease in revenue
Expected decrease in total variable costs Expected decrease in total costs
Expected decrease in fixed costs 92,000
$ 140,000
$ (230,000)
232,000
$ 2,000
Other Considerations
Management must also consider whether dropping the product or segment would hurt other product sales. In the examples given so far, we assumed that dropping the Premium Tablets would not affect Smart Touch Learning’s other product sales. However, think about a grocery store. Even if the produce department is not profitable, would managers drop it?
Probably not, because if they did, they would lose customers who want one-stop shopping.
In such situations, managers must also include the loss of contribution margin from other departments affected by the change when deciding whether to drop a department. Another example is a company that manufactures dining room tables and chairs. If the company dropped the tables, there would be a definite effect on chairs as most customers want to purchase chairs that match the table.
Management should also consider what it could do with freed manufacturing capacity. In the first Smart Touch Learning example, we assumed that the company pro- duces both Standard Tablets and Premium Tablets using the same manufacturing equip- ment. If Smart Touch Learning drops the Premium Tablets, could it make and sell another product using the freed machine hours? Is product demand strong enough that Smart Touch Learning could make and sell more of the Standard Tablets? Managers should consider whether using the machinery to produce a different product or expanding existing product lines would be more profitable than using the machinery to produce Premium Tablets.
Short-term business decisions should take into account all costs affected by the choice of action. Managers must ask the following questions: What total costs—variable and fixed—will change? Are there additional environmental costs (for example, waste water disposal) that should be considered? As Exhibits 25-7 and 25-8 show, the key to deciding
can be saved and to consider what would be done with the freed capacity. The decision rule is as follows:
Exhibit25-9 | Smart Touch Learning’s Contribution Margin per Unit
Sales price per tablet Variable costs per tablet Contribution margin per tablet
350.00
39.13%*
$ 225.00
$ 575.00 307.50
$ 192.50
$ 500.00
Standard: $192.50 / $500.00
*rounded
Premium: $225.00 / $575.00 Contribution margin ratio:
Premium Tablet Standard
Tablet
38.50%
DECISION RULE: Drop product or segment?
If the lost revenues exceed the total cost savings:
Do not drop
If the lost revenues are less than the total cost savings:
Drop
Product Mix
Companies do not have unlimited resources. Constraints that restrict the production or sale of a product vary from company to company. For a manufacturer like Smart Touch Learning, the production constraint may be labor hours, machine hours, or available materi- als. For a merchandiser, the primary constraint is display space. Other companies are con- strained by sales demand. Competition may be stiff, and so the company may be able to sell only a limited number of units. In such cases, the company produces only as much as it can sell. However, if a company can sell all the units it can produce, which products should it emphasize? For which items should production be increased? Companies facing constraints consider the following questions:
• What constraints would stop the company from making (or displaying) all the units the company can sell?
• Which products offer the highest contribution margin per unit of the constraint?
• Would emphasizing one product over another affect fixed costs?
Let’s return to our Smart Touch Learning example. Assume the company can sell all the Standard Tablets and Premium Tablets it produces, but it has only 19,500 machine hours of manufacturing capacity, and the company uses the same machines to make both types of tablets. In this case, machine hours are the constraint. The data in Exhibit 25-9 suggest that Premium Tablets are more profitable than Standard Tablets as the Premium Tablets have a higher contribution margin per unit and a higher contribution margin ratio.
Constraint A factor that restricts the production
or sale of a product.
However, in order to determine which product to emphasize, we cannot make the decision based only on contribution margin per unit. Instead, we must determine which product has the highest contribution margin per unit of the constraint. To determine which product to emphasize, follow the decision rule:
DECISION RULE: Which product to emphasize?
Emphasize the product with the
highest contribution margin per unit of the constraint.
Exhibit25-10 | Smart Touch Learning’s Contribution Margin per Machine Hour
(1) Hours required to produce one tablet (2) Tablets produced per hour [1 hour / (1)]
(3) Contribution margin per tablet
Contribution margin per machine hour [(2) × (3)]
*rounded
0.1000
$ 225.00
$ 22.50 10.0000 0.1333*
$ 192.50
$ 25.66*
7.5000
Premium Tablet Standard
Tablet
Exhibit25-11 | Total Contribution Margin with Machine Hour Constraint
Premium Tablet Standard
Tablet
Because machine hours are the constraint, Smart Touch Learning needs to figure out which product has the highest contribution margin per machine hour. Assume that Standard Tab- lets require 7.5 machine hours to produce, and Premium Tablets require 10.0 machine hours to produce. Exhibit 25-10 illustrates the calculation for the contribution margin per machine hour for each product.
Standard Tablets have a higher contribution margin per machine hour, $25.66, than Premium Tablets, $22.50. Smart Touch Learning will earn more profit by producing Standard Tablets. Why? Because even though Standard Tablets have a lower contribution margin per tablet, Smart Touch Learning can make more Standard Tablets than Premium Tablets in the 19,500 available machine hours and generate more total contribution mar- gin. Exhibit 25-11 proves that Smart Touch Learning earns more total profit by making Standard Tablets. Multiplying the contribution margin per machine hour by the available number of machine hours shows that Smart Touch Learning can earn $500,370 of contribution margin by producing only Standard Tablets but only $438,750 by producing only Premium Tablets.
To maximize profits, Smart Touch Learning should make 2,600 Standard Tablets (19,500 machine hours available / 7.5 machine hours required per Standard Tablet) and zero Premium Tablets. Smart Touch Learning should not make Premium Tablets because for every machine hour spent making Premium Tablets, Smart Touch Learning would give up $3.16 of contribution margin ($25.66 per machine hour for Standard Tablets versus
$22.50 per machine hour for Premium Tablets).
We made two assumptions here: (1) Smart Touch Learning’s sales of other prod- ucts will not be hurt by this decision and (2) Smart Touch Learning can sell as many Standard Tablets as it can produce. Let’s challenge these assumptions. First, how could making only Standard Tablets hurt sales of other products? The retailers who display Smart Touch Learning tablet computers in their stores may want a choice in products so customers can compare and choose the tablet that best suits their needs. If Smart Touch Learning produces only one type of tablet, retailers may be reluctant to display the brand. Sales of Standard Tablets might fall if Smart Touch Learning no longer offers Premium Tablets.
Let’s challenge our second assumption. Smart Touch Learning had only budgeted sales of 2,400 Standard Tablets and has the capacity to produce 2,600 (19,500 machine hours available / 7.5 machine hours required per Standard Tablet). Suppose that a new competitor has decreased the demand for Smart Touch Learning’s Standard Tablets and now the com- pany expects to sell only 2,000 Standard Tablets. Smart Touch Learning should only make as many Standard Tablets as it can sell and use the remaining machine hours to produce Premium Tablets. How will this constraint in sales demand change profitability?
Recall from Exhibit 25-11 that Smart Touch Learning will make $500,370 of contribu- tion margin by using all 19,500 machine hours to produce Standard Tablets. However, if Smart Touch Learning makes only 2,000 Standard Tablets, it will use only 15,000 machine hours (2,000 Standard Tablets * 7.5 machine hours required per Standard Tablet). That leaves 4,500 machine hours (19,500 machine hours - 15,000 machine hours) available for making Premium Tablets, which will allow the company to make 450 Premium Tablets (4,500 machine hours / 10.0 machine hours required per Premium Tablet). Smart Touch Learning’s new contribution margin will be $486,150, as shown in Exhibit 25-12.
Exhibit25-12 | Total Contribution Margin with Machine Hour Constraint and Limited Market
Contribution margin per machine hour Machine hours devoted to product Total contribution margin at full capacity
*rounded
× 4,500
$ 101,250
$ 22.50
× 15,000
$ 384,900
$ 25.66*
Premium Tablet
19,500
$ 486,150 Total Standard
Tablet
Because of the change in product mix, Smart Touch Learning’s total contribution margin will fall from $500,370 to $486,150, a $14,220 decrease. Smart Touch Learning had to give up $3.16 of contribution margin per machine hour ($25.66 - $22.50) on the 4,500 hours it spent producing Premium Tablets rather than Standard Tablets. However, Smart Touch Learning had no choice—the company would have incurred an actual loss from pro- ducing Standard Tablets that it could not sell. If Smart Touch Learning had produced 2,600 Standard Tablets but sold only 2,000, the company would have spent $184,500 to make the unsold tablets (600 Standard Tablets * $307.50 variable cost per Standard Tablet) yet received no sales revenue from them.
What about fixed costs? In most cases, changing the product mix emphasis in the short run will not affect fixed costs, so fixed costs are irrelevant. However, it is possible that fixed costs could differ by emphasizing a different product mix. What if Smart Touch Learning had a month-to-month lease on a production machine used only for making Premium Tablets? If Smart Touch Learning made only Standard Tablets, it could avoid the production equipment cost. However, if Smart Touch Learning makes any Premium Tablets, it needs the equipment. In this case, the fixed costs become relevant because they differ between alternative product mixes (Premium Tablets only versus Standard Tablets only versus both products).
Notice that the analysis again follows the two guidelines for short-term business deci- sions: (1) Focus on relevant data (only those revenues and costs that differ) and (2) use a contribution margin approach, which separates variable costs from fixed costs.
Sales Mix
The previous illustrations focused on production constraints for a manufacturing company.
Merchandising companies also have constraints, with display space as the most common constraint. Merchandisers are constrained by the size of their stores, and managers must choose which products to display.
Because Smart Touch Learning’s Standard and Premium Tablets require the same amount of shelf space, let’s consider Bragg Company, a fictitious company that operates gift shops in airports. Airport gift shops are fairly small, and Bragg has only 48 linear feet of bookshelves in each store. The following chart shows the average sales price, cost of purchasing the books, which is a variable cost, and contribution margin for hardcover and paperback books:
Hardcover Books Paperback Books
Sales Price $ 28.00 $ 12.00
Variable Cost 19.60 7.20
Contribution Margin $ 8.40 $ 4.80
Fixed costs are not affected by the choice of products to display. Based only on this information, it is apparent that hardcover books have a higher contribution margin per unit and should be the product emphasized. However, managers also have to consider the con- straint of limited shelf space. Management at Bragg has determined that each linear foot of bookshelves can display 10 hardcover books or 20 paperback books. Remember that the deci- sion rule for constraints is to emphasize the product with the highest contribution margin per unit of the constraint. Exhibit 25-13 shows the total contribution margin with the display space constraint.
Exhibit25-13 | Total Contribution Margin with Display Space Constraint
Contribution margin per book Books per linear foot of display space
Total contribution margin per linear foot of display space
× 20
$ 96.00
$ 4.80
× 10
$ 84.00
$ 8.40
Paperback Books Hardcover
Books