Decisions to discontinue a production line or product: When is discontinuation profitable and when is it destructive?
Decisions to Discontinue a Product Line: When is it Profitable and When is it Destructive?
Decision to discontinue a product line: A professional guide on how to evaluate product profitability via Segment Analysis, identify truly avoidable costs, and avoid the trap of fixed allocations—Digital Salla.
- The fundamental methodology: Segment Margin Analysis.
- Differentiating between Direct Fixed Costs and Common Fixed Costs.
- Step-by-step numerical example: Analyzing a “Losing” product line.
- The Fixed Cost Trap: Why some losses are better kept than dropped.
- Strategic and Qualitative factors: Impact on customers and brand image.
1) The Discontinuation Logic
When a product line shows a loss on the income statement, management’s first instinct is often to “Drop it.” However, in Management Accounting, we only drop a line if its Avoidable Costs are higher than its Total Revenues.
2) Identifying Avoidable vs. Unavoidable Costs
To make a sound choice, we must classify fixed costs into two categories:
2.1 Avoidable (Direct) Fixed Costs
Costs that will disappear if the product is dropped (e.g., salary of a dedicated supervisor, lease of a specific machine).
2.2 Unavoidable (Common) Fixed Costs
Costs that will persist and must be paid by other products (e.g., general factory rent, property taxes, corporate office salaries).
3) Segment Margin: The Decision Pillar
The Segment Margin is the most accurate measure of a product’s profitability. Segment Margin = Contribution Margin − Avoidable Fixed Costs.
Budgeting & Forecasting Model - Excel File
| Margin Status | Strategic Interpretation | Recommended Action |
|---|---|---|
| Positive Segment Margin | The product helps pay for shared company overhead. | KEEP (and improve efficiency). |
| Negative Segment Margin | The product loses money even before shared costs. | DROP (unless strategically vital). |
4) The Cost Impact Path (Visual Logic)
Why dropping a “Losing” product can sometimes hurt the company?
5) Case Study: Discontinuing Product Line A
Product A shows an annual Loss of ($5,000) in the books: Revenue $100k | Variable Costs $60k | Fixed Costs $45k.
| Item | Amount | Nature |
|---|---|---|
| Revenue Lost | ($100,000) | Incremental Reduction |
| Variable Costs Saved | +$60,000 | Incremental Gain |
| Avoidable Fixed Costs Saved | +$30,000 | Specific Salaries/Maintenance |
| Unavoidable Costs (Rent) | $0 | Stays even if dropped |
| Net Impact on Total Profit | ($10,000) | Total Profit will DROP |
6) The Fixed Cost Re-allocation Trap
Traditional financial reporting “Spreads” shared costs across products. When you drop one product, those shared costs don’t vanish—they are re-allocated to the remaining products.
- This can create a Death Spiral: Dropping Product A makes Product B look like it’s losing money (because it now carries more rent), which leads to dropping Product B, and so on.
7) Strategic and Qualitative Factors
The decision is never purely about the spreadsheet. Management must ask:
- Customer Synergy: Do customers buy Product B only because we also offer Product A? (e.g., Printers and Ink).
- Opportunity Cost: Can we use the space saved by dropping Product A to launch a more profitable Product C? (If yes, add Product C’s margin to the “Drop” savings).
- Employee Impact: Will dropping the line lead to mass layoffs and low morale?
- Market Share: Are we handing over a segment of our market to a competitor?
8) Operational Controls & Readiness Checklist
To ensure your Keep or Drop decisions are strategically sound:
Discontinuation Quality Gate Checklist
- Are Common Fixed Costs clearly separated from Direct Fixed Costs in the GL?
- Is the Opportunity Cost of alternative use for idle space quantified?
- Have you analyzed the Sales Mix impact on other products?
- Are Inventory Valuation (FIFO/WAC) impacts on the final write-off considered?
- Is there a plan to re-assign or utilize direct labor if the line is dropped?
9) Common Errors and How to Prevent Them
- Dropping based on Gross Profit: Overlooking that Gross Profit includes fixed manufacturing overhead which is often unavoidable.
- Ignoring Capacity Re-use: Dropping a line but letting the factory space sit empty (losing the opportunity cost).
- Static Analysis: Failing to realize that some “Variable” costs might become “Fixed” in the short term (e.g., guaranteed supply contracts).
- Forgetting Cannibalization: Dropping a low-price product that actually protected your high-price product from competitors.
10) Frequently Asked Questions
What is a Segment Margin?
It is the profit a specific product or department earns after covering all of its own variable and direct fixed costs, but before considering shared company-wide costs.
Why is dropping a line with a negative net profit often a mistake?
Because that product might still have a positive contribution margin that covers some shared fixed costs (like rent) that would otherwise have to be paid by other products.
When is a fixed cost avoidable?
When it is directly linked to the product line and will disappear if the line stops (e.g., marketing for that product specifically or dedicated machinery lease).
11) Conclusion
Deciding to discontinue a product line is one of the most difficult strategic choices in business. By moving beyond traditional “Accounting Profit” and utilizing Segment Margin Analysis, you gain the power to see which products are truly supporting the company’s survival. This methodology ensures that you only drop products that are a “Net Drain” on cash, while protecting those that—despite looking weak on paper—are vital pillars of your entity’s overall profitability.
Action Step Now (30 minutes)
- Find your lowest-performing product line.
- List its Direct Avoidable costs (Materials, Labor, Specific Ads).
- Compare that total to its Revenue. If Revenue > Avoidable Costs, KEEP IT and find ways to increase the margin.