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# Adding and Dropping Products: The Impact on the Income Statement

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XY Company: Segmented Income Statement

It is important to consider the financial impact of changing the product mix (i.e., adding or dropping products). Preparing a segmented income statement for various scenarios assists management in determining the estimated financial impact of making one choice over another. The case below expands on the variable costing statement from the first module by adding more details about fixed costs (direct versus common) and showing the revenues and costs associated with each product and not just in the aggregate.

The company we are looking at in this module makes two products and is considering adding one more since the company has excess capacity. One aspect of making this decision is to screen the various scenarios to determine the potential profitability. Financial information alone does not tell us what to do, but it is a good start.

XY Company currently manufactures two products, X and Y. The company has the capacity to make one additional product, with two (Z and W) currently under consideration. The forecasted annual sales and related costs for each product are as follows.

- Sales:

Product Z: 110,000

Product W: 150,000

Variable costs

- Production (%)

Product Z: 50%

Product W: 60%

Product Z: 10%

Product W: 5%

- Direct fixed expenses

Product Z: 10,000

Product W: 12,500
See below for the income statement for last year's operations.

Product X: \$275,000

Product Y: \$400,000

Total Sales: \$675,000

Less variable expenses

- Production

Product X: 100,000

Product Y: 200,000

Total: 300,000

Product X: 20,000

Product Y: 60,000

Total: 80,000

- Contribution margin

Product X: \$155,000

Product Y: \$140,000

Total: \$295,000

- Less direct fixed expenses

Product X: 10,000

Product Y: 55,000

Total: 65,000

- Segment margin

Product X: \$145,000

Product Y: \$85,000

Total: \$230,000

- Less common fixed expenses

75,000

Net income

\$155,000

Common fixed costs are allocated to each product line on the basis of sales revenues.

Prepare a variable costing income statement that includes products X, Y, and Z. Repeat for products X, Y, and W. Do you recommend adding product Z or W?
Suppose that you could add both Z and W, if either X or Y is dropped. Would you drop one of the current products to add both W and Z? Support your answer with computations.
Which of the products looks the most profitable? Assuming no restraint on customer demand or resources, which product would you choose in order to maximize profitability? What about qualitative, as opposed to quantitative, concerns?
Explain the difference between the contribution margin and the segment margin and how to use the information in the decision-making process.

#### Solution Preview

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XY COMPANY: SEGMENTED INCOME STATEMENT
It is important to consider the financial impact of changing the product mix (i.e., adding or dropping products). Preparing a segmented income statement for various scenarios assists management in determining the estimated financial impact of making one choice over another. The case below expands on the variable costing statement from the first module by adding more details about fixed costs (direct versus common) and showing the revenues and costs associated with each product and not just in the aggregate.

The company we are looking at in this module makes two products and is considering adding one more since the company has excess capacity. One aspect of making this decision is to screen the various scenarios to determine the potential profitability. Financial information alone does not tell us what to do, but it is a good start.

XY Company currently manufactures two products, X and Y. The company has the capacity to make one additional product, with two (Z and W) currently under consideration. The forecasted annual sales and related costs for each product are as follows.

Product Z Product W
Sales 110,000 150,000
Variable costs 50% 60%
Direct fixed expenses 10,000 12,500

See below for the income statement for last year's operations:

Product X Product Y Total
Sales \$275,000 \$400,000 \$675,000
Less Variable expenses
Production (\$100,000) (\$200,000) (\$300,000)
Selling and administrative (\$20,000) (\$60,000) (\$80,000)
Contribution ...

#### Solution Summary

The impact on the income statement for adding and dropping products are determined.

\$2.19