 Hello and welcome to this session. This is Professor Farhad in which we would look at keep or drop decisions. These topics are covered typically in managerial accounting or cost accounting also covered on the CPA exam. If you need additional resources about your managerial cost accounting or CPA exam, please visit my website, farhadlectures.com. So when do we have to use those keep or drop decisions in the reward? Most companies, they don't produce only one product. They may, they will produce many product and they might have many divisions. A case in point is Google. For example, Google, when you think of Google, you'll think of Google search and that's what you think of Google. But Google has other divisions such as, for example, YouTube or Google Maps or Google ads or Google androids. So what happened is this. Should we, should Google drop asserting division if that division is losing money? Well, from a numerical perspective, Google will have to take a look at the contribution margin. If the contribution margin is negative for that particular division, then from a numerical perspective, they will drop the division because they're operating at a loss. Well, although I said this, although that's true, for example, YouTube for a period of time, it was, it has a contribution margin is negative but Google did not drop it. So when we talk in classes, when we talk in courses, when we talk on the CPA exam, we're not talking about the real world. We're talking about hypothetical situation but the numbers are there just to guide you. Now, if the contribution margin is positive, should you still drop the division if the division is not profitable? Well, remember, you have to look at avoidable cost. You have to look at any allocated cost. What's gonna happen to that avoidable cost? What's gonna happen to that allocated fixed cost? Is it gonna go away? Is it gonna be transferred to another division? That's what we have to look at. If the contribution margin lost is greater than the avoidable fixed cost. So if we're making a profit and that contribution margin profit is greater than the avoidable fixed cost. So it's covering the avoidable fixed cost then we will keep. If the contribution margin lost is less than the avoidable fixed cost then it's not in our best interest to keep. Therefore we drop. Now, the best way to do this is to look at an actual example to see how this all fits together. Once again, and I'm repeating myself but we talk from strictly numbers perspective. There are other considerations, other factors that company look into before they keep or drop asserting division or asserting product. So let's take a look at an example to see how this all fits together. Cube manufacturing produces three different product, platinum, gold and silver and the financial statements from the last quarter is presented. So we have sales for each division, variable cost as well as the total. So what we can see that platinum is making a profit of 70,000 gold is making a profit of 40,000 silver is incurring a loss of $10,000. Now, once a division is incurring a loss the supervisor, the person that's in charge, the CEO, the CFO, they're gonna start to question why are we operating this division? What's going on with that division? Are we better off removing, closing this division? Well, let's take a look at our decisions to see if it's gonna work. Well, what happened if we close silver? What happened if we eliminate this division? If we eliminate this division, the sales of that division will be gone as well as the variable cost. Simply put, we have a contribution margin of 40,000 that's gonna be lost. The contribution margin will be lost. Now, the question becomes, okay, I lost the 40,000. What's gonna happen to my fixed cost? I have 50,000 here of fixed cost. Now that's gonna help me make a decision. If that fixed cost will go away, well, that's not bad. Maybe I will think about removing it. But if that fixed cost will have to be allocated because it's a fixed cost, it might be just allocated that division. If I don't allocate it to the silver division, I have to allocate it to the gold or the premium. Or maybe 25% of it will be allocated and 25% will be eliminated. So that's why we have to determine to make the decision to know what's gonna happen to that fixed cost. So let's assume we cannot get rid of the fixed cost. What would happen if we can't get rid of the fixed cost? In other words, it will have to be reallocated. Let's look at our situation. If we look at our current situation when we add everything up, total sales is 1.1 million, total variable cost 810. And what I'm doing is using those totals, basically. What we are standing right now, contribution margin is 290 and fixed cost is 190. Therefore, overall, the company is making 100,000. The alternative is to drop silver. If we drop silver, we're gonna be losing 200,000. Our sales is 990,000. Variable cost is 160. Variable cost 160 is lost. What's left is those two, 650. Contribution margin is 250. Now the fixed cost, we had 190 before and we are going to still have 190 after we drop. So hold on a second. So if that's the case, our profit used to be 100,000. Now our profit is 60,000. Should we drop the division? And the answer is no. Because if we drop the division, our profit will decrease by 40,000. Why will the profit decrease? Because we lost, so here's what happened. By dropping the silver division, we lost this $40,000. We lost this $40,000. But we did not lose this expense of 50. So we lost 40 on revenue and we kept 50. Well guess what's gonna happen? Our losses will increase by 40,000 by the lost contribution. Therefore should we drop it? And the answer is no. Now let's assume if we dropped it and we were able to also remove the $50,000. Let's assume that's the case. Well if we're able to remove the $50,000, it means fixed cost, our new fixed cost would have been 140,000. As a result, we would be at 110,000. We would have a $10,000 increase. And this $10,000 increase is because we had a loss and we eliminated that loss. So again, you could work the numbers where you are indifferent whether you drop or not. For example, you could say if I can get rid of only 20% of fixed cost and keep 40 or get rid of 30 and keep 70, so on and so forth. So you could make those what if in Alice. Take a look at another example. An airline company is presently operating at 70% capacity. Well, they're all operating now at really, really low capacity because of the coronavirus. Management of the airline is considering dropping routes between Europe and the US which is the transatlantic route. If these routes are dropped, the revenue associated with these routes would be lost. That makes sense. And the related variable cost saved, that's obvious. In addition, the company total fixed cost will be dropped by 20%. Well, that's relevant for us. Segmented income statement for the typical month appear as follow. All the numbers are a million. So we have within the US routes, within the Europe and the transatlantic. And if we can see clearly that within the Europe and within the US are making a profit of 300,000, the transatlantic flights are losing money. So the question is, should we drop the transatlantic flight? How do we make this decision? Well, we have to compare what we have right now, how much profit we have overall versus if we drop the division, what would happen to our profit and make the decision based on that. So right now, if we add up all the revenues, if we add up all the revenues, they should add up to 8.8 million. If we add up all the variable costs, they will add up to 3.9. As a result, we have a contribution margin of 4.9. If we add up all the fixed cost, all the fixed cost, the fixed cost is 4.4. As a result, we're making basically half a million. And this makes sense. We are making half a million dollar from the current status, which is the status quo. What happen if we drop this division? What happen if we drop this division? If we drop this division or these routes, first of all revenue will be reduced by 2.8. It's gonna give us revenue of 6 million overall for the company. Variable cost will be dropped by 1.5. Well, 1.5 minus 3.9 is 2.4. That's gonna give us new contribution margin of 3.6. Remember, we said that the fixed cost, which is the total fixed cost is 4.4 million. It's gonna be reduced by 20. It means we can keep, we're gonna have 80 left. So we're gonna have to deal with the fixed cost of 3.52, 3.52. As a result, we're gonna be making a profit of approximately $80,000. Is this a good idea? And the answer is not at all. We should keep, we should keep it because if we drop it, our profit will go down. And this is what you do. We'll go down by 420,000. So this is the difference between the status quo and the alternative if we drop the transatlantic flight. And this is basically a good example of adding or dropping. Now also, again, I'd like to always remind you that these decisions has to be taken within context. So for example, you may need those transatlantic flight. Why? Because those transatlantic flight might be feeding into your within Europe and within the US revenue. So if you drop them, you don't only lose, but you might also lose customers because they like to stay with you because they fly within the US, within Europe, and they go transatlantic. So if you drop those transatlantic, you may lose them within the US and within Europe. And those are considerations other than numerical numbers that you have to take into account. Now, what would you do under those circumstances? For example, your data analytics. If you have a good data analytics division, they would let you know who are your customers and are they using within the US, within Europe and transatlantic, what happened? You need to know a little bit more about the psychology of your customers. If you drop them, are they gonna move to another airline company, which in turn will make your situation worse? As always, I'm gonna ask you to like this recording, share it, and please visit farhatlectures.com for additional resources if you are an accounting or finance students, especially if you are a CPA candidate. My resources will help you pass the exam. Good luck, study hard, and most importantly, stay safe.