10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
2 min read•june 18, 2024
analysis helps managers decide whether to keep or cut business units. It involves examining and costs, calculating contribution and margins, and considering the impact of methods on performance evaluation.
When evaluating segments, managers must focus on and revenues. They should also consider , , and . These tools help make informed decisions about segment or retention.
Segment Profitability and Discontinuation
Revenues and costs for discontinuation
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- Relevant revenues
- Revenues lost if segment discontinued (sales revenue from segment)
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- Costs avoided if segment discontinued
- directly associated with segment
- Fixed costs generally not relevant unless avoidable by discontinuing segment (rent, salaries)
- Costs avoided if segment discontinued
- Irrelevant costs
- Costs continuing regardless of segment discontinuation decision
- (corporate overhead)
- (equipment purchase, research and development)
- of resources used by the segment
- Costs continuing regardless of segment discontinuation decision
Product line margin calculations
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- Segment revenue minus segment variable costs
- Amount each segment contributes to covering fixed costs and generating profit
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- Segment revenue minus segment variable costs and directly attributable fixed costs
- More accurate measure of segment profitability by considering segment-specific fixed costs (advertising, dedicated equipment)
- Segment profitability evaluation
- Compare segment margin to allocated fixed costs
- Positive segment margin indicates profitable segment contributing to overall company profitability
- can be used to determine the sales volume needed to cover all costs
Impact of cost allocation methods
- Cost allocation methods
- : Allocates only directly attributable costs to segments
- : Allocates service department costs to other departments based on sequence of allocation
- : Allocates service department costs to other departments considering mutual services provided
- Impact on segment performance
- Different cost allocation methods lead to different segment profitability measures
- Over-allocation of costs makes segment appear less profitable than actual
- Under-allocation of costs makes segment appear more profitable than actual
- Different cost allocation methods lead to different segment profitability measures
- Limitations of cost allocation
- often irrelevant for decision-making
- Managers should focus on and revenues when evaluating segment performance (direct labor, materials)
Additional considerations for segment evaluation
- Incremental analysis: Comparing the difference in costs and revenues between alternatives
- Joint costs: Costs incurred to produce multiple products simultaneously, requiring appropriate allocation methods
- : Non-financial considerations that may impact the decision to keep or discontinue a segment (brand image, employee morale, customer relationships)
Key Terms to Review (27)
Allocated costs: Allocated costs are expenses that are distributed among different departments or segments within an organization based on a predetermined method. These costs can impact decision-making and performance evaluation in managerial accounting.
Allocated Fixed Costs: Allocated fixed costs are overhead expenses that are assigned or distributed to specific cost objects, such as products, services, or departments, based on a predetermined allocation method. These costs do not vary with the level of activity or output, but are essential for the operation of the business.
Avoidable Costs: Avoidable costs are expenses that can be eliminated or reduced if a particular decision or action is taken. These costs are directly tied to a specific activity or decision and can be avoided by not undertaking that activity or making that decision. Avoidable costs are an important consideration in various managerial accounting contexts, including decision-making, make-or-buy analysis, and product or segment discontinuation.
Breakeven Analysis: Breakeven analysis is a financial tool used to determine the point at which a business's total revenue equals its total costs, meaning it has neither a profit nor a loss. It helps businesses evaluate and determine whether to keep or discontinue a segment or product.
Contribution margin: Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It is used to cover fixed expenses and contribute to profits.
Contribution Margin: Contribution margin is the amount of revenue that remains after deducting the variable costs associated with producing a product or service. It represents the portion of sales revenue that contributes to covering fixed costs and generating profit. This concept is crucial in understanding the financial performance and decision-making processes of organizations, whether they are merchandising, manufacturing, or service-based entities.
Controllable costs: Controllable costs are expenses that a manager has the power to influence or change directly. These costs are critical for performance evaluation in responsibility centers as they reflect managerial effectiveness.
Controllable Costs: Controllable costs are expenses that can be directly influenced and managed by a responsible manager or department within an organization. These costs are under the direct control and decision-making authority of the manager, allowing them to be adjusted or modified as needed to achieve performance goals.
Cost Allocation: Cost allocation is the process of assigning indirect or overhead costs to specific cost objects, such as products, services, or departments, based on a rational and systematic method. It is a crucial concept in managerial accounting that helps organizations accurately determine the true cost of their operations and make informed decisions.
Direct Method: The direct method is an approach used to evaluate and determine whether to keep or discontinue a segment or product. It focuses on directly tracing and assigning revenues and expenses to specific segments or products, providing a clear and transparent view of their profitability.
Discontinuation: Discontinuation refers to the act of ending or ceasing the production, sale, or support of a product, service, or business segment. It involves the deliberate decision to remove an offering from the market or operations, often due to factors such as declining profitability, changing market conditions, or strategic realignment.
Incremental Analysis: Incremental analysis is a decision-making tool that focuses on the changes or increments in revenues, costs, and profits associated with a particular decision. It involves identifying and evaluating the relevant, additional information that would result from a specific course of action, rather than considering the total or average figures.
Joint Costs: Joint costs refer to the shared costs incurred in the production of multiple products or services from a single process or activity. These costs cannot be uniquely attributed to any one product, as they are common to the entire production process.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be forgone in order to pursue a certain action or decision. It represents the trade-off involved in choosing one option over another and is a fundamental concept in economics and managerial decision-making.
Opportunity costs: Opportunity costs represent the potential benefits or profits an individual, investor, or business misses out on when choosing one alternative over another. It is a crucial concept in decision-making, helping to evaluate the relative profitability of different options.
Qualitative factors: Qualitative factors are non-numeric elements that influence decision-making and performance evaluation. These factors include aspects such as employee morale, customer satisfaction, and brand reputation.
Qualitative Factors: Qualitative factors are non-numerical, subjective considerations that play a role in decision-making processes. Unlike quantitative factors, which can be measured numerically, qualitative factors are more abstract and based on judgment, experience, and intuition. These factors are crucial in various managerial accounting contexts, as they provide a more holistic perspective to supplement the numerical data.
Reciprocal Method: The reciprocal method is a technique used to allocate shared or common costs among various cost objects, such as products, services, or business segments. It is particularly useful in situations where multiple departments or activities contribute to the generation of these shared costs, making it challenging to directly assign them.
Relevant Costs: Relevant costs are the future costs that are expected to change based on a decision being considered. These costs are important in evaluating alternative courses of action and making informed business decisions.
Relevant Revenues: Relevant revenues are the revenues that are expected to differ between alternative courses of action. They are the revenues that are directly impacted by a decision and are crucial in evaluating the financial implications of that decision. Relevant revenues are a key consideration in making managerial decisions, such as whether to accept or reject a special order or whether to keep or discontinue a segment or product.
Segment: A segment is a distinct part of a business for which financial information is separately tracked and analyzed. Segments can be product lines, departments, or geographical regions.
Segment Margin: Segment margin is a metric used to evaluate the profitability of a specific business segment or product line within an organization. It measures the contribution of a segment to the overall profitability of the company by considering the direct revenues and expenses associated with that segment, while excluding common or shared costs that cannot be easily attributed to a specific segment.
Segment Profitability: Segment profitability refers to the financial performance and viability of a distinct business unit or division within a larger organization. It involves analyzing the revenues, costs, and profits associated with a specific segment or product line to determine its contribution to the overall company's success.
Step-Down Method: The step-down method is a cost allocation approach used to assign indirect costs to various segments or products within an organization. It involves a hierarchical allocation of overhead costs, where costs are first assigned to the primary cost pools and then systematically allocated to secondary cost pools in a step-by-step manner.
Sunk Costs: Sunk costs refer to expenses that have already been incurred and cannot be recovered, regardless of future decisions. They are past costs that are irrelevant for future decision-making as they do not affect the incremental costs and benefits of a decision. Understanding the concept of sunk costs is crucial in various managerial accounting contexts, such as identifying relevant information for decision-making, evaluating make-or-buy decisions, determining whether to keep or discontinue a segment or product, and assessing whether to sell or process a product further.
Total variable costs: Total variable costs are the overall expenses that change in direct proportion to the level of production or sales volume. These costs increase as production increases and decrease as production decreases.
Variable Costs: Variable costs are expenses that fluctuate directly with changes in a company's production or sales volume. These costs increase or decrease in proportion to the level of business activity, unlike fixed costs which remain constant regardless of output. Understanding variable costs is crucial for analyzing cost behavior patterns, calculating contribution margin, and making informed business decisions.