Dropping or Adding Product Line
In a multi-product company, the management may have to decide on adding or dropping a product line. If a new product line is added, its sales and certain costs will also increase and reverse will happen when a product line is dropped. In order to arrive at such a decision, the management should compare the differential cost and incremental revenue and study its effect on the overall profit position of the organization.
A decision concerning the discontinuation of a product should be taken after considering the following:
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Competitive nature of the products of the company.
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Value of resources released on discontinuation.
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Contribution margin earned from that product.
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Whether any contribution from that product will reduce the burden of total fixed costs of the firm, which will help in better profits than if such product is discontinued.
Illustration
Excel Ltd., is engaged in 3 distinct lines of production. Their production cost per unit and selling prices are as under:
|
Particulars
|
Product X (Rs.)
|
Product Y (Rs.)
|
Product Z (Rs.)
|
|
Production units
|
6,000
|
4,000
|
10,000
|
|
Cost:
|
|
|
|
|
Material
|
36
|
52
|
60
|
|
Wages
|
14
|
18
|
20
|
|
Variable overheads
|
4
|
6
|
6
|
|
Fixed overheads
|
10
|
16
|
18
|
|
Total cost
|
64
|
92
|
104
|
|
Selling price
|
80
|
120
|
122
|
|
Profit
|
16
|
28
|
18
|
The management wants to discontinue one line and gives the assurance that production in two other lines shall rise by 50%. They intend to discontinue the line, which produces Product 'X', as it is less profitable.
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Do you agree to the scheme in-principle? If so, do you think that the line which produces 'X' should be discontinued?
-
Offer your comments and show the necessary statements to support your decisions.
Solution
|
Total Fixed cost
|
Rs.
|
|
X
|
6,000
|
units @ Rs.10 =
|
60,000
|
|
Y
|
4,000
|
units @ Rs.16 =
|
64,000
|
|
Z
|
10,000
|
units @ Rs.18 =
|
1,80,000
|
|
|
|
|
3,04,000
|
|
Contribution = Selling price - Variable Cost
|
= Selling Price - Variable Cost
|
|
|
X = Rs.80 - 54
|
=
|
Rs.26 per unit
|
|
Y = Rs.120 - 76
|
=
|
Rs.44 per unit
|
|
Z = Rs.122 - 86
|
=
|
Rs.36 per unit
|
In order to decide it is viable to discontinue the line that produces '×', the following have to be worked out.
If Product X is dropped
Sale of Y and Z will increase by 50%. Then the sales would be Y - 6,000 units and Z - 15,000 units.
|
Total Contribution
|
Rs.
|
|
Product Y: 6,000 units @ Rs.44 per unit =
|
2,64,000
|
|
Product Z: 15,000 units @ Rs.36 per unit =
|
5,40,000
|
|
|
8,04,000
|
|
Less: Fixed Cost
|
3,04,000
|
|
Profit
|
5,00,000
|
If Product Y is dropped
Sale of X and Z will increase by 50%. Then the sales would be X - 9,000 units and Z - 15,000 units.
|
Total Contribution
|
Rs.
|
|
Product X: 9,000 units @ Rs.26 per unit =
|
2,34,000
|
|
Product Z: 15,000 units @ Rs.36 per unit =
|
5,40,000
|
|
|
7,74,000
|
|
Less: Fixed Cost
|
3,04,000
|
|
Profit
|
4,70,000
|
If Product Z is dropped
Sale of X and Y will increase by 50%. Then the sales would be X - 9,000 units and Y - 6,000 units.
|
Total Contribution
|
Rs.
|
|
Product X: 9,000 units @ Rs.26 per unit =
|
2,34,000
|
|
Product Y: 6,000 units @ Rs.44 per unit =
|
2,64,000
|
|
|
4,98,000
|
|
Less: Fixed Cost
|
3,04,000
|
|
Profit
|
1,94,000
|
From the above, it is clear that, among the three alternatives, the highest amount of profit is earned when X line of production is discontinued. Thus, the management decision to discontinue X is correct.
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