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Discontinuing Product or Closing Down Division

Why Do Firms Close Down Products or Divisions?

  • Due to negative contribution (sales price < variable cost)
  • Products or divisions not contributing to fixed costs or profits
  • Such units may reduce overall profitability
  • Justifiable only for strategic reasons (e.g., brand presence, entry barrier)

When Should Products/Divisions Continue?

  • If they contribute positively (price > variable cost)
  • Even if loss is shown under full costing
  • Fixed costs often not relevant to the decision
  • Discontinuation may reduce overall profit if contribution is positive

Case Study: Steel Company with 5 Products

Products:

  1. Bars
  2. Sheets
  3. Pipes
  4. Ball Bearings
  5. Electro-steel

Cost Structure Breakdown

  • Variable Costs:

    • Raw material, power & fuel
    • Employees cost, other manufacturing cost
    • Direct marketing expenses

  • Product-specific Fixed Costs:

    • Depreciation and direct fixed expenses
      ✅ Relevant for decision-making

  • Allocated Plant & Corporate Fixed Costs:
    ❌ Not relevant (stay even if product is discontinued)

Profitability Analysis Using Full Costing

ProductProfitability
Sheets❌ Loss
Electro-steel❌ Loss
Bars, Pipes, Ball Bearings✅ Profitable

➡️ Management is considering discontinuing Sheets and Electro-steel

Profitability Using Relevant Costing

  • Sheets:

    • Contribution = ₹15,840
    • Product-specific fixed cost = ₹4,600
    • Profit = ₹11,240
      Loss shown earlier due to irrelevant allocated cost (₹16,800)
      ➡️ Should NOT be discontinued

  • Electro-steel:

    • Negative contribution = ₹1,000/tonne
    • Total loss (based on relevant costs) = ₹10 Cr
      ➡️ May be discontinued from cost perspective

Strategic Considerations (Beyond Numbers)

  • Electro-steel:

    • Though incurring ₹10 Cr loss, company may choose to continue for:
      • Long-term positioning
      • Market share retention
      • Customer contracts or branding

  • Sheets:

    • Profit is visible when removing irrelevant fixed cost
    • Discontinuing would unnecessarily reduce overall contribution

📌 Key Decision Criteria

Cost TypeRelevant?
Variable Costs✅ Yes
Product-Specific Fixed✅ Yes
Allocated Fixed Costs❌ No

Recommendations

  1. Use contribution analysis, not full costing, for divestment decisions.
  2. Maintain transparency in analysis and document:
    • Strategic reasons for retaining a loss-making product
    • Clear rationale for discontinuation
  3. Always validate the impact on overall profitability
  4. Rethink allocation of shared fixed costs to prevent misleading signals
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