Chapter 23
Managerial Accounting
Keep or Drop Decisions
Prepared by Diane Tanner
University of North Florida
What are Keep or Drop Decisions?
 A short-term decision of whether or not to
drop or continue one of the following:
 Product line – such as shoes at JCPenney, home
appliances at Best Buy
 Product – such as breakfast burritos at McDonalds,
Blue Moon beer at Hooters
 Service line – such as carpet installation by Home
Depot, textbook rentals at Follett book store
 Service – such as rental of DVDs by Netflix,
downloading of MP3s by Amazon
 Segment – such as a geographical division, retail
verses wholesale offerings, outpatient surgery in a
hospital, 3G cellular service
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Relevant Amounts
Incremental Revenue
The decline in revenue
from dropping
Incremental Cost Savings
The variable cost
savings due to dropping
The direct fixed cost
savings due to dropping
What is not relevant
 Allocated fixed costs
 Often called common costs
 Consists of overhead costs that a company allocates or
divides up amongst several units that use the costs
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How to Make Keep or Drop Decisions
If the decline in revenue < incremental cost savings
Drop the product/product line, unless
qualitative characteristics impact the decision
If the decline in revenue > incremental cost savings
Do not drop the product/product line, unless
qualitative characteristics impact the decision
If the decline in revenue = incremental cost savings
Use qualitative characteristics to assess
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Beware of Allocated Fixed Costs
 Dropping a product/service/line/segment that
has a net loss often creates a bigger loss
 Referred to as the Cost Allocation Death
Spiral
Why should we
keep the ice cream
segment? It shows a
loss?
Because not all
costs will disappear
when we allocate
costs to products.
Our allocations
can make a
segment look less
profitable than it
really is.
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Keep or Drop Example
Take Outs has three product lines in its retail stores: snacks,
salads, and sandwiches. The allocated fixed costs are unavoidable.
Results of July follow:
Snacks
Units sold
Revenue
Variable costs
Direct fixed costs
Allocated fixed costs
Operating income
Salads
Sandwiches
Total
800
$49,600
19,200
10,000
16,000
1,200
$52,800
26,400
14,000
18,000
2,400
$67,200
33,600
13,000
16,000
4,400
$169,600
79,200
37,000
50,000
$4,400
($5,600)
$4,600
$3,400
Demand of snacks is expected to increase by 10% if salads
are dropped. Prepare an incremental analysis.
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Keep or Drop Example
cont.
Data reproduced:
Snacks
Units sold
Revenue
Variable costs
Direct fixed costs
Allocated fixed costs
Operating income
800
$49,600
19,200
10,000
16,000
$4,400
Salads
1,200
$52,800
26,400
14,000
18,000
($5,600)
Sandwiches
2,400
$67,200
33,600
13,000
16,000
$4,600
Incremental decline in salad revenue
Incremental variable cost savings - salads
Incremental direct fixed costs savings –salads
Incremental snack revenue (10% x $49,600)
Incremental variable costs –snacks (10% x $19,200)
Incremental decrease in profit if drop salads
Total
4,400
$169,600
79,200
37,000
50,000
$3,400
($52,800)
26,400
14,000
4,960
(1,920)
($9,360)
Original profit +/- Change in profit = New profit
New profit = $3,400 - $9,360 = $5,960 loss
The End
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