DISCONTINUATION OF PRODUCT LINE

PRESENTED TO:-

PRESENTED BY:CHIRANSH GOYAL

DR MEERU SEHGAL

ROLL NO- 8118

If the products are making a contribution towards fixed cost or in other words if selling price is more than variable cost , it is preferable not to close down the business . This will help in reducing the losses which otherwise be more if the business is shut down. If the business closed down there may be certain fixed costs which could be avoided but there will be certain expenses which will have to be incurred at the time of closing the operations like redundancy payments , necessary maintenance of plant or overhauling of plant on reopening , training of personnel etc.

Such costs are associated with closing down of the business and must be taken into consideration before taking any decision . Fixed costs may be general or specific .General fixed costs may or may not remain constant while specific costs will be directly affected by the closing down of the operation . To conclude , if general fixed costs are likely to come down in the event of closure or suspension of activities , the excess of contribution over specific fixed costs will have to be compared with reduction in general fixed costs . If the former exceeds the latter it is profitable to continue the activities and close down or suspend activities if the latter exceeds the former . In addition to cost consideration , there may be some non-cost considerations which may weigh in taking the decision to close down or suspend its activities or not . The following non- cost considerations are :

Once the business is closed down , competitors may establish their products and our business may be lost . It may be difficult to recapture the lost market again ; heavy advertisement charges may have to be incurred to recapture the business again . Fear of retrenchment of workers . If workers are discharged it may be difficult to get experienced and skilled workers again at restart of the business . Plant may become obsolete with the closure of the business and heavy capital expenditure may have to be incurred on restart of the business . Reputation of the firm may suffer if some activities are closed down or suspended .

Temporary closing down or suspending activities may not be desirable if the relationship with the suppliers is adversely affected Fear of non-collection of dues from customers in case of business may not go in favour of closure of business .

Problem 1 :

Mermaid & Co. manufactures perfumes Exalt , Confident and Beala with installed capacity of 15000 units of exalt , 25000 units of confident and 35000 units of beala per month . The finance manager of the company has given the following data of performance for August :
TABLE 1 Production Plan
Exalt
No. of units produced and sold Rs. Sales price per unit Rs. Sales volume A Rs. 15000

Confide nt
25000

Beala
35000

12 180000

10 250000

11 385000

Labour and other variable costs Rs. Fixed OH Rs.

60000

75000

70000

45000

100000 140000

Total costs B Rs.

Profit / Loss Rs.

180000 275000 315000

_ - 25000 70000

An institutional director , who saw the report , recommended for Aggregate profit Rs. of Rs. the discontinuance of Confident as it has incurred a loss 45000 25,000 . The company s market is saturated . What would be your view ?

The contention of the institutional director is based on the report , which is on absorption costing basis . For decision-making , the relevant is marginal costing . Should the operational data be in marginal costing pattern , it would have given an entirely different picture as under.

TABLE -2 Cost sheet under marginal costing Exalt No. of units produced and sold Rs. 15000 Confident 25000 Beala 35000

Sales price per unit

Sales volume A Material cost Labour and other variable costs Total variable cost - B Contribution [ A-B ] Total contribution Less: Fixed overheads Profit

Rs.
Rs. Rs. Rs. Rs. Rs.

12
180000 75000 60000 135000 45000

10
250000 100000 75000 175000 75000

11
385000 105000 70000 175000 210000 330000 (285000) 45000

It may be observed that Confident had made a contribution of Rs. 75,000 . If it were to be discontinued , the overall performance of the

company would result in a loss of Rs. 30,000 , as against the profit of Rs. 45,000 with Confident . This could be seen in table 3 .
TABLE 3 Cost sheet if Confident is discontinued
Exalt
No. of units produced and sold Sales price per unit Sales volume A Material cost Labour and other variable costs Total variable cost B Contribution ( A-B) Total contribution Less : Fixed overheads Loss 15,000 Rs. 12 Rs.1,80,000 Rs. 75,000 Rs.60,000 Rs.1,35,000 Rs. 45000

Beala
35,000 Rs. 11 3,85,000 1,05,000 70,000 1,75,000 2,10,000

Conclusion is that the unit should continue producing Confident

255000 285000 (30,000 )

Problem2 : The Sky Rock Ltd Produces and sells three types of products P, Q and R. The management committee has decided to discontinue the production of Q since there is not much profit in it . From the following set of information , find out the profitability of the products and give your short comments on the decision of the management .
Selling price per unit P Q R Rs. 300 Rs. 275 Rs. 305 Direct material per unit Rs. 60 Rs. 30 Rs. 70 Direct wages per unit Dept. A Rs. 20 Rs. 20 Rs. 12 Dept. B Rs. 15 Rs. 20 Rs. 10 Dept. C Rs. 10 Rs. 10 Rs. 20

The absorption rates of overhead on direct wages are :

Dept. A Variable overhead Fixed overhead Solution 150% 200%

Dept. B 120% 240%

Dept. C 200% 150%

Statement Showing Comparative Profitability of Products P,Q and R P Selling price per unit Less: Variable cost : Direct material Direct wages : Dept. A Dept. B Dept. C Variable overhead : Dept. A ( 150% of direct wages ) Dept. B ( 120% of direct wages ) Dept. C ( 150% of direct wages ) Contribution Rs. 300 60 20 15 10 30 18 20 173 127 30 20 20 10 30 24 20 Q Rs. 275 70 12 10 20 18 12 40 R Rs 305

154 121

182 123

Less : Fixed cost : Dept. A ( 200% of direct wages ) Dept. B ( 240% of direct wages ) Profit P/ V Ratio : Contribution x 100 Sales

40 36 15 91 36 127 x 100 300 42.33%

40 48 15 103 18 121 x 100 275 44%

24 24 30 78 45 123 x 100 305 40.33%

Comments : The management has taken a view to discontinue product Q based on unitary profit . This is a wrong decision . This decision should be based on P/V Ratio, which is highest in product Q . Management should explore the possibility of increasing the production of product Q , because this step will increase the total profit of the company owing to better P/V Ratio of product Q . By discontinuing product Q , its share of fixed cost will be borne by product P and R and thus total profit of company will reduce .

Problem 3 : A company is engaged in 3 distinct lines of production. Their production cost per unit and selling prices are as under :
Production ( units ) Material cost Wages Variable overheads Fixed overheads A 3,000 Rs. 18 7 2 5 32 40 8 B 2,000 Rs. 26 9 3 8 46 60 14 C 5,000 Rs. 30 10 3 9 52 61 9

Selling price

The management wants to discontinue one line and gives you the assurance that production in two other lines , shall rise by 50% . They intend to discontinue the line which produces article A as it is less profitable .

i.

Do you agree to the scheme in principle ? If so , do you think the line which produces A should be discontinued .

ii. Offer your comments and show the necessary statements to support your decision .
Solution :

Statement Showing Comparative Profitability

Products

Units

A 3000 Rs. 120000 81000 39000 15000 24000

B 2000 Rs. 120000 76000 44000 16000 28000

C 5000 Rs. 305000 215000 90000 45000 45000

Total

Rs.
545000 372000 173000 76000 97000

Sales Less: Variable cost Contribution Less: Fixed cost Profit

If A is given up , sale of B and C will increase by 50% Contribution on B = 3000 x 22 = 66,000 Contribution on C = 7500 x 18 = 1,35,000 2,10,000 Less: Fixed cost 76,000 Profit 1,25,000 If B is given up , sale of A and C will increase by 50% Contribution on A = 4500 x 13 = 58,500 Contribution on C = 7500 x 18 = 1,35,000 Less: Fixed cost Profit 1,93,500 76,000 1,17,500

If C is given up , sale of A and B will increase by 50% Contribution on A = 4500 x 13 = 58,500 Contribution on B = 3000 x 22 = 66,000 1,24,500 Less: Fixed cost 76,000

Profit

48,500

When A is given up , the profit is maximum . The management decision to give up A is profitable . The decision to give up a product is to be guided by its contribution . The investment opportunity paying the highest contribution will be preferred . Problem 4 : The Skyrock Ltd. produces and sells three types of products P, Q and R . The management committee has decided to discontinue the production of Q since there is not much profit in it . From the following set of information find out the profitability of the products and give your short comments on the decision of the management . (Rs.)
Selling price per unit P Q R 300 275 305 Direct material per unit 60 30 70 Direct wages per unit Dept. A Dept. B Dept. C 20 20 12 15 20 10 10 10 20

The absorption rates of overhead on direct wages are :

Dept. A
Variable overhead Fixed overhead 150% 200%

Dept. B
120% 240%

Dept. C
200% 150%

Solution :
Profitability statement of Skyrock Ltd.
Particulars
1. 2. 3.

P 300 60 20 15 10 105 30 18

Q 275 30 20 20 10 80 30 24

R 305 70 12 10 20 112 18 12

4.

5.

Selling price per unit Direct material Direct wages : Dept. A Dept. B Dept. C Prime cost (2+ 3) Variable overhead Dept. A ( 150% of D. wages)

Dept. C wages)

( 200% of D.

Total 6. Total variable cost ( 4+5 ) 7. Contribution (1- 6 40 40 24 ) 36 48 24 8. Fixed cost 15 15 30 Dept. A ( 200% of D. 91 103 78 wages) 36 18 45 Dept. B ( 240% of D. 42% 44% 40% wages) Dept. C ( 150% of D. wages) Comments : Total The management has taken a view to discontinue product Q based 9. Profit (7- 8 on unitary profit . This decision should be based on P.V. ratio, which ) is highest in product Q . Management should explore the possibility 10. P.V. ratio Contribution x 100 of increasing the production of product Q , because this step will Sales

20 68 173 127

20 74 154 121

40 70 182 123

increase the total profit of the company owing to better P.V. ratio of product Q . By discontinuing product Q its share of fixed cost will be borne by products P and R and thus total profit of company will reduce .