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Business LibreTexts

12.11: Add or Drop Decisions

  • Page ID
    45970
  • Learning Outcomes

    • Create a report outlining the data to support an add or drop decision

    Remember our Jen’s Sweaters add or drop question? Here is a review:

    Thumbnail for the embedded element "Part 3 - Relevant Costs for Decision Making - Drop or Retain"

    A YouTube element has been excluded from this version of the text. You can view it online here: http://pb.libretexts.org/afm-2/?p=504

    Managers need to decide which product lines to continue, add or drop. An add or drop decision is based only on the relevant costs involved in the process. As we have discussed earlier, some costs are not relevant to a decision, so as we look at options between our product lines, we need to decide which costs should be considered as decisions are made. It isn’t always the item we sell for the highest price! Costs can outweigh revenues, and in those cases, we need to evaluate and analyze to determine what items to manufacture, offer as services or stock on our shelves.

    Let’s look at a grocery store example. We have five flavors of ice cream in our freezer, but would like to determine how to best utilize the freezer space. Our accounting department gives us the following information regarding revenues and costs for our ice cream freezer:

    Morrie’s Grocery: Ice Cream Cooler—What Should We Stock?
    Vanilla Chocolate Strawberry Neapolitan Butter Pecan
    Sales 1000 1200 900 700 1050
    Variable Costs 400 720 270 490 577.5
    Contribution Margin 600 480 630 210 472.5
    Direct Fixed Costs 100 180 90 105 105
    Allocated Fixed Costs 150 180 135 140 157.5
    Net Income 350 120 405 -35 210

    From this spreadsheet, it would look like dropping the Neapolitan would be a good idea, right?

    Let’s look a little closer at this situation to determine if that is the right decision.

    So, if we get rid of the Neapolitan flavor, what expenses will be relevant to our decision?

    Variable costs would go away, as that cost is directly related to the Neapolitan ice cream. Direct fixed costs would also go away, as those costs are directly attributed to that flavor too. But what happens to the allocated fixed costs? Those costs would need to be distributed among the remaining flavors. Remember things like rent and utilities will occur regardless of what products we carry.

    Drop the Neapolitan?
    Variable Costs Avoided 490
    Direct Fixed Costs Avoided 105 595
    Less: Sales Revenue Lost 700
    Decrease in Net Income 105

    The variable costs and direct fixed costs are called avoidable costs. These are the costs that would go away by eliminating this flavor.

    So you can see now, that eliminating the Neapolitan would have a negative effect on the net income.  What if we drop chocolate?

    Drop the Chocolate?
    Variable Costs Avoided 720
    Direct Fixed Costs Avoided 180 900
    Less: Sales Revenue Lost 1200
    Decrease in Net Income 300

    So who would drop chocolate anyway, right?

    So you can see the decision to add or drop a product isn’t as easy as it looks! They may increase the sales of chocolate, if they eliminated another flavor. Remember that is called an opportunity cost!

    Now let’s practice:

    CC licensed content, Original
    • Add or Drop Decisions. Authored by: Freedom Learning Group. Provided by: Lumen Learning. License: CC BY: Attribution
    All rights reserved content
    • Part 3 - Relevant Costs for Decision Making - Drop or Retain. Authored by: Tony Bell. Located at: https://youtu.be/Dedeck0HVXM. License: All Rights Reserved. License Terms: Standard YouTube License