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Add or Drop a Product Line (or Segment)

XYZ Company has three product lines. The company is considering dropping Product 2 because
it has been operating at a loss. The following summarizes the income of the three product lines.

Product Product Product


Total
1 2 3

Sales $15,000 $22,000 $37,000 $74,000

Less: Variable Costs 9,000 10,000 19,000 38,000

Contribution Margin$ 6,000 $12,000 $18,000 $36,000

Less: Fixed Costs

Traceable 3,000 10,000 6,000 19,000

Allocated 1,000 3,500 5,000 9,500

Net Income $ 2,000 ($ 1,500) $ 7,000 $ 7,500


Solution:

The allocated fixed costs should be removed when analyzing segment income. Hence, Product 2
should not be dropped since it has a positive segment margin.

Product Product Product


1 2 3

Sales $15,000 $22,000 $37,000

Less: Variable Costs 9,000 10,000 19,000

Contribution Margin $ 6,000 $12,000 $18,000

Less: Traceable Fixed Costs 3,000 10,000 6,000

Segment Income $ 3,000 $ 2,500 $ 12,000

Why are we removing the allocated fixed costs in our analysis? Because the company would
still incur the entire allocated fixed costs with or without Product 2. A portion of these costs is
actually absorbed by Product 2's segment income. If Product 2 is dropped, it will result in lesser
overall profits.

With Without
Product Product
2 2

Sales $74,000 $52,000

Less: Variable Costs 38,000 28,000

Contribution Margin $36,000 $24,000

Less: Fixed Costs

Traceable 19,000 9,000

Allocated 9,500 9,500

Net Income $ 7,500 $ 5,500

The allocated fixed costs are unavoidable costs. The entire $9,500 would be incurred with or
without Product 2. If Product 2 is dropped, it will result in lower overall net income. Hence, the
product line should not be dropped.
Accept or Reject a Special Order

In a month, ABC Company normally produces and sells 8,000 units of its product for $20.
Variable manufacturing cost per unit is $10. Total fixed manufacturing costs (up to the
maximum capacity of 10,000 units) are $38,000. Variable operating cost is $1 per unit and fixed
operating costs total $10,000.

A customer placed a special order for 1,500 units for $15 each. The customer is willing to
shoulder the delivery costs; hence the business will not incur additional variable operating costs.
Should the company accept or reject the special order?

Solution:

The company has 2,000 units excess capacity to fill up the special order of 1,500 units. The only
costs to be considered in this case are the variable manufacturing costs. The total fixed cost is
the same regardless of the level of activity. Even if an additional 1,500 units are to be produced,
the total fixed cost remains the same. In addition, both parties agreed that the company will
not incur in additional variable operating costs.

Should the company accept the offer? Yes. The selling price of $15 exceeds the variable
manufacturing cost of $10. This will result in additional income of $7,500 (1,500 x $5).

Proof:

w/o Special w/ Special


Order Order

Sales $160,000 $182,500

Less: Variable costs

Var. manufacturing 80,000 95,000

Var. operating 8,000 8,000

Contribution margin $72,000 $79,500

Less: Fixed costs

Fixed manufacturing 38,000 38,000

Fixed operating 10,000 10,000

Operating Income $24,000 $31,500


The $182,500 sales revenue includes 8,000 units sold at $20 and 1,500 units sold at $15 each.
Additional variable operating costs is avoided as mentioned in the problem. Fixed costs remain
constant regardless of the level of activity.

Example - Without Excess Capacity

Using the same information in the above scenario but this time, assume that the company
normally manufactures and sells 9,000 units instead of 8,000. Should the company accept the
special order?

Solution:

Since the company has excess capacity of 1,000 units only, it is not enough to fill up the special
order of 1,500 units. Hence, a portion of the regular sales (500 units) must be sacrificed to fill
up the entire special order. The lost contribution margin should be considered. Contribution
margin is equal to sales (at $20) minus variable costs ($10 variable manufacturing plus $1
variable operating).

Lost contribution margin = ($20 - $11) x 500 units = $4,500

The lost contribution margin is allocated over the items sold through the special order.

Lost contribution margin per unit = $4,500 / 1,500 units = $3

This cost is an additional consideration in the decision. Should the company accept the offer?
The answer is still yes since the selling price ($15) is higher than the cost ($13, i.e. variable
manufacturing cost per unit of $10 plus lost CM per unit of $3). This will result in additional
income of $3,000 (1,500 x $2).
Proof:

w/o
w/ Special
Special
Order
Order

Sales $180,000 $192,500

Less: Variable costs

Var. manufacturing 90,000 100,000

Var. operating 9,000 8,500

Contribution margin $81,000 $84,000

Less: Fixed costs

Fixed manufacturing38,000 38,000

Fixed operating 10,000 10,000

Operating Income $33,000 $36,000

The $192,500 sales revenue includes regular sales of 8,500 units (sold at $20 each) and 1,500
specially ordered units (sold at $15). As mentioned in the problem, the company will incur the
variable operating cost only for regular sales. Fixed costs remain the same.
Make or Buy Decision

XYZ Company has been manufacturing its own widgets that are used in producing its final
product. The cost of manufacturing 10,000 widgets is summarized below.

Direct materials $20,000

Direct labor 16,000

Variable factory overhead 9,000

Fixed factory overhead 15,000

Total manufacturing costs $60,000

A supplier offers to produce the widgets that XYZ needs for $5.30 plus freight costs of $0.50 per
widget. If the company decides to buy from the supplier, 60% of the fixed factory overhead
which represents depreciation and insurance costs will still continue. 40% will be avoided.

a.) Should the company continue to make the widget or purchase it from the outside
supplier? Based on comparative analysis of the costs of producing the widgets and costs
of buying them, the company should make rather than buy the widget since it will result
in $5,000 savings.

b.) Suppose that if the company chooses to buy the widget, the space used to manufacture
the widgets before can be rented out to a tenant for $7,500. This is an opportunity cost,
added to the cost of manufacturing the widgets.
Solution :

(a)

Direct materials $20,000

Direct labor 16,000

Variable factory overhead 10,000

Avoidable fixed factory overhead (40%)6,000

Cost of manufacturing the widgets $51,000

Purchase price (10,000 x $5.25) $52,500

Freight costs (10,000 x $0.50) 5,000

Cost of buying the widgets $57,000

The above could also be analyzed in another way. The total cost of making the widgets is given
at $60,000. If the company purchases them, it will pay $57,000. However, fixed factory costs of
$9,000 (60%) will not be avoided. This results in total costs of $66,000. The company will save
$6,000 in making the widgets.

(b)

Direct materials $20,000

Direct labor 16,000

Variable factory overhead 10,000

Avoidable fixed factory overhead (40%)6,000

Opportunity cost 7,500

Cost of manufacturing the widgets $59,500

In this case, the cost of buying the widgets ($57,000) is lower than the cost of manufacturing
them ($59,500). Hence, it is better for the company to buy the widgets as it will result in $2,500
savings.