Keep-Or-Drop Analysis
The Keep-or-Drop analysis is a crucial component in strategic decision-making, particularly when contemplating whether to continue or discontinue operations in various aspects of a business. This analysis is often applied to evaluate the profitability of unprofitable products, departments, or locations. These sectors can place significant financial strain on the company, but the decision to discontinue operations should not be made lightly. It requires comprehensive consideration and analysis to avoid unintended consequences that could further destabilise the business.
Creating segmented income statements can assist in this evaluation. These statements break down the business’s earnings into different segments, each representing a particular product or location. This allows for a detailed view of each unit’s profitability. For instance, a product line income statement can be used to analyse the profitability of a specific product, while an income statement for a location can provide insights into that location’s profitability.
Furthermore, the use of a contribution margin income statement can prove useful, as it separates variable costs from fixed costs. This distinction enables the business to understand the direct impacts of each product or location on the company’s overall profitability.
The process to evaluate Keep or Drop Decision
Initiating a robust three-step process, and concurrently considering both financial and non-financial factors, is pivotal to effectively evaluate a Keep or Drop decision. This process allows the organization to make the most informed decision considering all potential impacts on their operation.
The three steps to evaluate the Keep or Drop decision are:
Assessment of Financial Implications: This involves an in-depth examination of the product’s financial performance including contribution margin, fixed costs, and potential losses.
- Review product’s contribution margin and the impact of increasing sales.
- Analyze direct and common fixed costs and their avoidability.
- Evaluate potential losses if the product is discontinued.
Analysis of Operational Impact: This includes the assessment of the capacity freed up by discontinuing the product and its potential use elsewhere.
- Analyze capacity utilization and potential for reallocation.
Evaluation of Overall Effect: This involves understanding the potential ripple effects of discontinuing a product on other segments.
- Assess potential adverse effects on sales of other products.
- Consider the overall effect on company’s profitability and brand image.
The combination of these steps ensures a holistic approach to the Keep or Drop decision, taking into account all relevant factors.
Conclusion
In conclusion, the Keep-or-Drop analysis serves as a pivotal tool for businesses in decision-making processes, especially concerning product lines or departments.
This analytical approach allows for the evaluation of financial implications and potential consequences of either maintaining or eliminating specific elements within a business model.
Ultimately, the utilization of this analysis contributes to more informed and strategic business decisions, enhancing overall operational efficiency and profitability.