Decisions made to add or drop product lines are based on the impact that products have on operating income. When managers consider dropping a product line, they look to determine what costs they can avoid by doing so. If the costs avoided from dropping a product line are greater than that product’s contribution margin, net operating income will increase by dropping the line.
Similarly, if a new product line will have a contribution margin that is greater than any new fixed costs incurred, adding a new product line will increase the business’s operating income.
For example, AllRoads paves freeways, highways, streets, laneways and driveways. AllRoads is thinking of discontinuing working on highways and streets. If it stops paving both highways and streets, it will save all of the fixed costs for those two job types. However, it will lose out on approximately $100 of sales from freeways. On the other hand, if AllRoads stops paving streets only, it will only save $100 in fixed expenses. Should AllRoads discontinue working on highways and streets?
|
|
Total |
Freeways |
Highways |
Streets |
Laneways |
Driveways |
|
Sales |
$2140 |
$1,000 |
$500 |
$450 |
$90 |
$100 |
|
Variable Expenses |
1140 |
500 |
300 |
300 |
20 |
20 |
|
CM |
1000 |
500 |
200 |
150 |
70 |
80 |
|
|
|
|
|
|
|
|
|
Fixed Expenses |
856 |
400 |
200 |
180 |
36 |
40 |
|
|
|
|
|
|
|
|
|
Operating Income |
$144 |
$100 |
$0 |
$-30 |
$34 |
$40 |
Discontinue Highways and Streets:
Savings on Fixed Costs = 200 + 180 = 380
Lost Contribution Margin = 200 + 150 = 350
Loss Income from Freeways = 100 – 50 = $50
Incremental Income from discontinuing Highways and Streets = 380 – 350 – 50 = $ - 20
Discontinue Streets:
Savings on Fixed Costs = 100
Lost Contribution Margin = 150
Incremental income from discontinuing highways and streets = $ - 50
Therefore, even though highways or streets do not make an operating profit, the business is still better off keeping them.