Adding and Dropping Products
Preparing a segmented income statement for various scenarios assists management in determining the estimated financial impact of making one choice over another. It is expected that you understand how costs behave and that you are familiar with the contribution margin concept. This case expands on these ideas by examining different types of fixed costs.
The company we are looking at in this module makes two products and is considering adding one more since the company has excess capacity. One aspect of making this decision is to screen the various scenarios to determine the potential profitability. Financial information alone does not tell us what to do, but it is a good start.
TYZ Company currently manufactures two products, Y and Z. The company has the capacity to make one additional product, with two (P1 and P2) currently under consideration. The forecasted annual sales and related costs for each “new” product are as follows.
Selling and administrative (%)
Direct fixed expenses
See below for the income statement for last year’s operations for TYZ Company.
Less variable expenses
Selling and administrative
Less direct fixed expenses
Less common fixed expenses
Common fixed costs are allocated to each product line on the basis of sales revenues.
Computations (use Excel).
Prepare a variable costing income statement that includes products Y, Z, and P1. Repeat for products Y, Z, and P2.
What if P2’s variable production costs were reduced to 55% of sales? Prepare another variable costing income statement to show the change.
Suppose that you could add both P1 and P2, if either Y or Z is dropped. Would you drop one of the current products to add both P1 and P2? Show computations in Excel that will support a written answer in the memo.
Memo (use Word).
Analyze the computations in Excel and evaluate the three related proposals before making a recommendation.
Do you recommend adding product P1 or P2?
Do the lower production costs change your recommendation?
See question 3 above.
Which of the products looks the most profitable? Assuming no restraint on customer demand or resources, which product would you choose in order to maximize profitability? What about qualitative, as opposed to quantitative, concerns?
Write a 4- or 5-paragraph memo to the owner of the business. Start with an introduction and end with a recommendation. Each of the four or five paragraphs should have a heading.
Short essay (use Word).
Read the background information and do additional research as needed to comment on the following topics.
Discuss the importance of understanding the difference between the contribution margin and segment margin for purposes of making business decisions.
Discuss and provide examples for complimentary and substitution effects when determining product mix.
Start with an introduction and end with a summary or conclusion. Use headings and include proper references. Maximum length of two pages.
Each submission should include two files: (1) An Excel file; and (2) A Word document. The Word document shows the memo first and short essay last. Assume a knowledgeable business audience and use required format and length. Individuals in business are busy and want information presented in an organized and concise manner.