Decision for Abandonment (Close) of a Product or Department – Explanation with Solved Examples:
When a product line or department of business is unable to cover all its costs then the management may be concerned whether to continue with this or close its operations. Marginal costing asserts that the decision to close a product line/department should not be based on contribution rather than its profit or loss. It should be determined that if product line/department is making a positive contribution towards covering its fixed costs then it should not be closed on financial grounds.
Solved Example 1:
An automobile company produces three vehicles for which the following details are available:
The total costs comprise 2/3 variable and 1/3 fixed. The directors consider that as 800 CC cars are making a loss it should be discontinued.
Suggest the management whether 800 CC car be discontinued and what other factors should be considered.
The manufacturer of 800 CC car is making a positive contribution of $120000 towards covering the fixed cost so it should not be abandonment deposit of net loss of $30000. Moreover if production of 800 CC car is abandonment its contribution will also be lost resulting in a fall in total profits of the business by $12000 as fixed cost of 800 CC car will be charged to remaining two production lines.
Solved Example 2:
A private tuition college is providing tuition classes in different subjects. Following are the information for the year ended 30 June 2016:
Management is considering discontinuation of tuition classes of accounting and business studies as they are making loss. Advise the management on financial grounds only whether they should cease accounting and business studies classes.
As accounting class is making positive contribution of $120000 so it should not be discontinued. However business studies class should be discontinued as it is having negative contribution which means marginal revenues of the business are even insufficient to cover marginal cost.
Factors to be Considered before Closure of a Product or Department:
- Decision to close a department or product is to be based on contribution not profit or loss.
- The methods used to apportion the expenses should be the fairest methods.
- The possibility of improving the performance of the least profitable or loss making department.
- The effect of the closure of one department on the rest of the business should be investigated as customers attracted by the unprofitable department may make substantial purchases in other departments.
- Non-monetary factors like negative effect on the customers’ and suppliers’ in the future operations of the remaining business are also important.
- Loss of staff morale and overall reputation of the business due to displacement of staff of department subject to closure should also be considered.
- It must be remembered that not all the expenses apportioned to the department will disappear when the department is closed as fixed costs burden of remaining products may increase.
- Lastly the alternative uses of the resources becoming available after closure need to be considered. For example a department should only be closed if its floor space can be operated more profitably by a new department or by expanding an existing department or by renting out it to another business.