Let's continue our application process via the GnG Landscape setting, and look at a different operational decision. In particular, managing its product lines. GnG managers are considering eliminating their apartment and condominium line from the residential landscaping service department. Scott, an operations manager. Points out that the line is currently losing money. He presents the profitability statement at a manager's meeting. Taking a look at this statement we can see, for the current quarter. Revenues for this product line, are $25,000. The variable expenses made up of variety of different costs amount to $10,000. That means that the contribution margin is $15,000. Fixed expenses currently being allocated to the apartment and condominium line amount to $19,000. And so therefore, the reported net income for this product line is 4,000 to the negative. So, Scott is indeed right. Per this report, they're losing money. Now total residential servicing net income. That's all of those residential lines put together. Amounts to $52,000 in net income for the last quarter. So Scott argues that eliminating the apartment and condo line would increase net income by $4,000. The amount of the current loss of this line and we're to eliminate, be eliminated, we'll no longer have this loss. Let's look at Scott's argument a little bit closer. So what we have here is a keep or drop decision. We're deciding whether or not we should keep the apartment in condo line or drop it from our business altogether. So, I can organize my information according to these two decision paths. Keep or drop. In terms of revenues, assuming that last quarter is similar to what next quarter would be like. We're basically figuring out what revenues we would have if we were to keep the product. And what we would lose if we were to drop the product. So, if we were to keep the apartment and condo line. Let's assume that we would have the same $25,000 in revenues. If we were to drop it. We would no longer have this product line. So, we would no longer have these revenues. Revenues relevant here? Absolutely, they differ between the two decision alternatives. The variable cost by definition correlate with the activity of interest that we engaged and that is having this product line around. So if we were to keep the product line. Let's assume that we were to incur the same $10,000 in variable costs that we've incurred in the past. And if we were to drop this product line. Then we would no longer be engaged in activities that generate those variable costs. So let's assume that those variable costs go away if we were to drop the apartment and condo line. So our contribution margin. If we were to keep, we would have $15,000 in contribution margin. And zero in contribution margin, if we were to drop this line. Now onto the fixed costs. And the fixed costs in this case are a little bit more tricky. If we were to keep this product line. Then the fixed cost that we incur to have the total residential servicing line altogether, Would be allocated to this line in the amount of $19,000. The same amount that's been allocated to this line in the past. Now the question is, if we were to drop this line. What would happen to those fixed costs? What Scott is suggesting is that these fixed costs go away. But if these fixed costs are allocated to the different product lines. In other words, that these costs are incurred no matter what. No matter what levels of activities we engage in. Then we're not actually saving the $19,000 by dropping this product line. The firm as a whole would still incur these fixed costs. It's just that they would be allocated elsewhere. Scott's perspective assumes that these fixed costs go away. But if the fixed costs are not avoidable. Meaning that the firm still incurs them, and they're just allocated to the remaining product lines. Then the 19,000 is incurred, even if we were to drop the apartment and condo line. So per our original report. Scott was suggesting that we are losing $4,000 by having the apartment and condo line in place. And he suggested that we would save that loss. Cover it basically, in future periods. If we were to eliminate this product line. But via the relevant perspective. If the fixed cost are not actually changing. Then by dropping the product line. We would incur a $19,000 loss due to the fixed expenses that are not avoidable. So really in essence, all along the contribution margin from the apartment and condo line has been subsidizing these fixed costs. Bringing the loss closer to the break even point. And much better, than if we were to lose that contribution margin all together. Again, this assumes that these fixed costs are unavoidable. Now a related question in this setting has to do with. What is actually avoidable? And how much fixed cost would have to be avoided or saved to make Scott's plan feasible? Using the same information We would treat everything exactly the same. To keep, revenues will be 25,000. Variable cost would be 10,000. Contribution margin would be 15,000. Fixed cost would be 19,000. And the loss would be 4,000. To make the drop option feasible. We said that the revenues would not be there if we were to eliminate the apartment and condo line. So that 25,000 is gone. As is the variable cost of 10,000. And therefore, it follows that we would lose the contribution margin of 15,000 that we had earlier. Really, if we were to eliminate $15,000 worth of fixed costs as a result of dropping this line, and bringing those fixed costs down to 4,000. Then that would mean that the keep versus drop option would be equivalent, and we would be indifferent between the two. So we would need to eliminate $15,000 or more of the original fixed cost amount in order to make Scott's plan feasible. Any more than that would mean that our loss would get less and less, and approach closer to what his idea was. And that would be eliminating the loss that's getting added into the business as a whole. But if we're not able to eliminate $15,000. Then it's worse to drop the product line and lose the subsidization that we're getting from the contribution margin from apartments and condos. Let's have a checkpoint to make sure we're all on the same page. So just like with the earlier decision. What other concerns would you have about this decision? Well again, there's the strategic concern. Not being able to service apartments and condos. May show us as not really providing a complete product to the community. What that ultimately means is, that our reputation might suffer by dropping that product line. Of course, dropping that product line may help us, in a way. May allow us to allocate resources to other existing product lines. Perhaps some that are more profitable. And eventually, it might make this decision worth it in the long run. One other concern might be the effect on employees. Those variable costs probably entail a lot of labor. So when we think about eliminating a product line. We're affecting the employees and managers that currently work for it, to the extent that we don't have alternative work for them. They might need to be laid off or fired. That has implications for those employees and our reputation is deformed as well. So obviously, there are a number of different considerations that managers keep in mind when making decisions like this. The financial perspective is hardly the final answer to the question, but it certainly informs it. Because understanding relevant revenues and costs help to know whether need alternatives are feasible from a profitability perspective.
