decision making

Sometimes when a business sees that a product, department, or location is losing money, the first reaction is to shut it down. Discontinuing operations is a decision that should only be taken after careful consideration and number crunching.

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When deciding to keep or drop a part of the company, the first thing to do is to create an income statement broken into segments. For example, if a product is unprofitable, create a product line income statement. If there is a location that is not profitable, create an income statement for that location. Use a contribution margin income statement to separate variable costs from fixed costs.

Keep or Drop1

This is the kind of income statement that would make a company think about dropping a product. Overall, the company has a loss of $4,000 and it appears that Product A has a $38,000 loss. On the surface, it might look like dropping Product A and only producing Product B would result in a profit of $34,000. But is that correct?

Here are some things to consider when evaluating if a company should keep or drop a segment (product, department, or location):

1. Does the segment have a positive contribution margin?

If we look at Product A, it does have a positive contribution margin. This is important because the product is covering all of it’s variable costs and it is contributing toward foxed costs. While the contribution margin is not high enough to cover all of the fixed costs, increasing sales of Product A would increase contribution margin and lower the loss.

If the segment has a positive contribution margin, continue the evaluation.

2. Can any of the fixed costs be avoided if the segment was discontinued?

There are two types of fixed costs that should be considered, direct fixed costs and common fixed costs.

Direct fixed costs are fixed costs that can be directly traced to the segment. Just because a fixed cost is direct does not mean that it is avoidable. There may be depreciation, contractual obligations, and other costs that the company will not be able to cut even if the segment is discontinued. If the fixed costs cannot be avoided, losses will increase if the segment is discontinued because the segment will no longer be contributing to the total contribution margin.

Common fixed costs are organization sustaining fixed costs that are allocated to the segment. These fixed costs will continue even if the segment has been eliminated; they will just be allocated to the remaining segments.

Let’s say, in our example, that none of the direct fixed costs are avoidable. What happens to the loss if Product A is discontinued?

Keep or Drop 2

Since there are no longer sales from Product A, we eliminate the revenue and the variable costs from Product A. We also lose $85,000 in contribution margin that was helping to offset some of the fixed costs. The loss increased by $85,000 (the amount of contribution margin that was eliminated). What would happen if we could eliminate all of the direct fixed expenses?

keep or drop 3

If all of the direct fixed costs could be eliminated, now we see positive results. Notice that the common fixed cost is still $99,000.

Make sure to carefully examine fixed costs to see which, if any, could be cut.

3. Can the freed up capacity be used for another purpose?

If the segment was discontinued, could the company use the machinery and employees for another purpose? Could the company make additional units of another product or make a new product? Assessing these alternatives helps the company decide if there is something more profitable it could do instead. Idle capacity makes it less likely that fixed costs could be eliminated.

4. Will discontinuing a segment have adverse effects on the sale of other products?

Imagine that Product A is a cereal bowl and Product B is a matching plate. Do you think that discontinuing Product A would hurt the sales of Product B? I think it would. Before discontinuing a product make sure that sales of remaining products would not be adversely affected.

Let’s say that we could eliminate all the direct fixed costs from Product A but sales of Product B would fall 15%. Should we drop Product A? If we remove Product A and it’s direct fixed costs but lower the sales and variable costs of Product B by 15%, the results are not good.

Keep or drop 4

The loss is larger now than it was when the company was making Product A. The negative impact on sales of Product B outweighs the savings from discontinuing Product A.

Make sure to look at the adverse effects on other segments of the company before deciding to drop a segment.

Final Thoughts

When deciding if a company should drop an unprofitable segment, the company should create a segment contribution margin income statement. If the contribution margin is positive, the company should consider direct and common fixed costs, what to do with freed capacity, and the effect on sales of other products.

Related Video

Keep or Drop Decision Making

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Managers make lots of short-term decisions. We will begin looking at how managers make decisions and how to determine if information gathered is relevant to the process.

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The decision making process

When managers make decisions, they go through a five step process. We may not even be aware that we are actually going through these steps as we make decisions. You have probably unconsciously gone through this process in your own decision making.

1. Define the goal

Whenever we made decisions, there is a goal. The goal can be something simple like “I’m hungry and need to eat something for lunch.” Whenever you are making decisions, there is a goal in mind. The more fully you can define the goal, the better you will be at gathering information later on. If you are hungry and want to decide what to eat for lunch, perhaps you add healthy to the goal. Not just a lunch, but you want to have a healthy lunch.

2. Identify alternative courses of action

You have a solid goal, now it’s time to figure out your alternatives. Let’s use our lunch example. What are some healthy options for lunch? You could eat at home or at the school dining commons. You could go out to eat. If you went out to eat, where could you go? A sit down restaurant is one option. Fast food is another. At this stage we are not assessing the alternatives. Identify the alternative courses of action that appear to fit your goal.

3. Gather and analyze information

In step 2, we didn’t think a lot about the alternatives, other than just identifying them. In step 3, we begin to gather information.

If you ate in the dining commons, it would be free (if you have a meal plan). There are lots of choices, hopefully some of them are healthy. They have a salad bar and you are really craving salad and an iced tea. If you went to the dining commons, you would probably run into some of your friends.

The sit down restaurant also has a salad bar and iced tea. The trip would cost you about $15 including tip. Since the restaurant is a bit expensive, it would be difficult to convince a friend to go with you.

The fast food restaurant doesn’t have very good salad options but does have iced tea. Since you want a salad, you decide to remove the fast food restaurant from your alternatives.

Therefore, we are left with two alternatives: Salad bar and iced tea at the dining commons with friends or salad bar and iced tea at a sit down restaurant alone.

Lunch

As we start to analyze the information, you might notice that there are some things in common between our two alternatives. The meal and beverage are the same under both of the alternatives. When information is the same among all alternatives, that information is irrelevant to the decision being made. They are irrelevant because they will not change which alternative you choose. Irrelevant information should be removed from the information you use to make your decision. Therefore, we need to remake our chart.

Lunch 2

Now, all we are left with is the relevant information. Relevant information has two key characteristics:

  1. It differs among the alternatives
  2. It happens in the future

Many times, when we are making decisions, we think about things that happened in the past. Maybe yesterday you had fast food for lunch and you didn’t feel great about it afterward. Is that relevant to where you are going to go for lunch today? No. Costs that happened in the past are called sunk costs and are not relevant to the decision you are making now.

Only consider the relevant information when making decisions. It will allow you to consider less information and help speed up the decision making process.

4. Choose the best alternative

Sometimes choosing the best alternative is not easy. We cannot just rely on the numbers. We must also consider the qualitative information. Qualitative information is information outside the scope of dollars and cents. There are always other factors that should be considered that cannot be measured. For example, maybe you have a test this afternoon and really need some time to study. Driving to the restaurant would eat up some of your studying time but going to the dining commons means a loud environment and it might be hard to study with your friends at the table. It might be worth losing a few minutes driving and spending $15 to have some quiet time to study.

When making actual decisions, heavily weigh the quantitative factors. If the two alternatives are close, don’t forget to weigh the qualitative factors as well.

5. Implement the alternative

Once you have made your decision, now is the time to implement it. In this case, go to lunch. In most business decisions, implementation is not that easy. Take the steps necessary to put the alternative chosen into action.

One final step

Well done! You’ve made your decision and implemented it. There is one final step that should be taken after your alternative has been put into action. The last step deals with the controlling aspect of managerial accounting. Once your plan has been implemented, you need to review your decision. The review process includes determining if the alternative chosen was the right one and if all of the assumptions made during the decision making process were accurate. You cannot be a successful manager if you do not follow-up after the fact to determine if the choice you made was the right one.

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After taking financial accounting, many students dread the idea of another semester of journal entries, debits, and credit.

Fortunately, managerial accounting is very different from financial accounting. I have had a number of students in the past who hated financial accounting but really liked managerial accounting. Typically, most non-accounting majors feel that managerial accounting is more relevant to their field. I hope that you will give managerial accounting some time before you make judgement on the subject.

There are a number of ways in which managerial accounting differs from financial accounting. Let’s look at some of them here.

Who are the users of managerial accounting information?

Unlike financial accounting which is designed for external users, managerial accounting is focused on internal managers. Managerial accounting is designed to help managers plan for the future, make decisions for the company ,and see if their plans and decisions were accurate (also called controlling).

Who makes the rules in managerial accounting?

In financial accounting, the rules are set by the Financial Accounting Standards Board (FASB) or by the International Accounting Standards Board (IASB). The standards set by FASB are collectively called GAAP (Generally Accepted Accounting Principles) and the standards set by the IASB are collectively called IFRS (International Financial Reporting Standards). These rules must be followed when companies are filing reports for external users.

Because the reports generated are for internal management, there are no reporting rules in managerial accounting. In this course, we discuss best practices for obtaining the information that managers need to plan and make decisions. There is no external body that states what our managerial reports must look like.

This also means that managerial accounting is not as simple as learning the income statement, statement of stockholder’s equity, balance sheet and statement of cash flows (maybe easy was the wrong word here). In managerial accounting if you can come up with something you want to measure, we can usually create a report for it. That means that the possibilities are almost endless. Want an analysis of future marketing costs and projected return on investment? We can do that. Want to know if we should continue to make our product by hand or automate the process? Yup, we can do that, too. That’s one of the things I love about managerial accounting. It takes a lot more thought and creativity than financial accounting.

Looking at segments to monitor performance

Financial accounting requires us to look at each company as a whole. Many companies are made up of a number of different brands but all of those brands are reported together in one set of financial statements. Think of a company like GAP. GAP not only owns all the GAP branded stores, but also Banana Republic, Old Navy, Piperlime, Athleta, and Intermix. All of these brands are lumped together into a single set of financial statements.

It would be very difficult for managers to do planning and decision making based on the single set of financial statements for a company like GAP. Instead, managers will break a company into segments based on what makes sense for the company. Some examples of ways that managers can break a company into segments include:

  • Geographic location – breaking the company into regions
  • Brand
  • Product lines – casual, dress, business wear
  • Specific products – a particular cut of jeans
  • Customer demographics – men vs women, urban vs. suburban, age groups

If a manager can define a segment and believes that the information will be useful to planning, decision making,or controlling, reports can be generated for that segment.

Focus on the future

Financial accounting is all about historical information. In the financial statements, we are reporting things that have already happened.

Since managerial accounting deals mainly with planning and decision making, we are looking into the future and trying to predict what will happen based on historical trends. We are always looking for the most up-to-date information to use in these tasks. Managerial accountants are more focused on relevant information, where financial accountants are required to ensure that information is reliable and objective. In order to make decisions in a timely manner, managers must be able to gather information quickly.

Creating reports as often as needed

Financial accounting dictates that reports are created quarterly and annually. Because managerial accounting reports are created for planning, decision making, and controlling, reports are created whenever this functions need to take place. Many financial reports are created on a daily basis as part of the controlling function. Other reports are only created once in order to aid in the decision making process. Budgeting reports can be created monthly, quarterly, or annually based on need. There are no frequency requirements in managerial accounting. Reports are created as needed to fulfill management needs.

Managerial accounting is quite different from financial accounting but study habits are very similar

As you can see, managerial accounting is very different from financial accounting. As you progress through your managerial accounting course, the differences will become more clear. However, I believe that the way you study for managerial accounting is similar to the successful study habits for financial accounting.

Yes, there are a lot of numbers and equations in managerial accounting but you can actually make it through the course without knowing a single formula. Focus on the concepts in the course. Link those concepts to the way a business actually operates. When you think of these concepts in terms of the processes that are going on in the business, the numbers are easy to calculate. As I write the material for this course, I will always discuss the processes to help you get around learning the formulas but I will list the formulas as well. It is my hope that as your understanding of the concepts increases, your reliance on the formulas will decrease.

Managerial accounting uses basic math just like financial accounting. If you can add, subtract, multiply, and divide, you have all the math skills needed for this course. Don’t get overwhelmed by all the numbers. Focus on the concepts and the numbers are not difficult.

One last piece of advice

This may be the most important piece of advice I can give you. Label all of your numbers. If something is expressed in dollars, label it as dollars. If something is expressed in machine hours, label it. If you $100,000 and divide it by 25,000 machine hours, your answer will be $4/machine hour. This will be very useful as you try to apply this number to other parts of a problem. Get in the habit of labeling all of your numbers early. This will save you a lot of time and confusion as you progress through the course.

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Introduction to Managerial Accounting: Overview

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