Question 18.2: A closure decision Vera Limited has three main product lines...
A closure decision
Vera Limited has three main product lines: 1, 2 and 3. The company uses an absorption costing system. The following information relates to the budget for the year 2018.
| Product line | 1 | 2 | 3 | Total |
| Budgeted sales (units) | \underline{\underline{10 000} } | \underline{\underline{4 000} } | \underline{\underline{6 000} } | |
| £000 | £000 | £000 | £000 | |
| sales revenue | \underline{300} | \underline{200} | \underline{150} | \underline{650} |
| Direct materials | 100 | 40 | 60 | 200 |
| Direct labour | 50 | 70 | 80 | 200 |
| Production overhead | 75 | 30 | 35 | 140 |
| Non-production overhead | \underline{15} | \underline{10} | \underline{5} | \underline{30} |
| \underline{240} | \underline{150} | \underline{180} | \underline{570} | |
| Profit (Loss) | \underline{\underline{60} } | \underline{\underline{50} } | \underline{\underline{(30)} } | \underline{\underline{80} } |
Additional information:
1 Both direct materials and direct labour are considered to be variable costs.
2 The total production overhead of £140,000 consists of £40,000 variable costs and £100,000 fixed costs. Variable production overheads are absorbed on the basis of 20 per cent of the direct labour costs.
3 The non-production overhead of £30,000 is entirely fixed.
4 Assume that there will be no opening or closing stock.
Required:
Determine whether product line 3 should be closed.
Points
1 The first step in determining whether to recommend a closure of product line 3 is to calculate the contribution that each product line makes.
2 In order to do so, it is necessary to rearrange the data given in the question in a marginal cost format, i.e. separate the fixed costs from the variable costs.
3 If product line 3 makes a contribution then other factors will have to be taken into account before an eventual decision can be made.
Calculations
| Product line | 1 | 2 | 3 | Total |
| Budgeted sales (units) | \underline{10 000} | \underline{4 000} | \underline{6 000} | |
| £000 | £000 | £000 | £000 | |
| Sales revenue | \underline{300} | \underline{200} | \underline{150} | \underline{650} |
| Less: Variable costs: | ||||
| Direct materials | 100 | 40 | 60 | 200 |
| Direct labour | 50 | 70 | 80 | 200 |
| Variable production overhead (question note 2: 20% of direct labour cost) |
\underline{10} | \underline{14} | \underline{16} | \underline{40} |
| c/f | \underline{\underline{160} } | \underline{\underline{124} } | \underline{\underline{156} } | \underline{\underline{440} } |
| b/f | \underline{160} | \underline{124} | \underline{156} | \underline{440} |
| Contribution | \underline{\underline{140} } | \underline{\underline{76} } | \underline{\underline{(6)} } | 210 |
| Less: Fixed costs: | ||||
| Production overheads (£140 – 40) |
(100) | |||
| Non-production overheads (See question note 3) |
\underline{(30)} | |||
| Profit | \underline{\underline{80} } |
Observations
It would appear that product line 3 neither makes a profit nor contributes towards the fixed costs.
Should it be closed? Before such a decision is taken a number of other factors would have to be considered. These are as follows.
- Are the budgeted figures accurate? Have they been checked? How reliable are the budgeted data?
- What method has been used to identify the direct material costs that each product line uses? Is it appropriate for all three product lines?
- The question states that direct labour is a variable cost. Is direct labour really a variable cost? Is the assessment of its cost accurate and realistic?
- Variable production overheads are absorbed on a very broad basis related to direct labour costs.
Does this method fairly reflect product line 3’s use of variable overheads? - Product line 3 appears to result in only a small negative contribution. Can this be made positive by perhaps a small increase in the unit selling price or by the more efficient use of direct materials and direct labour?
- Assuming that the cost data supplied are both fair and accurate, would the closure of product line 3 affect sales for the other two product lines or the overall variable costs?
- If closure of product line 3 is recommended, should it be closed permanently or temporarily? More information is needed of its prospects beyond 2018.
The decision
Clearly without more information it is impossible to come to a firm conclusion. Assuming that the cost accounting procedures are both accurate and fair, it would appear that on purely financial grounds, product line 3 should be closed. However, until we have more information we cannot put this forward as a conclusive recommendation.