DISCONTINUATION DECISIONS

Most organizations periodically analyses profits by one or more cost objects, such as products or
services, customers and locations. Periodic profitability analysis can highlight unprofitable
activities that require a more detailed appraisal (sometimes referred to as a special study) to
ascertain whether or not they should be discontinued. In this section, we shall illustrate how the
principle of relevant costs can be applied to discontinuation decisions.

Consider the following example you will see that it focuses on a decision whether to discontinue
operating a sales territory, but the same principles can also be applied to discontinuing products,
services or customers.

Example
The Aero Company is a wholesaler that sells its products to retailers throughout the Far East.
Aero’s head-quarters is in Hong Kong. The company has adopted a regional structure with each
region consisting of three to five sales territories. Each region has its own regional office and a
warehouse that distributes the goods directly to the customers. Each sales territory also has an
office where the marketing staff are located. The South East Asian region consists of three sales
territories with offices located in Singapore, Kuala Lumpur and Bangkok. The budgeted results
for the next quarter are as follows:

Required:
Assuming that the above results are likely to be typical of future quarterly performance, should
the Bangkok territory be discontinued?

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In Example above, Aero Company analyses profits by locations. Profits are analyzed by regions,
which are then further analyzed by sales territories within each region. It is apparent from the
example above that the South East Asian region is profitable (showing a budgeted quarterly
profit of £202,000) but the profitability analysis suggests that the Bangkok sales territory is
unprofitable. A more detailed study is required to ascertain whether it should be discontinued.
Let us assume that this study indicates that:
1. Discontinuing the Bangkok sales territory will eliminate cost of goods sold, salespersons’
salaries and sales office rent.
2. Discontinuing the Bangkok sales territory will have no effect on depreciation of sales office
equipment, warehouse rent, depreciation of warehouse equipment and regional and
headquarters expenses. The same costs will be incurred by the company for all of these items
even if the sales territory is discontinued.
Note that, in the event of discontinuation, the sales office will not be required and the rental will
be eliminated, whereas the warehouse rent relates to the warehouse for the region as a whole and,
unless the company moves to a smaller warehouse, the rental will remain unchanged. It is
therefore not a relevant cost. Discontinuation will result in the creation of additional space and if
the extra space remains unused, there are no financial consequences to take into account.
However, if the additional space can be sublet to generate rental income, this income would be
incorporated as an opportunity cost for the alternative of keeping the Bangkok territory.
Relevant cost analysis relating to the discontinuation of the Bangkok territory

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The above shows the relevant cost and revenue computations. Column (1) shows the costs
incurred and revenues derived by the company if the sales territory is kept open (i.e. the items
listed in the final column of Example) and column (2) shows the costs and revenues that will
occur if a decision is taken to drop the sales territory. Therefore in column (2) only those costs
that would be eliminated (i.e. those in item (1) on our list shown above) are deducted from
column (1). For example, the above example specifies that £240,000 sales persons’ salaries will
be eliminated if the Bangkok territory is closed so the entry in column (2) is £360,000 (£600,000
2 £240,000)
You can see that the company will continue to incur some of the costs (i.e. those in item (2) on
our list shown on the previous page) even if the Bangkok territory is closed and these costs are
therefore irrelevant to the decision. Again you can either include, or exclude, the irrelevant costs
in columns (1) and (2) as long as you ensure that the same amount of irrelevant costs is included
for both alternatives if you adopt the first approach. Both approaches will show that future profits
will decline by £154,000 if the Bangkok territory is closed. Alternatively, you can present just
the relevant costs and revenues shown in column (3).
This approach indicates that keeping the sales territory open results in additional sales revenues
of £1,700,000 but additional costs of £1,546,000 are incurred giving a contribution of £154,000
towards fixed costs and profits.
We can conclude that the Bangkok sales territory should not be closed.

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Review questions
Question 1
Farmer in Ikungi has 240,000 square metres (m2) of land on which he grows maize, potatoes,
barley and wheat. He is planning his production for the next growing season. The following
information is provided relating to the anticipated demand and productive capacity for the next
season:

Maize Potatoes Barley Wheat

Contribution per tonne of output TZS 160 TZS 112 TZS 96 TZS 80
m2 required per tonne of output 80 32 24 16
Estimated sales demand (tonnes) 3 000 3 000 3 000 3 000

Required area to meet sales demand (m2) 240 000 96,000 72,000 48,000

It is not possible in the short run to increase the area of land beyond 240,000m2 for growing the
above crops.
Required:
You have been asked to advise on the mix of crops that should be produced during the period.

Question 2
JB Limited is a small specialist manufacturer of electronic components and much of its output is
used by the makers of aircraft for both civil and military purposes. One of the few aircraft
manufacturers has offered a contract to JB Limited for the supply, over the next 12 months, of
400 identical components.
The data relating to the production of each component are as follows:

(i) Material requirements:

3kg material M1 – see note 1 below
2kg material P2 – see note 2 below
1 Part No. 678 – see note 3 below
Note 1. Material M1 is in continuous use by the company. 1000kg are currently held in stock at a
book value of TZS 4.70 per kg but it is known that future purchases will cost TZS 5.50 per kg.

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Note 2. 1200kg of material P2 are held in stock. The original cost of this material was TZS 4.30
per kg but as the material has not been required for the last two years it has been written down to
TZS 1.50 per kg scrap value. The only foreseeable alternative use is as a substitute for material
P4 (in current use) but this would involve further processing costs of TZS 1.60 per kg. The
current cost of material P4 is TZS 3.60 per kg.
Note 3. It is estimated that Part No. 678 could be bought for TZS 50 each.
(ii) Labour requirements:
Each component would require five hours of skilled labour and five hours of semi-skilled. An
employee possessing the necessary skills is available and is currently paid TZS 12 per hour. A
replacement would, however, have to be obtained at a rate of TZS 13 per hour for the work
which would otherwise be done by the skilled employee. The current rate for semi-skilled work
is TZS 10 per hour and an additional employee could be appointed for this work.
(iii) Overhead:
JB Limited absorbs overhead by a machine hour rate, currently TZS 20 per hour of which TZS 7
is for variable overhead and TZS 13 for fixed overhead. If this contract is undertaken it is
estimated that fixed costs will increase for the duration of the contract by
TZS 3200. Spare machine capacity is available and each component would require four machine
hours.
A price of TZS 250 per component has been suggested by the large company which makes
aircraft.
You are required to:
(a) State whether or not the contract should be accepted and support your conclusion with
appropriate figures for presentation to management;
(b) Comment briefly on three factors that management ought to consider and which may
influence their decision

Question 3
The management of Springer plc is considering next year’s production and purchase budgets.
One of the components produced by the company, which is incorporated into another product
before being sold, has a budgeted manufacturing cost as follows:

(TZS )
Direct material 14
Direct labour (4 hours at TZS 3 per hour) 12
Variable overhead (4 hours at TZS 2 per hour) 8
Fixed overhead (4 hours at TZS 5 per hour) 20
Total cost 54 per unit

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Trigger plc has offered to supply the above component at a guaranteed price of TZS 50 per unit.
Required:
Considering cost criteria only, advise management whether the above component should be
purchased from Trigger plc. Any calculations should be shown and assumptions made, or aspects
which may require further investigation should be clearly stated.
Question 4
The Reward One Company manufactures windows. Its manufacturing plant has the capacity to
produce 12,000 windows each month. Current production and sales are 10,000 windows per
month. The company normally charges $250 per window. Cost information for the current
activity level is as follows:
Variable costs that vary with number of units produced
Direct materials $ 600,000
Direct manufacturing labor 700,000
Variable costs (for setups, materials handling, quality
control, and so on) that vary with number of batches,
100 batches × $1,500 per batch 150,000
Fixed manufacturing costs 250,000
Fixed marketing costs 400,000
Total costs $ 2,100,000
Reward One has just received a special one-time-only order for 2,000 windows at $225 per
window. Accepting the special order would not affect the company’s regular business or its fixed
costs. Reward One makes windows for its existing customers in batch sizes of 100 windows (100
batches × 100 windows per batch = 10,000 windows). The special order requires Reward One to
make the windows in 25 batches of 80 windows.
Required:
a) Should Reward One accept this special order? Show your calculations.
b) Suppose plant capacity were only 11,000 windows instead of 12,000 windows each month.
The special order must either be taken in full or be rejected completely. Should Reward One
accept the special order? Show your calculations.

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Question 5
Diamond Corporation produces baseball bats for kids that it sells for $37 each. At capacity, the
company can produce 54,000 bats a year. The costs of producing and selling 54,000 bats are as
follows
Cost per Bat Total Costs
Direct materials $ 14 $ 756,000
Variable direct manufacturing labor 4 216,000
Variable manufacturing overhead 2 108,000
Fixed manufacturing overhead 5 270,000
Variable selling expenses 2 108,000
Fixed selling expenses 3 162,000
Total costs $ 30 $ 1,620,000
Required:
1) Suppose Diamond is currently producing and selling 44,000 bats. At this level of production
and sales, its fixed costs are the same as given in the preceding table. Home Run Corporation
wants to place a one-time special order for 10,000 bats at $21 each. Diamond will incur no
variable selling costs for this special order. Should Diamond accept this one-time special
order? Show your calculations.
2) Now suppose Diamond is currently producing and selling 54,000 bats. If Diamond accepts
Home Run’s offer, it will have to sell 10,000 fewer bats to its regular customers. (a) On
financial considerations alone, should Diamond accept this one-time special order? Show
your calculations. (b) On financial considerations alone, at what price would Diamond be
indifferent between accepting the special order and continuing to sell to its regular customers
at $37 per bat. (c) What other factors should Diamond consider in deciding whether to accept
the one-time special order?