A decision whether or not to continue an old product line or department, or to start a new one is called an add-or-drop decision. The management of the company may face a problem of dropping/shutdown or continuing the manufacturing and marketing facilities. An add or drop decision is based only on the relevant costs involved in the process. It is always in the interest of a company to continue to operate facilities as long as products or services sold to recover variable cost and make a contribution toward recovery of fixed cost.
But the problem of a drop or continue arises when the income statement regarding the product shows a loss. In deciding whether to add a new product line or drop an existing one, the management must consider relevant benefits and costs. Then management of the company attempts to find out the reasons for the loss and makes a decision regarding drop or continue the manufacturing and marketing facilities.
In deciding whether to continue or drop, expected future revenue should be compared with the relevant cost. For this, the relevant cost must be separated into a variable/avoidable and fixed/unavoidable cost. Certain cost- fixed cost- does not eliminate by dropping facilities, like depreciation, interest, property tax and insurance. These costs continue during complete inactivity also. An add-or-drop decision must be based only on relevant information.
If operations are continued, certain expenditure connected with shutting down will be saved. Such expenditure includes reopening cost expenses, the cost for recruiting and training to new workers, etc.
For taking a decision to drop or continue the facilities, the income statement should be prepared under the contribution margin format. To maximize your business’s profitability, you need to be equipped to make an objective decision. Income statements for a drop or continue facilities will show:
- Contribution margin
- Net profit and,
- Percentage of net income to net sales
An alternative which has a higher contribution margin should be chosen as it will absorb the fixed cost and gives higher profit. Facilities with a high amount of fixed cost cannot be dropped as the fixed cost is irrelevant cost and the fixed cost will not decrease by dropping the particular facilities.
In a traditional cost management system, segmented income statements, using unit-based fixed or variable costs, improve the ability to make keep-or-drop decisions. The fixed cost imposed by dropping the facilities will have to be paid cumulatively in total resulting extra burden of fixed cost to continuing facilities and thereby reduced the overall profit of the company.
So, the decision of dropping or continuing the facilities should be judged on the basis of overall company profit.