RELEVANT COSTING - Add or Drop (Department/Service)

Add or Drop Decision

A decision whether or not to continue an old product line or department, or to start a new one is called an add-or-drop decision. An add-or-drop decision must be based only on relevant information.

Relevant information includes the revenues and costs which are directly related to a product line or department. Examples of relevant information are sales revenue, direct costs, variable overhead and direct fixed overhead. Such decision must not be based on irrelevant information such as allocated fixed overhead because allocated fixed overhead will not be eliminated if the product line or department is dropped.

The following example illustrates an add-or-drop decision:

Example

A company has three products: Product A, Product B and Product C. Income statements of the three product lines for the latest month are given below:

Product Line	A	B	C
Sales	$467,000	$314,000	$598,000
Variable Costs	241,000	169,000	321,000
Contribution Margin	$226,000	$145,000	$277,000
Direct Fixed Costs	91,000	86,000	112,000
Allocated Fixed Costs	93,000	62,000	120,000
Net Income	$42,000	− $3,000	$45,000

Use the incremental approach to determine if Product B should be dropped.

Solution

By dropping Product B, the company will loose the sale 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 B and not the allocated fixed costs. Hence:

If Product B is Dropped
Gains:
Variable Costs Avoided	$169,000
Direct Fixed Costs Avoided	$86,000	$255,000
Less: Sales Revenue Lost		$314,000
Decrease in Net Income of the Company		$59,000

Written by Irfanullah Jan

https://accountingexplained.com/managerial/relevant-costing/add-or-drop-product-line