Differential Analysis

Adding or Dropping Product Lines

Differential analysis is an effective tool when a company is deciding whether to add a product or drop one.

Product line decisions are among the most important and critical ones that a company can make. Every day, companies consider whether to discontinue an old product line that isn't selling as steadily as it used to. They also consider what other products—if any—they should try to develop. Assessing the financial implications of making changes to a product line is thus of significant importance in managing a company. Using differential analysis helps owners and managers make decisions about product line offerings and potential changes in other segments.

For example, a car company may make several lines of vehicles, including luxury SUVs, midsize sedans, and low-cost compact cars. The company's analysis of its product lines might show that the SUVs and sedans are profitable, while the company loses money on the compact car line. Managers may consider sales volume and variable expenses across all the product lines, looking at pricing and revenues along with measuring and allocating fixed expenses related to salaries, advertising, utilities, depreciation, rent, insurance, and administrative expenses across all product lines.

This examination may lead to the conclusion that the company should drop its compact car line. However, in this situation the company may need to analyze its fixed costs more fully to make sure they are being allocated properly across all product lines. If eliminating the compact car product line saves more in fixed and variable costs than the line brings in through revenue, then closing the line is an informed choice. However, if closing the line does not eliminate all of the fixed costs currently allocated to the budget car line and simply forces some of those costs to be redistributed to the remaining product lines, then the company might be worse off by dropping the compact car line.

Perhaps all three product lines might be built in the same factory. In that case, it may make sense to allocate the rent for the building equally across the product lines or to allocate it based on how many units each product line produces. However, closing down one of the product lines would not necessarily reduce the rent needed for the factory if it would not be practical or cost effective to move to a smaller, cheaper building. That rental cost would then just be reallocated across the two remaining product lines.

An avoidable cost is an expense a manager eliminates by choosing one alternative over another in a decision-making process. In this scenario, payroll and advertisements for the budget car are avoidable costs, but costs for rent and furniture are not avoidable. Utilities would be somewhat lower if a third of the factory became idle, so part of that expense is avoidable. In this case, the company may be better off keeping the compact car product line. The amount of fixed costs that the company would save from closing the line would be less than the revenue the line produces once the costs of closing down the compact car product line are redistributed.

Differential Analysis of Product Lines

Costs and Revenues Total Luxury SUVs Mid-Sized Sedans Low-Cost Compact Cars
Sales $500,000 $250,000 $150,000 $100,000
Variable Costs $225,000 $120,000 $50,000 $40,000
Contribution Margin $275,000 $130,000 $100,000 $60,000
Fixed Costs $175,000 $95,000 $80,000 $70,000
Net Operating Income $100,000 $35,000 $20,000 ($10,000)
Fixed Costs Total Cost Assigned to Compact Cars Not Avoidable Avoidable
Payroll $15,000 $15,000
Advertisements $10,000 $10,000
Utilities $5,000 $3,000 $2,000
Furniture $12,000 $12,000
Rent $28,000 $28,000
Total $70,000 $43,000 $27,000

These tables show the data that managers considered while trying to decide whether to eliminate a product line.

In this example, the company can avoid only $27,000 of fixed costs, which is less than the contribution margin of the compact car line. Thus, the company should continue to make compact cars—that is, unless or until they can find a more profitable use for the compact car factory space.