Question

Describe what adverse effects might happen if a company decided to drop a segment (one of many) that shows a net loss after subtraction of allocated fixed costs.

If a company’s management is highly concerned about downside risk and the possibility of losing money, and less concerned about high profitability when sales are high, would they prefer to have more variable costs or more fixed costs? Why?

Answer 1

Adverse effects that might happen if a company decides to drop one of its many segments that shows net loss after subtraction of allocated fixed costs are as followed :

• While calculating net profit or loss from the segment to be dropped, fixed cost which is going to remain the same even after disposal of such segment should not be deducted as it is a sunk cost which is not relevant for decision making. Hence, the units remaining after disposal may have to bear the fixed costs thus further minimizing the profits of the enterprises as the whole.
• One of the major adverse affects of dropping a segment for the company could be decline of its market share price as dropping a segment indicates the imbalance of the company's management and incapability of the company to expand and diverse its operations.
• If the company discontinue one of its segments, it could also lead to eradication of the synergy profit that the co-operations of different segments of the company provided to the enterprises as the whole.
• Several other complications in the costing of its products w.r.t. joint costs may arise when the company decides to drop one of its segments.

When the company is more concerned about losing money and less concerned about making high profits when the sales is high should prefer more variable cost and less fixed cost because of the reason that fixed cost is irrespective of the sales quantity and thus helps in generating huge profits or losses. Whereas, on the other side, variable cost will be incurred only in sync with sales demand. If the variable cost is high, the profitability when the sale increases will remain high and vice versa. Hence, it is advisable for the company in question to keep its variable cost high and fixed cost low to remain conservative.