 Hello and welcome to this session. This is Professor Farhad in which we will discuss keep a product line or a drop a product line. These are short-term decisions or sometimes they are called non-routine decisions. Simply put companies every once in a while they may drop a product, a product line, a whole geographical location, close it or a segment of a business. So we need to learn from an accounting perspective, from a managerial accounting perspective. How do companies arrive to that decision using numbers? A case in point to illustrate this concept in the real world is Apple when they drop the iPod. This looks like an iPhone, but it's an iPod. They no longer produce it. Therefore they discontinued a product line. And this is an example of it. But in this session we would learn about the numbers, what numbers they will take into account when they are making these decisions. Now Apple is not exclusively in this business of discontinuing a product. Sometime you might go into a McDonald's, they might drop a product, you might go into Starbucks. So that's very common in all businesses. Basically we're going to do a quick review about what we learned in the prior session, relevant and irrelevant costs. We're going to be looking at differential analysis. And basically we're going to be looking at future revenues and future costs of alternative actions. Also we're going to be focusing specifically on what we called relevant cost or relevant cost or benefit for that matter. We focus more on cost. Any cost that can be avoidable that could go away is considered relevant cost. Again, this is review cost that can be eliminated as a whole or in part by selecting one option over the other. This is what a relevant cost is. So what is the general rule for keep or drop decisions? Well, here's what we're going to do. We're going to compare the contribution margin that would be lost if we discontinued this product. We compare this to the, would compare this to the cost that would be avoided if the line was dropped. Simply put, we would look at the contribution margin. If the contribution margin, if this contribution margin from this product, which is a plus, is greater than the avoidable fixed cost, simply put, it's covering its fixed cost specifically for that product, then we should keep because otherwise, otherwise we're losing money. It has to cover its avoidable fixed cost and opportunity cost. Now in the case of Apple, it could be they discontinued the iPod touch because they could use this capacity to produce iPhones and iPhones might have higher profit margins. So what they did, they said, okay, guess what? Let's free up this capacity instead of producing iPod touch, let's produce iPhone. So maybe they focused on the opportunity cost. I'm not saying what they focused on. I'm just giving you an example of what an opportunity cost would look like. Now think of it from another perspective, simply put, if you cannot cover your fixed cost specifically through your contribution margin, you should not have that product line. And remember avoidable costs just to kind of do a quick review are future variable production costs such as direct material, direct labor, variable overhead, simply mostly the variable, future variable, selling costs or shipping costs, those are relevant costs, future fixed costs incurred specifically for this project or decision. For example, if you need to buy a machine for that project, because you're undertaking a new product line, either keeping or dropping, then that's relevant cost. Although it's fixed cost, it becomes relevant because it's specifically for that project and any future opportunity cost. In the case of Apple, they are foregoing capacity to produce something else. Now the best way to illustrate this concept is to actually look and add an example with numbers to clarify this contribution margin versus avoidable fixed cost. Now before we look at an example, most likely you are a student or a CPA candidate. And if that's the case, welcome, you have arrived, you are looking for some help, go step further farhatlectures.com, where I have additional resources, lectures, multiple choice, true false questions, that's going to help you understand these concept better. I can be a good companion to your CPA review course or to your accounting course. If you have not connected with me only then please do so. Like this recording, the mere fact that you're watching, it means it's helping you like it, share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at this company where we have the segment income statement for Adam premium units. So Adam is producing premium unit of some sort. They have a generic unit and a premium unit. And this is the income statement for that segment specifically. And let's just examine the income statement first. We have sales of 5 million, variable manufacturing cost, variable shipping cost and commission, about not about $2 million in total variable cost, sales minus variable cost will give us the contribution margin of 3 million. This is important. Then we have fixed cost. Notice this is a variable costing income statement separating the variable cost from the fixed cost. We have a general factory overhead $600,000 salary of line managers for that division, $900,000 depreciation of equipment, advertising that's direct to that product, rent factory space $700,000 general and administrative expenses of $300,000. The total is $4 million. And if we take 3 million in contribution margin minus all the fixed expenses, we come up with the net operating loss of a million. And here we are discussing the idea of closing Adam premium units because the premium units that Adam producing based on their income statement, segment income statement, they are incurring a loss. So we need to find out whether it's a good idea to basically drop this line, get rid of it or not. So what we need to do here, we need to analyze cost a little bit further. So we have to do a little bit more of further investigation. And this is what further investigation revealed about fixed cost. The fixed general factory overhead, this number here, the $600,000 and the fixed general administrative expenses, those two costs will not be affected by dropping the premium unit. Simply put, they are unavoidable. Simply put, even though we close that unit, they won't go away. Guess what's going to happen? This cost will be reallocated to other product line and they will be considered unwelcome cost and quote by other managers because if this division is gone, if this line, the product line is gone, that's absorbing this $900,000, guess what? If it's unavoidable, they don't go away. We have to allocate them. And this is the worst thing for a manager, manager of a product line or of a specific unit. You're going to tell them, look, you're going to have to absorb some of that $900,000. So they're going to be unwelcome cost. Simply put, they are unavoidable. Unavoidable, unwelcome is my own term. Now also, what we know that the equipment used to manufacture the premium has no resale or alternative value. What does that mean? It means the depreciation of equipment. So when we close this unit, we're not getting root of the equipment itself. It's going to stay with us. We cannot sell it. Therefore, we're going to keep on depreciating this unit. Therefore, also this cost will not go away. So now we have to analyze whether it's a good idea to close this unit or to keep it. So this is what keep and drop. So what do we do? What did we learn? We're going to compare the contribution margin to the cost that we can avoid. And let me highlight the cost that we can avoid because we highlighted the cost that we could not avoid. If we close down this unit, we don't need the managers to be there. We don't have to advertise directly a million dollars for those units since we are no longer producing them. And we have a rent for factory space that's going to free up and we don't have to pay 700,000. Now we are ready to compare the contribution margin of three million to the avoidable cost. So simply put, this unit is producing three million dollars. And it's fixed cost that can be avoided is 2.6 million. Guess what? If we discontinue, what happened if we discontinue? Let's think about it. If we discontinue, this three million is gone, which is that's bad news. Okay? The good news is we're going to be getting root of some cost. How much of the cost we're going to be getting root of 2.6 million? This is the good news. Guess what? No, it's bad for me. If I am going to get root of three million in revenue and only 2.6 million of cost, that's not in my best interest. If I do so, I'm going to be at a disadvantage of 400,000. Simply put, if I discontinue this division, what's going to happen is I'm going to be at a $400,000 disadvantage because all the cost that I could not avoid will have to go somewhere else. So the company as a whole will be less off. They will have lower operating income because the cost that I could not avoid, they go somewhere else. So now this division is helping me cover some of that cost. Another way to prepare the analysis is basically to prepare a comparative income statement where we keep the premium unit or if we drop them. What happened if we drop them? If we drop them, what's going to happen is the $600,000 will stay with us. It does not go away. The $500,000, the depreciation of the equipment will not go away and the $300,000 will not go away. So all these costs will have to be reallocated somewhere else. Therefore, what's going to happen rather than a million, we're going to have an additional $400,000 in losses. Why? Because those costs will have to be absorbed by somewhere else. Right now, the premium unit is helping in covering how much? In covering $400,000 of those costs. So we are better off as a company keeping this. This is the $400,000. Once again, what's going to happen? The difference is right now is $5 million. So the difference overall in contribution margin is $3 million. This is another way to look at it and these are the avoidable costs. So what's happening is we are generating $400,000 from this company from this unit and this $400,000 is covering other costs that we have to cover somewhere else. So if we get rid of this unit, we basically lose an additional $400,000. Now, in the real word, companies will take numbers, which is quantitative numbers, but they would also look at non-quantitative or qualitative numbers or people numbers. So we have to take into account other consideration is given to other stakeholders like customers. Think when your customers think about when your customers, when you discontinue a product and they like this product. Think of Apple. Think the iPod touch. Now, the iPod touch, the iPhone replaced it and the iPhone will have everything that the iPod touch have plus more. But the point is, let's assume you discontinued a product and the customers like this product. So they may not be happy about it and they might be thinking what other product you will be discontinued in the future. So it's not good for the image of the companies. For the employees, the morale of the employees, if you know the people next line or next building to you are being laid off because their product line are discontinued, you're going to be asking yourself, what's next? Am I next on that line? Also, the community is large because if you discontinue a product, guess what? You're going to lay off employees and that's not going to be good in the environment in which you operate. So simply put, there are quantitative, but from an accounting perspective, we only look at the numbers. But in the real world, you have quantitative factors and qualitative factors that the management will have to look at. What should you do now? Go to farhatlectures.com and work MCQs, true, false, exercises that's going to help you understand these concepts. Invest in yourself. Don't shortchange yourself. If you're listening to me at this point, you are vested in your education. Invest in yourself. Good luck, study hard, and of course, stay safe.