This lesson examines decisions about adding or dropping business segments, such as product lines, geographic locations, or departments. It covers the use of relevant costing and segment income statements to evaluate the financial impact of such decisions, including the treatment of avoidable and unavoidable fixed costs.

• Definition and Purpose: Organisations must evaluate the products and services that they offer and determine the product mix or segment structure that best meets the organisation’s objectives. Differential decision analysis using relevant costs can be used to quantify the effects of adding or dropping a segment, such as a product line or a department.

• The Relevant Cost Analysis:

  • Relevant Costs: The costs that will be eliminated if the segment is dropped are relevant. This includes the segment’s direct costs (direct materials, direct labour, variable overhead) and any avoidable fixed costs that are directly traceable to the segment. The revenue that would be lost is also relevant.

  • Irrelevant Costs: Allocated fixed costs (common costs) that would continue regardless of the decision are not relevant. For example, the cost of rent for a building that houses multiple departments would not be eliminated if one department is dropped.

  • The Decision Rule: A segment should be dropped if the avoidable costs (including any lost contribution margin) exceed the segment’s revenue. However, if the segment is contributing to covering common fixed costs, it may be more profitable to keep it.

• Analyzing Segment Income Statements: When evaluating a segment, it is helpful to use a segmented income statement that distinguishes between direct (traceable) costs and common (allocated) costs. This allows management to see the true contribution of each segment and avoid misleading conclusions.

• Qualitative Factors: In addition to the quantitative analysis, qualitative factors must be considered. These include the impact on customer relationships, the loss of complementary products, the effect on employee morale, and the strategic importance of the segment.