Which of the following is not relevant to a decision about whether to drop a segment

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:

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 Variable Costs Contribution Margin Direct Fixed Costs Allocated Fixed Costs Net Income

1000	1200	900	700	1050
400	720	270	490	577.5
600	480	630	210	472.5
100	180	90	105	105
150	180	135	140	157.5
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 Direct Fixed Costs Avoided Less: Sales Revenue Lost Decrease in Net Income

490
105	595
	700
	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 Direct Fixed Costs Avoided Less: Sales Revenue Lost Decrease in Net Income

720
180	900
	1200
	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:

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44. Which of the following is not relevant to a decision about whether to drop a segmentor not?a.The available fixed cost direct to that segment.b.The contribution margin expected to be earned by the segment.c.The complementary effects of discontinuing the segment.