The Unprofitable Product Line
A mid-sized manufacturer sells three products: A, B, and C. Last year's income statement shows total revenue of $5,000,000 and total costs of $4,200,000, yielding an operating profit of $800,000. Product A had revenue of $2,000,000 and direct costs of $1,500,000. Product B had revenue of $1,800,000 and direct costs of $1,600,000. Product C had revenue of $1,200,000 and direct costs of $900,000. The company allocates $200,000 of fixed overhead (rent, admin salaries) to products based on revenue. After allocation, Product B shows a loss. Management is considering dropping Product B. The company has no alternative use for the freed capacity, and dropping B would not affect sales of A or C.
1. Calculate the operating profit for each product before and after overhead allocation. Based on this, should the company drop Product B? Explain.
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Before overhead allocation:
- Product A: $2,000,000 - $1,500,000 = $500,000 profit
- Product B: $1,800,000 - $1,600,000 = $200,000 profit
- Product C: $1,200,000 - $900,000 = $300,000 profit Total profit = $1,000,000, which matches total revenue minus direct costs ($5,000,000 - $4,000,000 = $1,000,000). The remaining $200,000 is the unallocated overhead, so operating profit = $800,000.
After allocating $200,000 overhead based on revenue (A: 40%, B: 36%, C: 24%):
- A: $500,000 - $80,000 = $420,000
- B: $200,000 - $72,000 = $128,000
- C: $300,000 - $48,000 = $252,000 Total profit still $800,000. Product B still shows a profit, not a loss. If the allocation method were different (e.g., equal split), B might show a loss, but that is an artifact of allocation. The key is that B contributes $200,000 toward covering fixed overhead. Dropping B would eliminate its $1,800,000 revenue and $1,600,000 direct costs, saving $1,600,000 but losing $1,800,000, so profit would fall by $200,000. Therefore, the company should not drop Product B.
2. Suppose the company could use the freed capacity from dropping B to launch a new product D with expected revenue of $1,700,000 and direct costs of $1,500,000. Should they drop B and launch D? What other factors should be considered?
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If B is dropped and D is added:
- Lost contribution from B: $200,000
- Gained contribution from D: $1,700,000 - $1,500,000 = $200,000 Net effect on profit: $0. So financially, it's a wash. However, other factors matter: risk (D is unproven), strategic fit, impact on customer relationships (B might be part of a product bundle), and potential cannibalization. Also, the $200,000 overhead allocation is irrelevant because it doesn't change with the decision. The decision should be based on incremental contribution. Since the net is zero, qualitative factors should drive the choice. If D has growth potential, it might be worth switching; if B has loyal customers, keeping B might be safer.