Add Delete Product Decisions - New Project 5

Table B-1 Income Statement for Barbeque Bargains presents the income statement for the past year, separated by product line (this is often referred to as a segmented income statement). Carefully examine Table B-1 Income Statement for Barbeque Bargains. Notice that the charcoal barbecues product line shows a loss of $8,000 for the year. This is the reason management would like to consider dropping this product line.

Answer: Direct fixed costs are fixed costs that can be traced directly to a product line. Direct fixed costs are often differential costs. For example, the salary of the manager responsible for charcoal barbecues is easily traced to the charcoal barbecues product line. If this product line is eliminated, the product line manager’s salary is also eliminated (unless the product line manager has a long term employment contract)

Allocated fixed costs (also called common fixed costs) are fixed costs that cannot be traced directly to a product line, and therefore are assigned to product lines using an allocation process. Allocated fixed costs are typically not differential costs. For example, rent paid for Barbeque Bargains retail store is allocated to all three product lines because it is not easily traced to each product line. However, the retail store rent likely will not decrease if the charcoal barbecues product line is eliminated (unless the company chooses to move to a smaller, less costly store). The charcoal barbecues’ allocation for rent would simply be reallocated to the other two products. Thus rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing Barbeque Bargains.

Company’s total allocated fixed costs of $120,000 are allocated based on the percentage of total sales of $600,000. .

The differential analysis presented in Panel C Product Line Differential Analysis for Barbeque Bargains provides the answer. Panel A shows the income statement for Alternative 1: keeping all three product lines. Panel B shows the income statement for Alternative 2: dropping the charcoal barbecues product line. And panel C presents the differential analysis for the two alternatives. The differential analysis in panel C shows that overall profit will decrease by $10,000 if the charcoal barbecue product line is dropped.

Misleading Allocation of Fixed Costs

Question: How can the charcoal barbecues product line show a loss of $8,000 in the Income Statement - Panel A , while the company as a whole is better off keeping this product line?

Answer: The answer lies within allocated fixed costs. Even though total allocated fixed costs of $120,000 cannot easily be traced to each product line, company management wants each product line manager to be aware of these costs. As a result, it uses an allocation process to assign the costs to product lines. Thus the charcoal barbecues product line is assigned $18,000 in allocated fixed costs even though these costs cannot be controlled by the product line. If the charcoal barbecues product line is eliminated, $18,000 in allocated fixed costs is not eliminated. Instead, $18,000 in costs is assigned to the other two product lines.

In many situations, this increased allocation to other product lines may cause other product lines to appear unprofitable. The message here is to be careful when analyzing segmented information containing cost allocations. Allocated costs are typically not differential costs and are sunk costs, and therefore are typically not relevant to the decision.

An alternative and more correct view of the decision facing Barbeque Bargains—whether to keep or drop the charcoal barbecues product line—is simply to calculate profitability of this product line  before deducting allocated fixed costs using a Contribution Margin Income Statement.