In this video of short-term business decisions we're going to be specifically
looking at an example of how to determine whether or not we should drop
a specific product line. So in our example we're gonna look at VCR tapes
versus DVD discs. So top managers of Movie Plus they're alarmed by their
operating losses. They are considering dropping the VCR tape product line.
Company accountants have prepared the following analysis to help make this
decision. So we can see by our income statement here we have DVDs, we have VCRs,
and our total. We can see the DVDs seem to be making an operating income
of $17,000. VCR tape seems to be incurring a loss of $33,000. We know
that total fixed costs will not change if the company stops selling VCR tapes.
So the fixed cost won't change. So we need to prepare an incremental analysis
to determine whether or not it's beneficial for us to drop the VCR tapes.
So what we also need to remember is that again fixed costs are not going to
change if we stop making VCR tapes. So our question really becomes if we drop
VCR tapes will this increase our total operating income by $33,000? If that's
true then our total operating income will then be positive and will no longer
be a loss. So what we need to do is again prepare an incremental analysis to
determine if this is really going to happen. So looking at our income
statement once again we recall that fixed costs are not going to change.
So that's $69,000 that we have somehow allocated to VCR tapes
is simply going to shift over to DVDs. If we ship that if we shift that fixed cost
of $69,000 over to the DVD line we would still be incurring a
loss for our business. So what we can tell ourself here is what we'll actually
be losing since there are no avoidable fixed cost is that $36,000 in
contribution margin that the VCR tape line is contributing to the overall
business. So if we look at that in an incremental analysis we can see that we
would be losing the $129,000 that the VCR tape is bringing in in revenues but
we'd also be able to get rid of $93,000 in expenses.
So notice how I have the reduction in revenues as a negative number. Think of
losing revenues as a bad thing so that's negative. Losing expenses is a good thing
that's why you see the 93,000 as a positive number.
The expected change in operating income would be a loss or negative of $36,000
because the loss in revenues exceeds the loss or cost savings and expenses. So we
would not drop this product line. So let's continue on with this example and
assume that Movie Plus can avoid $30,000 of those fixed expenses if they drop the
VCR tape product line. So we need to prepare another incremental analysis to
determine or show whether Movie Plus should stop selling VCR tapes. You should
really already know the answer to this. We already said that we would lose
$36,000 in contribution margin if we drop the VCR product line. Well if we're
able to avoid $30,000 in fixed cost that would still leave us with a $6,000 loss
to operating income if we drop the VCR tape product line. We can see that in an
incremental analysis. We're still losing $129,000
dollars in revenues if we drop the VCR tape product line, but we're also able to
get rid of $93,000 in variable cost and now we're able to
get rid of $30,000 in fixed cost giving us a loss in our
operating income of $6,000. We should not drop the VCR tape product line.
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