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.

Question

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)	[latex]\underline{\underline{10 000} }[/latex]	[latex]\underline{\underline{4 000} }[/latex]	[latex]\underline{\underline{6 000} }[/latex]
	£000	£000	£000	£000
sales revenue	[latex]\underline{300} [/latex]	[latex]\underline{200} [/latex]	[latex]\underline{150} [/latex]	[latex]\underline{650} [/latex]
Direct materials	100	40	60	200
Direct labour	50	70	80	200
Production overhead	75	30	35	140
Non-production overhead	[latex]\underline{15} [/latex]	[latex]\underline{10} [/latex]	[latex]\underline{5} [/latex]	[latex]\underline{30} [/latex]
	[latex]\underline{240} [/latex]	[latex]\underline{150} [/latex]	[latex]\underline{180} [/latex]	[latex]\underline{570} [/latex]
Profit (Loss)	[latex]\underline{\underline{60} }[/latex]	[latex]\underline{\underline{50} }[/latex]	[latex]\underline{\underline{(30)} }[/latex]	[latex]\underline{\underline{80} }[/latex]

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.

Accepted Answer

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)	[latex]\underline{10 000} [/latex]	[latex]\underline{4 000} [/latex]	[latex]\underline{6 000} [/latex]
	£000	£000	£000	£000
Sales revenue	[latex]\underline{300} [/latex]	[latex]\underline{200} [/latex]	[latex]\underline{150} [/latex]	[latex]\underline{650} [/latex]
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)	[latex]\underline{10} [/latex]	[latex]\underline{14} [/latex]	[latex]\underline{16} [/latex]	[latex]\underline{40} [/latex]
c/f	[latex]\underline{\underline{160} }[/latex]	[latex]\underline{\underline{124} }[/latex]	[latex]\underline{\underline{156} }[/latex]	[latex]\underline{\underline{440} }[/latex]
b/f	[latex]\underline{160} [/latex]	[latex]\underline{124} [/latex]	[latex]\underline{156} [/latex]	[latex]\underline{440} [/latex]
Contribution	[latex]\underline{\underline{140} }[/latex]	[latex]\underline{\underline{76} }[/latex]	[latex]\underline{\underline{(6)} }[/latex]	210
Less: Fixed costs:
Production overheads (£140 - 40)				(100)
Non-production overheads (See question note 3)				[latex]\underline{(30)} [/latex]
Profit				[latex]\underline{\underline{80} }[/latex]

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.

Question 18.2: A closure decision Vera Limited has three main product lines...

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