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2.8. Discontinuing a Product, Department, or Project

One of the more difficult decisions management must make is when to abandon a business unit that is performing poorly. Such decisions can have far reaching effects on the company, shareholder perceptions about management, employees, and suppliers. The tools of Enterprise Performance Evaluation chapter provided insight into performance evaluation methods that are helpful in identifying lagging sectors, and the preceding chapter showed how misuse of absorption costing information can invoke a series of successive product discontinuation decisions that bring about a downward business spiral. So, what analytical methods should be employed to support a final decision to pull the plug on a business unit?

Management should not merely conclude that any unit generating a net loss is to be eliminated! This is an all too common error made by those who lack sufficient accounting knowledge to look beyond the bottom line. Sometimes, eliminating a unit with a loss can reduce overall performance. Consider that some fixed costs identified with a discontinued unit may continue and must be absorbed by other units. This creates a potential domino effect where each falling unit pushes down the next. Instead, the appropriate analysis is to compare company wide net income "with" and "without" the unit targeted for elimination.

Casa de Deportes is a mega sporting goods store occupying 80,000 square feet of space in a rented retail center. Each department is evaluated for profitability based on the following information:

Fishing

Hunting

Camping

Golf

Total

Sales

$ 6,000,000

$ 8,000,000

$ 4,000,000

$ 3,000,000

$21,000,000

Variable expenses

3,600,000

4,800,000

2,400,000

1,800,000

12,600,000

Contribution margin

$ 2,400,000

$ 3,200,000

$ 1,600,000

$ 1,200,000

$ 8,400,000

Less fixed costs:

General/administrative

$ 600,000

$ 800,000

$ 400,000

$ 300,000

$ 2,100,000

Selling

1,200,000

1,600,000

800,000

600,000

4,200,000

Rent

250,000

250,000

250,000

250,000

1,000,000

Utilities

40,000

40,000

40,000

40,000

160,000

Depreciation

50,000

35,000

60,000

40,000

185,000

Total fixed costs

$ 2,140,000

$ 2,725,000

$ 1,550,000

$ 1,230,000

$ 7,645,000

Net income (loss)

$ 260 000

$ 475 000

$ 50 000

$ (30 000)

$ 755 000

Management is quite concerned about the Golf Department. It has had plenty of time to flourish, but has never turned a profit. Further, no one at Casa de Deportes, including the Golf Department manager, believes this situation is apt to change anytime soon. The accounting department was asked to prepare a report of the overall financial impacts if Golf is discontinued. In preparing the "without golf" report, it was learned that only 70% of the General and Administrative costs would be eliminated, rent and depreciation would continue to be incurred, and utilities would be reduced by only half. The selling costs would be completely eliminated. The unavoidable costs from the golf department are assumed to be shifted equally to the other departments (although other allocation methods could be used, the overall conclusions would not change). The income report "without golf" appears as follows:

Fishing

Hunting

Camping

Golf

Total

Sales

$ 6,000,000

$ 8,000,000

$ 4,000,000

$ -

$18,000,000

Variable expenses

3,600,000

4,800,000

2,400,000

-

10,800,000

Contribution margin

$ 2,400,000

$ 3,200,000

$ 1,600,000

$ -

$ 7,200,000

Less fixed costs:

General/administrative

$ 630,000

$ 830,000

$ 430,000

$

$ 1,890,000

Selling

1,200,000

1,600,000

800,000

-

3,600,000

Rent

333,334

333,333

333,333

-

1,000,000

Utilities

46,666

46,667

46,667

-

140,000

Depreciation

63,333

48,333

73,334

-

185,000

Total fixed costs

$ 2,273,333

$ 2,858,333

$ 1,683,334

$ -

$ 6,815,000

Net income (loss)

$ 126 667

$ .341 667

$ (83 334)

$ -

$ 385 000

Obviously, discontinuing the Golf Department will not help the overall situation. The reallocation of unavoidable costs not only reduces overall profitability, but it also paints the Camping Department in a precarious light. Further, this analysis does not take into account potential sales reductions in other departments that might occur from reductions in overall store traffic (e.g., a "golfing only" customer might nevertheless buy an occasional flashlight from the camping department, etc.). Another factor not included above are the incremental costs from closing a department (e.g., inventory write-offs, increased unemployment compensation costs for laid off workers, etc.). As you can see, the decision to discontinue a product, department, or project is far more complex than it might at first seem.

2.9. The 80/20 Concept

Many businesses have broad product lines and large customer bases. However, an in-depth evaluation is likely to reveal that a significant portion of its success is centered around a narrow set of products, customers, and services. The remainder of the business activity may be very marginal. For example, a technology-based business may find that some of its lowest-volume customers consume the largest amount of the tech support staff's time (due to customer inexperience with the product) while the large volume customers require almost no assistance with the company's product.

It requires a great deal of business discipline to "abandon" a product, customer, or service, but such decisions can actually contribute to business success. Consider the following quote from ITW, a large and successful corporation that embraces the 80/20 concept:

"A key element of the Company's business strategy is its continuous 80/20 business process for both existing businesses and new acquisitions. The basic concept of this 80/20 business process is to focus on what is most important (the 20% of the items which account for 80% of the value) and to spend less time and resources on the less important (the 80% of the items which account for 20% of the value). The Company's operations use this 80/20 business process to simplify and focus on the key parts of their business, and as a result, reduce complexity that often disguises what is truly important. The Company's 700 operations utilize the 80/20 process in various aspects of its business. Common applications of the 80/20 business process include:

• Simplifying manufactured product lines by reducing the number of products offered by combining the features of similar products, outsourcing products or, as a last resort, eliminating products.

• Simplifying the customer base by focusing on the 80/20 customers and finding different ways to serve the 20/80 customers.

• Simplifying the supplier base by partnering with key 80/20 suppliers and reducing the number of 20/80 suppliers.

• Designing business processes and systems around the key 80/20 activities.

The result of the application of this 80/20 business process is that the Company improves its operating and financial performance. These 80/20 efforts often result in restructuring projects that reduce costs and improve margins. Corporate management works closely with those business units that have operating results below expectations to help the unit apply this 80/20 business process and improve their results."

Some contend that this approach results in sacrificing long-term opportunities to enhance short-term profitability. For instance, a "small and inexperienced" customer that is abandoned today might eventually grow to be a major player. As a result, the 80/20 philosophy is not always the optimum strategy and good business judgment should always be exercised in the decision-making process.

 
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