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3.7.3 Abandonment decisions

From time to time management will be faced with the problem of deciding to abandon an
unprofitable activity. This is really a least-cost alternative decision and so made on the criterion
of relative marginal costs.

Ceasing Production of Certain Products

It is sometimes suggested that, where a given product is apparently making a loss,

manufacture and/or marketing of this product should cease, to improve the company’s overall
profit performance.
 KENBAR CYCLES LIMITED
PROFIT AND LOSS STATEMENT FOR YEAR ENDED 31.12.19..

Model A16 Model E35 Model N40 Total

£’000 £’000 £’000 £’000
Direct materials 110 100 150 360
Direct labour 50 40 80 170
Variable overhead 65 60 100 225
Fixed overhead 45 120 220 385
TOTAL COSTS 270 320 550 1,140
Profit/(loss) 45 65 (50) 60
SALES VALUE 315 385 500 1,200

Model N40 is incurring losses of £50,000 per annum, which is ten per cent of its sales value.
The implication of this profit and loss statement is that the withdrawal of Model N40 from the
market will avoid losing £50,000 and (by inference) raise profits to £110,000. This is faulty
reasoning, but a risk which is inherent in the total cost form of presentation. The marginal
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presentation of the year’s results would avoid the risk and give a more meaningful report.

KENBAR CYCLES LIMITED

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PROFIT AND LOSS STATEMENT FOR YEAR ENDED 31.12.19..

Model A16 Model E35 Model N40 Total

£’000 £’000 £’000 £’000
Sales value 315 385 500 1,200
Marginal cost 225 200 330 755
Contribution 90 185 170 445
Fixed overhead 385
Profit/Loss 60

Since Model N40 yields an annual contribution of £170,000, the abandonment of this product
will lose this contribution and so turn the overall profit of £60,000 into a loss of £110,000. (The
contribution from A16 and E35 is £275,000 towards the fixed costs of £385,000). The marginal
presentation shows that it is better to continue production of Model N40 rather than lose its
contribution. As a general proposition it can be postulated that it is more profitable to continue
marketing a product which yields some contribution rather than abandon it. (If possible, it would
be better still to replace it with another product having a higher P/V ratio).
3.7.4 Temporary closure of factory or department

Here there is a similar situation to that of discontinuance of a product such as

Model N40. A factory which is expected to earn some contribution should
continue in operation rather than be shut down. However, if the factory is
part of a group, the decision is quite different when the output from the
closed factory is not lost but transferred to another factory in the group with
spare capacity. For example, a temporary fall in the sales volume of a
company’s products may result in either of two factories being capable of
satisfying the expected demand. In this situation the company can optimize
its profits by concentrating production in that factory which has the lowest
marginal costs. In reaching a decision, consideration should be given to
predictable cost changes generated by the decision: such as additional
distribution costs, care and maintenance of the closed premises, restarting
costs, and any fixed cost savings such as salaries in the closed factory.

3.7.5 Permanent abandonment of premises

A company may find it more profitable to concentrate its output in some

factories by closing down others. The decision, in this instance, is made on
the basis of incremental costs and will depend on that combination of
resources which yields the greater overall group profit. The permanent

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closure of a factory saves fixed cost s expenditure and also frees capital (by
the sale of assets) for alternative investment, as well as providing the
opportunity to take advantage of low marginal costs elsewhere. It is possible
that the sale of freehold land and buildings could provide considerable

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investment funds free of interest which would make the abandonment
particularly attractive. This has been demonstrated effectively by asset
stripping following a successful takeover.
There may be a high social cost in a factory closure which is difficult to
evaluate, but in any case it will be borne by the whole community rather than
the individual manufacturer. A growing awareness of the social
consequences which follow factory closures may persuade politicians that the
cost to the community represents a hidden subsidy to the profits of an
individual company. A tax or other deterrent for such cases in the future
would be an additional cost of abandonment decisions and so make it
relatively less profitable to close a factory.