Keep Drop Customers Decisions - New Project 5

Phillips Accountancy provides bookkeeping, tax, and audit services to its clients. Management believes Phillips Accountancy has several unprofitable customers and would like to perform differential analysis to find out how profits would change if Phillips dropped these customers. Alternative 1 includes the annual revenues, costs, and resulting profit if the company keeps all existing customers. Alternative 2 includes the annual revenues, costs, and resulting profit if the company drops what it believes are unprofitable customers. How should management decide whether to keep all existing customers or drop certain customers?

Answer: Table PA-1 Differential Analysis for Phillips Accountancy presents the format used by management to perform differential analysis. In this case, differential analysis is used to evaluate whether Phillips Accounting should keep all customers or drop unprofitable customers. The information in Table PA-1 Differential Analysis for Phillips Accountancy confirms that Phillips Accountancy would be better off dropping the unprofitable customers (Alternative 2), because company profits would increase by $20,000. The general rule is to select the alternative with the highest differential profit.

Notice that in Table PA-1 Differential Analysis for Phillips Accountancy the columns labeled Alternative 1 and Alternative 2 show revenues, costs, and profit for each alternative. The third column, labeled Differential Amount, presents the differential revenues and costs and resulting differential profit. Positive amounts appearing in this column indicate Alternative 1 is higher than Alternative 2.

Negative amounts appearing in the Differential Amount column indicate Alternative 1 is lower than Alternative 2. The fourth column shows whether Alternative 1 is higher or lower than Alternative 2 for each line item.

For example, the differential amount of $1,000,000 for revenue indicates Alternative 1 produces $1,000,000 more in revenue than Alternative 2. The differential amount of $750,000 for variable costs indicates variable costs are $750,000 higher for Alternative 1 than for Alternative 2. Move to the bottom of Table PA-1 Differential Analysis for Phillips Accountancy. Notice that the differential amount for profit is a negative ($20,000). This indicates that Alternative 1 results in profits that are $20,000 lower than Alternative 2. Thus Alternative 2 (dropping unprofitable customers) is the desirable course of action.

Notice that the columns labeled Alternative 1 and Alternative 2 show information in summary form (i.e., no detail is provided for revenues, variable costs, or fixed costs). Some managers may want only this type of summary information, whereas others may prefer more detailed information. It is important to be flexible with the format, to best meet the needs of managers.

Management of Colony Landscape Maintenance would like to know if dropping the Brumfield account would increase overall company profit. The differential analysis presented in Table CL-2 Customer Differential Analysis for Colony Landscape Maintenance provides the answer. Panel A shows the income statement for Alternative 1: keeping all three customers. Panel B shows the income statement for Alternative 2: dropping the Brumfield account. And panel C presents the differential analysis for both alternatives. The differential analysis presented in Table CL-2 shows that overall profit will decrease by $5,000 if Colony drops the Brumfield account.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.

The following annual income statement is for Tatum & Associates, a firm that provides legal services to its customers.

Tatum & Associates is concerned about the losses associated with the Elko Corporation account and is considering dropping this customer. Allocated fixed costs are assigned to customers based on percentage of sales. If a customer is dropped, total allocated fixed costs are assigned to the remaining customers. All variable costs and direct fixed costs are differential costs.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.