9.3: Continue with or discontinue a product
A product, department, territory, or other segment of a company may not be performing to expectations and may even be generating a loss. The company may consider discontinuing that segment to eliminate its variable costs and any operating losses associated with the segment. However, fixed costs such as depreciation, property taxes, and insurance will not be reduced. Therefore, eliminating a segment does not always result in higher income for the business as a whole. The decision as to whether to continue with or discontinue a product, etc., is based upon the relative difference between the financial impacts.
Healthy Habits Company sells a variety snack food items. The following income statement information relates to the popcorn product line for the previous year.
|
Sales |
$720,000 |
|
Cost of goods sold |
480,000 |
|
Gross profit |
$240,000 |
|
Operating expenses |
500,000 |
|
Loss from operations |
($260,000) |
It is estimated that 25% of the cost of goods sold amount is fixed and 40% of the operating expenses are fixed.
The following differential analysis compares the cost of continuing the popcorn product with the cost of discontinuing it. Note that the fixed portions of the cost of goods sold and operating expenses would be incurred under either alternative, so they are not included.
|
Continue |
Discontinue |
Difference |
|
|
Revenue |
$700,000 |
||
|
Costs: |
|||
|
\(\ \quad \quad\)Variable cost of goods sold 1 |
$360,000 |
||
|
\(\ \quad \quad\)Variable operating expenses 2 |
300,000 |
||
|
Income |
$40,000 |
$40,000 |
1 $480,000 x 75%
2 $500,000 x 60%
Although continuing the sale of popcorn results in an operating loss for that product line, it does yield $40,000 in operating income when fixed costs are eliminated from the calculation. Since fixed costs will be incurred regardless of whether popcorn is sold or not, keeping it in the product offerings has a positive impact on the company’s earnings. Discontinuing popcorn results in no revenue or variable costs at all, so the company would miss out on the $40,000 contribution toward paying fixed costs. The company should continue selling popcorn.