Continue or Discontinue February production
Because of competition, the demand has dropped for shampoo. Chemists anticipate that the production of a superior product can be started on March 1. Below are the results of production and sales of the current hair care products as of the end of February.
Income Statement for Month Ended Feb 28 , 2010
Sales (205,800 @ $53) = $10,907,400
Cost of Goods Sold = $10,281,000
Gross Profit = $626,400
Selling and Administrative Expense = $1,558,860
Operating Income (Loss) = ($932,460)
Using absorption costing method we can see that, if we continue production of the current hair care product in Feb, we will incur the $932,460 loss as shown above. No additional costs would be incurred if we continue operations in the section of the plant associated with the product.
Now if we break down the costs a little bit more and do a variable costing calculation we see as below
Income Statement for Month Ended Feb 28, 2010
Sales (205,800 @ $53) = $10,907,400
Variable Cost of Goods Sold = $9,261,000
Manufacturing Margin = $1,646,400
Variable Selling and Administrative Expense = $1,378,860
Contribution Margin =$267,540
Fixed Manufacturing and Admin Costs =$1,200,000
Operating Income (Loss) = ($932,460)
Whether we continue to produce or not we will incur the fixed cost in any case. However if we produce the contribution margin will somehow be used to make up some amount of fixed cost. If we continue operation then we make a loss of $932,460 where as if we discontinue operation then we make a loss of $1,200,000 ( Equal to the fixed cost) so it is advisable to continue production.
When contribution margin is negative then and only then it is advisable to stop production for the month.
Now Suppose the company is projected to sell 294,000 units instead of earlier projected 205,800 units then the income state will look like below
Income Statement for Month Ended Feb 28, 2010
Sales (294,000 @ $53) = $15,582,000
Cost of Goods Sold = $14,250,000
Gross Profit = $1,332,000
Selling and Administrative Expense = $2,149,800
Operating Income (Loss) = ($817,800)
Using absorption costing method we can see that, if we continue production of the current hair care product in Feb with increased sales then we will incur the $817,800 loss as shown above. No additional costs would be incurred if we continue operations in the section of the plant associated with the product.
The company has a huge fixed cost overhead irrespective of production volume so it is advisable to the company to continue production if it’s contribution margin is positive.
