Question

Huang Inc. has one product line that is unprofitable. What circumstances may cause overall company net income to be lower if the unprofitable product line is dropped?

Answer 1

There are several reasons that companies choose to keep unprofitable product lines going. Although it is possible that the company is just hanging in there with a product, much of the time it has to do with marketing strategy; the company is using the product line as part of its overall strategy to retain a certain type of customer or to bring in new customers. It is possible that the product line itself is unprofitable per unit, but the product is part of a marketing strategy meant to attract consumers to related products.

Product Life Cycle

One factor in the decision to keep a product line going during unprofitable periods is the product life cycle, during which a product’s share of the marketplace builds, peaks and levels out. The consumer response leads to changes in the ways in which the product is marketed. Marketing strategists are aware of the potential roller coaster ride that the product line may take over time, and work to create ways to re-energize sales.

Pricing Strategies

Product lines that have been around for many years often come in and out of popularity, and companies may be riding out the dip in sales waiting for the return of trends that favor the product line. Most consumers have seen luxury products that peak in popularity at high-end retailers, seem to disappear and reappear in discount chains. Those products have outlived their high price point strategy and the product line reached the stage in which it is more profitable at a lower price point, but the middle stage of the cycle found the product line unprofitable.

Brand Loyalty

Brand loyalty is another reason companies keep unprofitable product lines. A similar situation to maturing in the product life cycle occurs when a company introduces new variations on a product. They may keep the old product around as part of a brand loyalty strategy to retain old customers while trying to get them to try new product variations. New customers recognize the brand name even if they have not used the product before and the company uses that awareness to generate sales on newer versions of products that older customers might avoid.

Loss Leaders

A shorter term but very common marketing strategy used by businesses of all sizes that trade profits on one product for another is the loss leader. A loss leader is a sales item that is sold at or below the profit margin in order to entice customers to come into the store for the sale item in hopes that they will buy other, more profitably priced items. Small businesses may not offer the large product ranges of large corporations, but they are subject to the same product life cycle phenomena in their product lines and can use price points similarly to their advantage.

Companies tend to divide their organization along product lines, geographic locations, or other management needs for decision-making and reporting. A segment is a portion of the business that management believes has sufficient similarities in product lines, geographic locations, or customers to warrant reporting that portion of the company as a distinct part of the entire company.

Fundamentals of the Decision to Keep or Discontinue a Segment or Product

Two basic approaches can be used to analyze data in this type of decision. One approach is to compare contribution margins and fixed costs. In this method, the contribution margins with and without the segment (or division or product line) are determined. The two contribution margins are compared and the alternative with the greatest contribution margin would be the chosen alternative because it provides the biggest contribution toward meeting fixed costs.

The second approach involves calculating the total net income for retaining the segment and comparing it to the total net income for dropping the segment. The company would then proceed with the alternative that has the highest net income. In order to perform these net income calculations, the company would need more information than they would need in order to follow the contribution margin approach, which does not consider the costs and revenues that are the same between the alternatives.

Managers use differential analysis to determine whether to keep or drop a customer. The format is similar to the differential analysis format used for making product line decisions. However, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines.