Question

What is the proper approach to analyzing whether or not a product line should be dropped? Be sure to include incremental analysis in answer.

Answer 1

An add or drop decision i.e. a product line should be continued or not must be based on relevant information.

Relevant information is the information which includes revenues and costs which are directly related to a product.

Examples - Sales revenue, Direct material costs, direct labor costs, variable overhead or direct fixed overhead. In this, allocated fixed overhead should be excluded while making this decision; as those will still be incurred; in case product line is dropped.

Incremental analysis can be used for this decision making. Incremental analysis is a decision making technique used in business to determine the true cost difference between alternatives.

Example

A Company has 3 products : Product X, Product Y and Product Z. Income statements of the three product lines for the month are given below:

Product line	X	Y	Z
Sales	$467000	$314000	$598000
Variable costs	241000	169000	321000
Contribution margin	$226000	$145000	$277000
Direct Fixed Costs	91000	86000	112000
Allocated Fixed Costs	93000	62000	120000
Net Income	$42000	-$3000	$45000

So, in this example, using incremental approach:

By dropping product Y, the company will loose the sales revenue from the product line. The company will also obtain gains in the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product Y and not allocated fixed costs. Hence:

If product Y is dropped:

Gains:
Variable costs avoided	$169000
Direct Fixed Costs avoided	$86000	$255000
Less: Sales revenue lost		$314000
Decrease in net income of the company		$59000