Decisions to discontinue an operating segment, like a store, or a product line,
are difficult ones for organizations to make. There is often employee relations that need to be considered.
I’m not going to go into those here since this short video focuses on the financial decision
making but I want to be aware that other factors exist that influence these decisions.
So here we have a multi-step income statement for Apu’s Quik-E-Mart for the year ended 2017.
As you can see, this store lost money and has negative operating income, which we would call an operating loss.
So should this store be closed down?
At first glance, the answer might be “yes” because of the loss, but let’s dive deeper.
When deciding whether or not to discontinue an operating segment, we need to consider certain items.
Firstly, we only want to focus on the relevant costs.
So costs that have happened in the past aren’t relevant to the new decision.
Secondly, we want to consider any impact this decision might have on related stores or product lines.
Our decision rule is that we discontinue a segment if the eliminated fixed costs are greater than the eliminated contribution margin.
Furthermore, we don’t want to use an external reporting financial statement
like the multi-step income statement to assist in these decisions.
We want to use the contribution margin income statement because the amount of contribution margin is critical to the decision.
You can see I’ve re-arranged the Quik-E-Mart data into a contribution margin income statement. The store still has an operating loss of $4,800.
Let’s look at a few different scenarios.
With scenario 1, assume that all fixed costs can be eliminated with the closing of the store.
So let’s compare eliminated fixed costs with eliminated contribution margin.
The contribution margin is $25,200;
the fixed costs are $30,000.
So the fixed costs savings are greater than the lost contribution margin,
therefore, the company would be $4,800 better off by closing the store.
However, being able to eliminate all fixed costs is pretty unlikely when closing a store or product line so let’s look at another scenario.
With this scenario, assume that no fixed costs can be eliminated.
Let’s compare eliminated fixed costs with eliminated contribution margin.
The contribution margin is $25,200
and the eliminated fixed costs are $0.
Since there are no fixed costs savings, the lost contribution margin would make this company $25,200 worse off by closing the store.
Okay, so let’s look at a more likely scenario. Let’s say that the depreciation expense and half of the other fixed costs can be eliminated.
This is very likely because some of the fixed costs are common company-wide costs that get allocated to each store.
Thus eliminating a store doesn’t eliminate those costs.
It just means that all the remaining stores have a little bit more fixed costs allocated to them.
So let’s compare eliminated fixed costs with eliminated contribution margin.
Again the contribution margin is $25,200
and the fixed costs are $5,000 for depreciation expense and $12,500 for the other fixed costs.
Since the fixed costs savings of $17,500 are less than the lost contribution margin, this company would be $7,700 worse off by closing the store.
So remember when making these decisions to compare eliminated fixed costs with eliminated contribution margin.