Should you keep or drop a segment?

Formulation of the problem

Costing can reveal that some segments (e.g. product lines, customer segments, geographical markets) do not manage to cover all the costs assigned to them. The question then becomes whether the segment should be discontinued. The decision to keep or drop (or even add) a segment is also very close to a long-term decision. Now, differential analysis is adequate as long as major investments or disinvestment are not part of the involved. Indeed, large scale investing activities imply huge difference in cash flows over the years and therefore call for capital budgeting techniques.

Classification based on relevance

Many of the costs assigned to a segment may not be driven by the existence of that segment. For instance, indirect capacity fixed costs which are allocated to a segment are often not avoided when the segment is dropped. Therefore, to make a keep-or-drop decision, it is useful to build a segmented contribution income statement to facilitate the subsequent classification based on relevance.

A segmented contribution income statement breaks down the contribution income statement per segment. It displays first the contribution margin for each segment. Second, it subtracts from each segment’s contribution margin the fixed costs which are direct to that segment, showing the segment margin. This segment margin is the contribution of each segment to the coverage of indirect fixed costs and the generation of a company-wide profit.

In a decision about whether to keep or drop a segment, the segment’s contribution margin is always relevant: if the segment is dropped, corresponding revenues are forgone (opportunity cost) and corresponding variable costs are avoided. At the other extreme, indirect fixed costs are typically not avoided when the segment is dropped and thus are irrelevant1.

The question is a bit more difficult for direct fixed costs. Some of them are not affected by the decision, like asset depreciation or the value of remaining inventory; these are sunk costs. Some of the direct costs however can be avoided: discretionary fixed costs like advertising, wages of employees whose contract can be terminated, and the rent of the equipment dedicated to that segment.

In addition, dropping a segment may free capacity which could possibly be redeployed to generate a contribution margin on other segments. Such a contribution margin is thus an opportunity of keeping the segment.

Net Economic Impact and indifference points

For this exercise, you can download here data and solutions if you did not already. Try to compute the net economic impact and the indifference point in volume (which here is thus the break-even point of the Cosmo), price, unit variable cost, and fixed cost change. To do this, assume that dropping the product would also allow you to save 750 euros over the fixed costs of production, as in the make or buy example.

Qualitative factors

In terms of risks, it should be noted that dropping a product reduces the diversity of a product portfolio, and concentration usually increases risks by increasing dependence on a narrow range of options.

In terms of strategy, it is important to determine whether that business segment is not a hook for other products or contributes to the company’s reputation and image. Moreover, discontinuing a product negatively impacts sales on complementary products which might be more profitable. Alternatively, sales may be redirected towards substitute product with either a higher or a lower unit contribution margin. Therefore, when making the decision to keep or drop products, managers must carefully anticipate the effect on other related product lines.

Complementary products are products which are used together, like printers and cartridges.

Substitute products are products which can be used in lieu of one another, like two different kinds of water.

As for CSER, dropping a segment usually negatively impacts employees and employment, effectively local communities. Alternatively, some products may be particularly noxious and discontinuing them may be environmentally friendly.

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  1. A deeper analysis of the demands made by the segment on common resources and large disinvestment changes the perspective on the long term. But then time value of money kicks in and capital budgeting becomes a more appropriate approach.↩︎