1. Cost Accounting for Decision-making
Lesson 6

2. Part III Different Types of Business Decisions
(Elimination or Retain an Unprofitable Segment)

3. Activity 1 – Group Discussion
‘If a branch of a company incurs a loss, then it
should be shut down.’ Do you agree? Explain?
Students are divided into groups of three to four for discussion. Teacher invites students to share their views.

4. Suggested Solution Not necessarily to shut down the branch, because
A temporary loss may be the result of an inclusion of allocated common costs or sunk costs that cannot be avoided even if the branch is closed.
The branch should be shut down only if the contribution margin that will be lost as a result of the closing is less than the fixed costs that would be avoided.
Teacher makes comments and discusses the answers.

5. Five Types of Business Decisions
Hire, make or buy
Accept or reject an order at a special price
Eliminate or retain an unprofitable segment
Retain or replace equipment
Sell or process further
Teacher highlights the third type of decision-making situation – elimination or retain an unprofitable segment.

6. Elimination or Retain an Unprofitable Segment
Segments could be referred to product lines, services, sales territories, divisions, departments, stores, or outlets.
Segment margin =
Segment’s revenue – its variable costs – its traceable fixed costs
Common allocated costs are irrelevant costs because they will be incurred regardless of the decision.
Teacher explains what is a segment and how to calculate segment margin.

7. Elimination or Retain an Unprofitable Segment
DECISION RULE
Positive segment margin
Keep the segment
Negative segment margin
Eliminate the segment *
Teacher explains the decision rule for eliminating or retaining an unprofitable segment.
* Even the segment has negative segment margin, it may be still continued if it can generate more sales of other segments.

8. Example of Making Segment Decision
ABC Ltd. comprises two divisions – X and Y. The segment income statement for the company is as follows:
X ($)
Y ($)
Total
Sales
135,000
15,000
150,000
Less: Variable costs
52,500
7,500
60,000
Contribution margin
82,500
90,000
Less: Direct fixed costs
55,500
16,500
72,000
Segment margin
27,000
(9,000)
18,000
Less Common allocated fixed costs
12,000
Net profit
6,000
Teacher illustrates segment decision with an example.
Should Division Y be dropped?

9. Suggested Solution Yes, the company should drop Division Y.
By dropping this division, the company will increase net profit by $9,000.
Unless the company can offset the division’s segment loss by increasing sales revenue or by reducing direct costs in the near future, management should drop the division.
Teacher explains the solution and makes a conclusion.

10. Activity 2: Class Discussion
What other factors the company should consider before making a final decision?
Teacher invites students to share their ideas on qualitative factors for eliminating a segment.

11. Factors to be Considered
Possibility to increase sales of Division Y in the near future
Effect on staff morale as to the closure
Costs involved for the closure
Effects on loss of customers of Division Y as to other divisions
Teacher explains some possible factors for consideration in making decision on the closure of segment.

12. Classwork
K-market Clothing Store is deciding whether to close its men’s section. The following information is extracted from the operating statement of the men’s section:
Sales revenue: $800,000
Fixed costs: $200,000
Variable costs: $650,000
Teacher asks students to do the calculations and provide comments.

13. Required:
If the men’s section is closed, only $40,000 of fixed costs can be saved. What will be the effect of the closure on the company’s profit?
The CEO is thinking to replace the men’s section with a toy’s section, it is estimated that $300,000 contribution margin could be generated each year without any additional fixed costs incurred. Should the company replace the men’s section with the toy’s section?
Teacher explains the details of the question.

14. Suggested Solution 1. If the men’s section is closed:$
Sales revenue from men’s section
800,000
Less: Variable costs related to men’s section
650,000
Lost in contribution margin
150,000
Less: Fixed cost savings
40,000
Lost in profit
110,000
Teacher explains the solution and makes a conclusion.
It should not close the men’s section because the
overall profit would decrease by $110,000, which is far greater than the loss from keeping the section of $50,000 (i.e. $800,000 - $200,000 - $650,000).

15. Suggested Solution
2. If the men’s section is replaced by the toy’s section: $
Contribution margin from toy’s section
300,000
Less: Loss on profit from the closure of the men’s section
110,000
Increase in profit
190,000
It should replace the men’s section with the toy’s section because the overall profit would be increased by $190,000.

16. Homework: Q7
Teacher asks students to do Question 7 at home.

17. END