Blueprint Problem: Cost-Based Decision Making – Keep or drop decisions
Differential Analysis: Keep-or-Drop Decisions
Managers must often decide between two or more alternatives. Differential analysis is used in decision
making. When using differential analysis, it is important to only include those amounts that are different between the alternatives.Differential cost is subtracted fromdifferential revenue to determinedifferential income/loss.
Differential analysis requires that relevant costs must be identified. When determining which costs are relevant, which of the following
statements is true?
SelectAll fixed costs are irrelevant.All mixed costs are relevant.All variable costs are relevant.Relevancy must be determined on a
case-by-case basis.Correct 1 of Item 1
For example, a manufacturing company may have a segment or product that is operating at a loss. The decision to keep the segment/product
or discontinue it is called akeep-or-drop decision and uses differential analysis to assist in the decision-making
process.
Differential analysis is only one step in deciding to keep or drop the segment or product. Management must also take into consideration
nonquantitative data. If the company drops a product, will it affect the sales of other products? If employees are laid off or terminated, will it affect
employee morale? These nonquantitative issues will influence the success or failure of a keep-or-drop decision.
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While fixed costs are usually not relevant to a keep-or-drop decision, there are cases where they can be changed or
eliminated.
APPLY THE CONCEPTS: Calculate remaining cost in a keep-or-drop decision
Len Corporation makes three products: snowboards, skateboards, and skis. The contribution margin income statement for each department is
provided:
| Snowboards | Skateboards | Skis | |
| Sales | $175,000 | $180,000 | $160,000 |
| Less: variable expenses | 70,000 | 36,000 | 56,000 |
| Contribution margin | $105,000 | $144,000 | $104,000 |
| Less: fixed expenses: | |||
| Salaries | $61,250 | $63,000 | $64,000 |
| Depreciation | 14,000 | 27,000 | 32,000 |
| Advertising | 4,000 | 9,000 | 48,000 |
| Net income (loss) | $25,750 | $45,000 | $-40,000 |
The net income for skis has been negative for several periods despite management’s efforts to increase sales and decrease expenses.
Therefore, Len Corporation is considering discontinuing production of skis. If the ski line is dropped, all variable costs currently associated with that
department will be eliminated, as will all advertising costs, but only 70% of the salaries currently associated with that department will be eliminated. If
the ski line is dropped, what amount of salaries will remain?
Select$0$44,800$19,200$64,000Correct 1 of Item 2
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Salaries are often mixed costs, with some relevant to the decision and some fixed, at least over the short term. Thus, a
percentage must often be estimated to split the cost category into its two components.
APPLY THE CONCEPTS: Calculate differential income in a keep-or-drop decision
Complete the table to compare the effects of dropping the ski line of products. Enter all amounts as positive numbers except for a net
loss. If an amount is zero, enter “0”. The cost data for the each department is shown below.
| Snowboards | Skateboards | Skis | ||
| Sales | $175,000 | $180,000 | $160,000 | |
| Less: variable expenses | 70,000 | 36,000 | 56,000 | |
| Contribution margin | $105,000 | $144,000 | $104,000 | |
| Less: fixed expenses: | ||||
| Salaries | $61,250 | $63,000 | $64,000 | |
| Depreciation | 14,000 | 27,000 | 32,000 | |
| Advertising | 4,000 | 9,000 | 48,000 | |
| Net income (loss) | $25,750 | $45,000 | $-40,000 | |
| Alternatives | Differential Effect | |||||
| Keep | Drop | Increase/Decrease | ||||
| Sales | $ | $ | ||||
| Less: variable expenses | ||||||
| Contribution margin | $ | $ | ||||
| Less: fixed expenses: | ||||||
| Salaries | $ | $ | $ | |||
| Depreciation | ||||||
| Advertising | ||||||
| Net income (loss) | $ | $ | $ | |||
Based on the analysis, Len Corporation should SelectkeepdropCorrect 22 of Item 3 the ski line. If the ski line is dropped,
its overall income will SelectdecreaseincreaseCorrect 23 of Item 3.
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Use the information in the previous sections to divide the costs into their relevant and non-relevant portions, in order to
decide which items change with the “Drop” decision.
If the company loses more money when they select the “Drop” alternative over the “Keep” alternative, they are usually better
off keeping the business to contribute to overall fixed costs.
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