Closing a loss-making line can reduce company profit

Removing a line that reports a loss can leave the company earning less. If some of the costs charged to that line continue after it closes, its reported loss is not the amount the business saves.

What the line report says

Consider an invented print studio planning one month. It sells standard prints and custom signs. Every order accepted before this comparison has been completed. The studio can either keep offering custom signs for the new month or stop accepting them before it begins.

Under the supplied plan, custom signs earn $20,000 in revenue, incur $12,000 of variable operating expenses and require a $3,000 dedicated support package. The package can be canceled before the month without a fee; all $3,000 would then cease. These are assumptions for this illustration, not conclusions about an actual contract.

The company also has $20,000 of common operating expenses for the month, including management pay and depreciation. All $20,000 continues if custom signs stop. Its internal report assigns $6,000 of that total to custom signs and $14,000 to standard prints.

The sign line therefore reports a $1,000 loss: $20,000 of revenue, less $12,000, $3,000 and the allocated $6,000. That result includes an expense allocation the company would still carry after closing the line.

Follow the company through the change

Stopping custom signs removes $20,000 of revenue and $15,000 of expenses: the $12,000 variable amount and the $3,000 support package. The remaining $6,000 is not another saving. It is part of the common expenses that continue.

The company's monthly operating profit falls by $5,000. The custom work had been providing that amount toward common expenses after covering its own avoidable costs.

The whole-company comparison should give the same answer. Standard prints produce $80,000 of revenue, incur $40,000 of variable expenses and $10,000 of their own specific fixed expenses. Those figures stay unchanged in both alternatives. The figures supplied here include every operating expense in the comparison; financing and income taxes are outside it.

• Keep both lines: $100,000 revenue − $52,000 variable expenses − $13,000 specific fixed expenses − $20,000 common expenses = $15,000 operating profit.
• Keep standard prints only: $80,000 revenue − $40,000 variable expenses − $10,000 specific fixed expenses − $20,000 common expenses = $10,000 operating profit.

Before closure, the standard-print report showed $16,000 after its $14,000 share of common expenses. After closure, assigning it the full $20,000 reduces its reported result to $10,000. Standard sales have not deteriorated. The remaining report now carries the expenses previously assigned to custom signs.

A different bill can change the answer

Now change one condition. A supplied supplier amendment allows a company-wide support package to be reduced by $6,000 for the coming month if custom signs stop. The remaining service is unchanged and no replacement cost is needed. The common expenses fall from $20,000 to $14,000. This is a different cost arrangement, not a different label on an unchanged payment.

Keeping both lines still leaves $15,000. Closing custom signs now leaves $80,000 − $40,000 − $10,000 − $14,000 = $16,000. In this revised case, closing improves operating profit by $1,000.

What makes that $6,000 removable? An actual end date, release from the commitment and workable arrangements for the remaining service would support the change. Moving the cost to another department would not.

ACCA's relevant-costs discussion explains why reallocating existing fixed costs does not establish a saving. The studio and every amount here are original hypothetical conditions.

Put the service and the period back in

Both studio comparisons assume no exit costs, asset transactions or unfinished customer promises. Standard-print demand and service remain unchanged, and the released capacity has no alternative use in this month. An actual closure needs those questions answered. An available machine does not, by itself, supply a new order.

A cost that ends next quarter is still present in this month's comparison. A charge for ending an agreement belongs in the period it affects. Keep the payment calendar separate from the operating-profit result; these figures supply no collection or payment dates.

Start with the reported line result, then identify the revenue lost, expenses that stop and expenses that remain. Reconcile the change to the whole company. Finally, follow the work the expense supports: who still needs the service, and what would replace it?