A loss on the full-cost statement is not a reason to drop it

The full-cost statement that says “close it”

Maplecrest Dental Group runs three clinics in Waterloo Region. Its managing partner allocates the 270,000 of head-office cost — the practice manager, billing, the shared IT system — equally, 90,000 to each clinic, and reads the result:

                        Northfield   Riverside   Westgate     Total
Revenue                   900,000     750,000    600,000   2,250,000
Variable costs            540,000     450,000    380,000   1,370,000
Contribution margin       360,000     300,000    220,000     880,000
Direct fixed costs        220,000     190,000    170,000     580,000
Segment margin            140,000     110,000     50,000     300,000
Allocated head office      90,000      90,000     90,000     270,000
Clinic result              50,000      20,000    (40,000)     30,000

Westgate “loses 40,000 a year”. The partner wants to close it. The question the exam asks is whether the company’s profit of 30,000 goes up if Westgate goes — and the full-cost statement cannot answer it, because one of its lines does not pass the relevance test.

Rebuild the segment

Apply the test to Westgate’s lines under the two alternatives, keep and drop. Its revenue (600,000) and variable costs (380,000) disappear if it closes — they differ, so its contribution margin of 220,000 is relevant: that is what the company loses. Its direct fixed costs of 170,000 — the Westgate lease, its own receptionist, its equipment service contract — are traceable to the clinic and avoidable if it closes; they differ, so they are relevant: that is what the company saves. The allocated head-office cost of 90,000 is the line that fails: the practice manager, the billing team and the IT system cost 270,000 whether Maplecrest runs three clinics or two. Closing Westgate does not save it; it reallocates it — 135,000 each to Northfield and Riverside.

The relevant measure of a segment is therefore its segment margin: contribution margin less the fixed costs that are direct (traceable and avoidable). Westgate’s is 220,000 − 170,000 = +50,000. The clinic covers every cost that exists because it exists, and contributes 50,000 towards the head-office cost that would exist anyway.

Keep, drop, difference

                          Keep        Drop      Difference (drop − keep)
Revenue                2,250,000   1,650,000       −600,000
Variable costs         1,370,000     990,000       +380,000
Contribution margin      880,000     660,000       −220,000
Direct fixed costs       580,000     410,000       +170,000
Segment margin           300,000     250,000        −50,000
Head-office cost         270,000     270,000              0
Company profit            30,000    (20,000)        −50,000

Drop Westgate and Maplecrest’s profit falls from 30,000 to −20,000. The difference column is the answer in one number: −50,000, which is exactly Westgate’s segment margin — the contribution lost (220,000) less the fixed costs avoided (170,000). The three-column layout is how the final wants the decision presented; the difference column is where the marks are.

When closing would be right

The rebuild does not say Westgate can never be closed. It says closing it to save the loss is wrong, because the loss is an allocation. Closing is right only if the freed space, staff and capital have a better use worth more than 50,000 a year — the alternative-use twist in Lesson 12.3 — or if a qualitative factor the numbers cannot hold outweighs 50,000. A recommendation that stops at the number is half an answer.