Eliminate Unprofitable Segments

Decisions to Eliminate Unprofitable Business Segments

 

  • ·        A firm must consider whether to eliminate a particular division or segment if it is not profitable.  The decisions are called keep-or-drop or continue or discontinue decisions.  Managers must consider which costs and benefits would change as a result of the decision.  Because some costs may be incurred even if the segment is eliminated, we need to do an incremental analysis to determine the net effect on the bottom line.  Before deciding to eliminate a product line, one needs to ask the following questions:
    • o       What costs (and revenues) would change as a result of the decision to discontinue the product line?
    • o       Would the costs (and revenues) of other product lines be affected by the decision to discontinue a product line?
    • o       Are there alternative uses for the resources currently devoted to a product line (opportunity costs)?

 

In order to conduct an effective an effective analysis, one should look at a segment margin income statement by segment or product line.  The segment income statement is based on the contribution margin approach to an income statement.  The contribution margin income statement is expanded to show the segment margin of each product line.  To get the segment margin, one takes the contribution margin and subtracts out direct fixed costs of each of the particular segments to get the segment margin of each product line.   A direct fixed cost is one that can be attributed to a specific segment of the business.  Examples include a machine that produces only one type of product, a supervisor who is responsible for a specific division, and advertising aimed at a specific region or product line.  Eventhough these costs are fixed, and thus independent of the number of units produced or sold, they relate to only one segment and thus could be avoided if the segment were eliminated.

 

Unlike direct fixed costs that relate to a specific segment, common fixed costs are shard by multiple segments and thus will be incurred even if a segment is eliminated.  In evaluating segment profitability, managers should focus on the segment margin rather than the bottom line profit margin.  The segment margin tells managers how much incremental profit a segment generates that helps to cover common fixed costs and contribute to companywide profit.  A product may not be profitable for a bottom line standpoint, but it could generate a positive segment margin which could help to cover common fixed costs.

 

Another question managers must consider is to address whether the elimination of one segment will affect the cost and revenues of other segments.  Lastly, managers need to consider whether any opportunity costs should be considered.

 

  • ·        Incremental Analysis – One can look at the costs and benefits in eliminating a segment.  One would look at the loss of sales as a cost, and look at the cost savings as a benefit for a particular product line.  Then, one would look at the opportunity costs and benefits in the effects of the discontinuance of one segment and how this would affect another other segments.  One would then create an alternative income statement showing the effects of the discontinuance on the other segments.  One then would look the increase and decrease of segment margins after the change.  If the segment margin is positive after the shut down of the product line, then one should shut down the product line.

 

  • ·        Qualitative Analysis – As in the other decision scenarios, the quantitative analysis is only a starting point for making the decision.  Managers must always consider other important factors including the effect of the decision on customer loyalty and employee morale.  Managers must also think about the likely impact of discontinuation on other products and customers.  Sometimes firms can have complementary products, or products that are used together Eliminating one product could have consequences on the other.  When choosing to discontinue products, managers must carefully anticipate the effects on other related product lines.