Question

1-Describe the decision making process to add or delete products, services or departments.

2-Describe and defend the relevance or irrelevance of book value in the decision to replace equipment.

3-Is the gain or loss on disposal of equipment a taxable event to the organization?

Answer 1

Dropping or Adding a Product Line:

Often firms manufacturing a number of products may find one or more of its products are not worthwhile for producing from the profitability point of view. Since the objective of any business organization is to maximize its profits, the firm can in such cases consider the economies of dropping such unprofitable products and adding more profitable products. In such cases the firm may have two alternatives as under

a)To drop the unprofitable products and to leave the capacity unutilized.

b)To drop the unprofitable product and to utilize the capacity for the manufacture of a more remunerative product.

If we consider alternative a) above what is more important is the number of fixed expenses apportioned to the product which is going to be discontinued.If the capacity relating to the product in question is going to be left unutilized, the contribution which the product is making towards a recovery of fixed expenses will not be forthcoming. Thus continuance of a product line which is adjudged as unprofitable, on the basis of absorption costing may make matters worse. The use of contribution approach will help the firm to take a sound decision on such occasions. as some of the fixed expenses can be reduced by dropping a product line, such fixed costs become relevant while making the decision about the discontinuance of the product line.

If we consider alternative b) the fixed expenses apportioned to the product line discontinued will remain the same of being absorbed by the new product. The companies are now between discontinuance of the product line and introducing of another remunerative product line. Since the fixed expenses are not going to be reduced, the product which yields the highest contribution is preferred because it will maximize the overall profitability of the firm.

The process is same when we make a decision on Adding or deleting services or departments.

Relevance or irrelevance of book value in the decision to replace equipment:

The cost of the old machine is a sunk cost, not a future cost. This cost and the related depreciation result from the past decision to acquire the old machine. Even though all the outlay costs discussed earlier would be relevant to a decision to continue or discontinue operations, the sunk cost of the old machine is not relevant even to this decision.

If management elects to keep the old machine, its book value will be depreciated over its remaining useful life of four years. However, if management elects to replace the old machine, its book value is written off when it is replaced. Even if management elects to discontinue operations, the book value of the old machine must be written off.

GAIN or LOSS on disposal of equipment:

Whenever you dispose of a business asset, you may have a taxable event. The decision might not be taxable, but it’s usually reportable and sometimes you might enjoy something of a tax refund.

When a capital gain occurs for a depreciable asset, the difference between the cost basis and book value is taxed as depreciation recapture. This is important because the tax rates for ordinary income such as depreciation recapture and capital gains may be different.