10.6 Decision Making - Keep or Drop Flashcards
When a company decides to divest a segment, the underlying reason for this decision could be any one of the following except
A. The segment is a chronic loser and the company is unwilling to commit the resources to make it profitable.
B. Another company is willing to pay a higher price for the segment than its present value to the current owner.
C. As a result of a change in the company’s long-range strategy, what was once a good fit is no longer a good fit.
D. The realization of economies of scale where average cost declines as volume increases.
D. The realization of economies of scale where average cost declines as volume increases.
Reasons for divestitures include governmental antitrust litigation, refocusing of a firm’s operations, and raising capital for the core business operation. The realization of economies of scale where average cost declines as volume increases is not a reason for a company to decide to divest a segment.
A company sells two products that are manufactured in the same production department on two different machines. The contribution margin per unit of the two products is $120 and $80, respectively. When deciding if the second product should be discontinued, which one of the following pieces of information is needed to make the correct decision?
A. Alternative use of the second product’s space.
B. Depreciation expense of the second product’s machinery.
C. Commissions paid on the second product’s sales.
D. Production department manager’s salary.
A. Alternative use of the second product’s space.
If the second product is discontinued, the current space devoted to its production may be converted into a space for a new product to generate additional profit. However, if no alternative use exists for the space, it may be more beneficial to continue producing the second product. Thus, the alternative use of the second product’s space needs to be known in order to make the correct decision.
Superior Tables is a table manufacturer. The company is considering eliminating the Easy Living product line because of losses over the past year. Results for the year just ended for the Easy Living product line are as follows.
Sales (20,000 units): $ 6,000,000
Variable manufacturing costs: 2,700,000
Fixed manufacturing costs: 2,400,000
Administrative costs: 2,000,000
Operating loss: $(1,100,000)
None of the fixed manufacturing costs can be eliminated, but 25% of the administrative costs are variable and can be eliminated if the product line is eliminated. Based on the information above, should the Easy Living product line be eliminated?
A. Yes, because eliminating the product line would increase the operating income by $1,100,000.
B. No, because eliminating the product line would increase the operating loss by $(2,800,000)
C. No, because eliminating the product line would only save $500,000 of administrative costs still resulting in an overall loss.
D. Yes, because eliminating the product line would increase the operating income by $1,500,000 from the saved administrative costs.
B. No, because eliminating the product line would increase the operating loss by $(2,800,000).
If the Easy Living product line is eliminated, the following items will be eliminated:
* Revenues = $6,000,000
* Variable manufacturing costs = $2,700,000
* Partial administrative costs = $500,000
Only the following components will remain:
* Fixed manufacturing costs = $2,400,000
* Administrative costs = $1,500,000
The result is a net loss of $(3,900,000), which is a $(2,800,000) greater loss than the current net loss of $(1,100,000). Thus, eliminating the Easy Living product line is unfavorable because it results in a higher net loss than continuing to operate the line.
A tennis equipment company produces two lines of tennis shoes, Professional and Amateur. Income statement data for the tennis shoes is shown below:
Professional / Amateur = Total
Total Sales $550,000 / $750,000 = $1,300,000
Variable costs 275,000 / 400,000 = 675,000
Direct fixed costs 100,000 / 300,000 = 400,000
Allocated fixed costs 37,500 / 112,500 = 150,000
Operating income $137,500 / $ (62,500) = $75,000
Since the Amateur line shows a loss, the company is considering eliminating this line of tennis shoes. Based on the data provided, should the company drop the Amateur tennis shoe line?
A. Yes, operating income will increase by $25,000
B. No, operating income will decrease by $350,000
C. No, operating income will decrease by $50,000
D. Yes, operating income will increase by $62,500
C. No, operating income will decrease by $50,000
Since the allocated fixed costs are still going to be incurred if the Amateur line is discontinued, $112,500 allocated fixed costs should be ignored. There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin - Amateur $(350,000)
Fixed cost savings 300,000
Increase (decrease) in operating income $(50,000)
Approach 2: New Income Statement
Sales $550,000
Variable costs 275,000
Contribution margin = 275,000
Fixed costs 250,000*
Operating income = $25,000
*Professional direct $100,000 + Total allocated 150,000
The change in operating income is a decrease of $50,000 ($75,000 - $25,000).
A company recently reviewed the profitability of each of its segments. The company’s Western Unit projected a loss for the coming period and was shut down. In which one of the following situations would the total company profits decrease after shutting down the Western Unit?
A. Western Unit’s projected loss was less than the allocated home office cost.
B. Western Unit’s projected fixed costs were eliminated.
C. Western Unit’s inventory was transferred to other divisions.
D. Western Unit’s projected contribution margin was negative.
A. Western Unit’s projected loss was less than the allocated home office cost.
This situation would cause total company profits to decrease after shutting down the Western Unit. Western Unit would not have a loss if it was not allocated a portion of the home office cost. After shutting down the Western Unit, this cost will continue to be incurred and allocated to other units.
A company manufactures three products, T1, T2, and T3. Their financial information is shown below.
Sales
T1: $60,000
T2: $90,000
T3: $24,000
Variable costs
T1: 36,000
T2: 48,000
T3: 15,000
Contribution margin
T1: 24,000
T2: 42,000
T3: 9,000
Fixed costs:
Avoidable
T1: T9,000
T2: 18,000
T3: 6,000
Unavoidable
T1: 6,000
T2: 9,000
T3: 5,400
Operating income
T1: $ 9,000
T2: $15,000
T3: $ (2,400)
Management is concerned about the financial performance of T3. If the company drops the T3 product line, the operating income will
A. Decrease by $9,000.
B. Increase by $3,000.
C. Decrease by $3,000.
D. Increase by $2,400.
C. Decrease by $3,000.
If the T3 product line is eliminated, all associated revenues and costs will also be eliminated, with the exception of unavoidable fixed costs. There are two approaches to solving this question, and candidates could use either. Given an existing operating loss of $2,400, the only relevant factor is the $5,400 of unavoidable costs.
Approach 1: Incremental Method
Lost contribution margin – T3 $(9,000)
Fixed cost savings 6,000
Increase (decrease) in operating income $(3,000)
Approach 2: New Income Statement
Sales
T1: $60,000
T2: $90,000
Total: $150,000
Variable costs
T1: 36,000
T2: 48,000
Total: 84,000
Contribution margin
T1: $24,000
T2: $42,000
Total: $66,000
Total Fixed costs: 47,400*
Operating income: $18,600
*T1 $15,000 + T2 $27,000 + T3 unavoidable $5,400
Original total operating income was $21,600 ($9,000 + $15,000 – $2,400). The change in operating income is a decrease of $3,000 ($21,600 – $18,600).
A camera manufacturing company is considering eliminating Model XP5 from its camera line because of losses over the past quarter. The past quarter’s financial information for Model XP5 is shown below.
Sales (1,000 units): $600,000
Manufacturing costs:
Direct materials: 300,000
Direct labor ($15 per hour): 120,000
Overhead: 200,000
Operating loss: $ (20,000)
Overhead costs are 70% variable and the remaining 30% is depreciation of special equipment for Model XP5 that has no resale value. If Model XP5 is dropped from the product line, operating income will
A. Increase by $60,000.
B. Decrease by $20,000.
C. Decrease by $40,000.
D. Increase by $20,000.
C. Decrease by $40,000.
There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Module XP5* $(40,000)
Fixed cost savings 0
Increase (decrease) in operating income $(40,000)
*$600,000 sales – $300,000 direct materials – $120,000 direct labor – $140,000 variable overhead ($200,000 × 70%)
Approach 2: New Income Statement
Sales $ 0
Variable costs 0
Contribution margin $ 0
Fixed costs* 60,000
Operating loss $(60,000)
*30% of overhead costs of $200,000
The change in operating income is a decrease of $40,000 ($20,000 loss decreases to $60,000 loss).
A company has two business units (Division 1 and Division 2) that are currently operating as profit centers. Management is evaluating the possibility of discontinuing Division 2 because of the operating losses it has experienced over the last few years. Select information from the operating budget for the upcoming fiscal year is shown below.
Division 1 / Division 2
Sales $800,000 / $400,000
Cost of goods sold 300,000 / 250,000
Gross margin $500,000 / $150,000
Variable selling and administrative expenses 100,000 / 80,000
Fixed selling and administrative expenses 75,000 / 75,000
Operating income (loss) $325,000 / $ (5,000)
Fixed selling and administrative expenses are allocated equally between the two units. If Division 2 is discontinued, fixed selling and administrative expenses are expected to decrease by 20% from the current level, and Division 1’s sales are expected to increase by 15%. Based on the budget information above, should the company discontinue Division 2, and why?
A. Yes, because operating income will increase by $80,000.
B. No, because operating income will decrease by $40,000.
C. Yes, because operating income will increase by $20,000.
D. No, because operating income will decrease by $10,000.
C. Yes, because operating income will increase by $20,000.
There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Division 2 $(70,000)
–> ($400,000 – $250,000 – $80,000)
Gained contribution margin – Division 1 60,000
–> ($800,000 – $300,000 – $100,000) × 15%
Fixed cost savings 30,000
–> Current fixed cost total $150,000 × 20% = $30,000
Increase (decrease) in operating income $ 20,000
Approach 2: New Income Statement
After Division 2 is discontinued, the fixed selling and administrative expenses of Division 2 will be reduced to $60,000 [$75,000 × (1 – 20%)]. The gross margin of Division 1 will increase to $575,000 [$500,000 × (1 + 15%)]. The total operating income will be $340,000.
Division 1 / Division 2
Sales $920,000 / $0
Cost of goods sold
345,000
0
Gross margin
$575,000
$0
Variable selling and administrative expenses
115,000
Fixed selling and administrative expenses
60,000
60,000
Operating income (loss)
$400,000
$(60,000)
Therefore, total operating income will increase by $20,000 ($340,000 – $320,000).
A firm is at a critical decision point and must decide whether to go out of business or continue to operate for 5 more years. The firm has a labor contract with 5 years remaining that calls for $1.5 million in severance pay if the firm’s plant shuts down. The firm also has a contract to supply 150,000 units per year, at a price of $100 each, to the firm’s only remaining customer for the next 5 years. The firm must pay the customer $500,000 immediately if it defaults on the contract. The plant has a net book value of $600,000, and appraisers estimate the facility would sell for $750,000 today but would have no market value if operated for another 5 years. The firm’s fixed costs are $4 million per year, and variable costs are $75 per unit. The firm’s appropriate discount rate is 12%. Ignoring taxes, the optimal decision is to
A. Shut down because the annual cash flow is negative $250,000 per year.
B. Shut down since the breakeven point is 160,000 units, while annual sales are 150,000 units.
C. Keep operating since the incremental net present value is approximately $350,000.
D. Keep operating to avoid the severance pay of $1,500,000.
C. Keep operating since the incremental net present value is approximately $350,000.
If the firm makes the decision to cease operations, the firm will incur an immediate cash outflow calculated as follows:
Shutdown:
Severance pay $(1,500,000)
Contract breach penalty (500,000)
Plant disposal 750,000
Net cash flow $(1,250,000)
If the decision is made to keep operating, the annual cash inflows from product sales will be $3,750,000 [150,000 units × ($100 – $75)]. These inflows are netted against the annual outflows for fixed costs, and the result is discounted as an ordinary annuity at 12% for 5 years as follows:
Continue:
Contract profit $ 3,750,000
Fixed costs (4,000,000)
Annual cash flows $ (250,000)
Times: PV factor 3.605
Present value $ (901,250)
The firm will thus incur a smaller net loss by continuing operations [$1,250,000 – $901,250 = $348,750].
** Breakeven analysis is not the appropriate tool in a shutdown decision.
Condensed monthly operating income data for Korbin, Inc., for May follows:
Urban Store / Suburban Store / Total
Sales: $80,000 / $120,000 / $200,000
Variable Costs: 32,000 / 84,000 / 116,000
Contribution margin: 48,000 / 36,000 / 84,000
Direct fixed costs: 20,000 / 40,000 / 60,000
Store segment margin 28,000 / (4,000) / 24,000
Common fixed cost 4,000 / 6,000 / 10,000
Operating income 24,000 / (10,000) / 14,000
Additional information regarding Korbin’s operations follows:
* One-fourth of each store’s direct fixed costs would continue if either store is closed.
* Korbin allocates common fixed costs to each store on the basis of sales dollars.
* Management estimates that closing the Suburban Store would result in a 10% decrease in the Urban Store’s sales, while closing the Urban Store would not affect the Suburban Store’s sales.
* The operating results for May are representative of all months.
One-half of the Suburban Store’s dollar sales are from items sold at variable cost to attract customers to the store. Korbin is considering the deletion of these items, a move that would reduce the Suburban Store’s direct fixed expenses by 15% and result in a 20% loss of Suburban Store’s remaining sales volume. This change would not affect the Urban Store. A decision by Korbin to eliminate the items sold at cost would result in a monthly increase (decrease) in Korbin’s operating income of
A. $(7,200)
B. $(5,200)
C. $(1,200)
D. $2,000
C. $(1,200)
There are two approaches to solving this question, and candidates could use either.
Approach 2: Incremental Method
Lost contribution margin - Suburban*
($36,000 x 20%) $(7,200)
Fixed cost savings
($40,000 direct fixed costs x 15%) 6,000
Increase (decrease) in operating income $(1,200)
*Suburban’s contribution margin must derive wholly from sales of other items. Eliminating sales at variable costs reduces other sales by 20%.
Approach 2: New Income Statement
Urban Store / Suburban Store / Total
Sales: $80,000 / $148,000* / $128,000
Variable Costs: 32,000 / 19,200** / 51,200
Contribution margin: 48,000 / 28,800 / 76,800
Direct fixed costs: 20,000 / 34,000 *** / 54,000
Store segment margin 28,000 / (5,200) / 22,800
Common fixed cost - / - / 10,000
Operating income - / - / 12,800
- 50% sales at variable cost x $120,000 = $60,000
20% of remaining sales = $12,000 ($60,000 x 20%)
New sales = $120,000 - $60,000 - $12,000
** (84,000 - 60,000) x 80%
*** 40,000 x 85%
Operating income decrease $1,200 ($14,000 - $12,800).
A company operates numerous vending machines in a variety of locations. The company is expanding, needs more machines, and is deciding whether to move machines from unprofitable segments to meet this need. Abbreviated income statements of the two possible unprofitable segments are shown below. The other segments, not shown, are profitable with income over $200,000.
Non-Chain Motels / Local Parks
Sales $250,000 / $100,000
Cost of goods sold 130,000 / 50,000
Travel to service/refill machines 125,000 / 45,000
Allocated corporate costs 70,000 / 30,000
Income (loss) (75,000) / (25,000)
Which segment(s) should be discontinued?
A. Both non-chain motels and local parks.
B. Neither non-chain motels nor local parks.
C. Non-chain motels only.
D. Local parks only.
C. Non-chain motels only.
Only relevant costs should be considered in making this decision. Since the allocated corporate costs are still going to be incurred if the segment is discontinued, these costs should be ignored. Therefore, the income (loss) for each segment is calculated as follows:
Non-Chain Motels / Local Parks
Sales $ 250,000 / $100,000
Cost of goods sold (130,000) / (50,000)
Travel to service/refill machines (125,000) / (45,000)
Income (loss) $ (5,000) / $ 5,000
Since $5,000 will be saved if non-chain motels are discontinued, they should be discontinued. However, discontinuing local parks will negate $5,000 of profit, so they should continue.
Condensed monthly operating income data for Korbin, Inc., for May follows:
Urban Store / Suburban Store / Total Sales $80,000 / $120,000 / $200,000 Variable costs 32,000 / 84,000 / 116,000 Contribution margin $48,000 / $ 36,000 / $ 84,000 Direct fixed costs 20,000 / 40,000 / 60,000 Store segment margin $28,000 / $ (4,000) / $ 24,000 Common fixed cost 4,000 / 6,000 / 10,000 Operating income $24,000 / $ (10,000) / $ 14,000
Additional information regarding Korbin’s operations follows:
* One-fourth of each store’s direct fixed costs would continue if either store is closed.
* Korbin allocates common fixed costs to each store on the basis of sales dollars.
* Management estimates that closing the Suburban Store would result in a 10% decrease in the Urban Store’s sales, while closing the Urban Store would not affect the Suburban Store’s sales.
* The operating results for May are representative of all months.
A decision by Korbin to close the Suburban Store would result in a monthly increase (decrease) in Korbin’s operating income of
A. $(10,800)
B. $(6,000)
C. $4,000
D. $(1,200)
A. $(10,800)
There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Suburban $(36,000)
Lost contribution margin – Urban
($48,000 × 10%) (4,800)
Fixed cost savings
($40,000 direct fixed costs × 75%) 30,000
Increase (decrease) in operating income $(10,800)
Approach 2: New Income Statement
Sales ($80,000 × 90%) $72,000
Variable costs ($32,000 × 90%) 28,800
Contribution margin $43,200
Direct fixed costs* 30,000
Common fixed cost 10,000
Operating income $ 3,200
*$20,000 Urban + ($40,000 Suburban × 25%)
Operating income decreases $10,800 ($14,000 – $3,200).
Current business segment operations for Whitman, a mass retailer, are presented below.
Merchandise / Automotive / Restaurant / Total
Sales
$500,000 / $400,000 / $100,000 / 1,000,000
Variable costs
$300,000 / 200,000 / 70,000 / 570,000
Fixed costs
100,000 / 100,000 / 50,000 / 250,000
Operating income (loss)
$100,000 / $100,000 / $(20,000) / $ 180,000
Management is contemplating the discontinuance of the Restaurant segment since “it is losing money.” If this segment is discontinued, $30,000 of its fixed costs will be eliminated. In addition, Merchandise and Automotive sales will decrease 5% from their current levels.
What will Whitman’s total contribution margin be if the Restaurant segment is discontinued?
A. $220,000
B. $380,000
C. $160,000
D. $367,650
B. $380,000
There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Restaurant $(30,000)
Lost contribution margin – Merchandise1 (10,000)
Lost contribution margin – Automotive2 (10,000)
Increase (decrease) in contribution margin $(50,000)
1($500,000 – $300,000) × 5%
2($400,000 – $200,000) × 5%
Current contribution margin is $430,000 ($1,000,000 – $570,000). Total contribution margin after discontinuance is $380,000 ($430,000 – $50,000).
Approach 2: New Income Statement
Merchandise / Automotive / Total
Sales $475,0001 / $380,0002 / $855,000
Variable costs 285,0003 / 190,0004 / 475,000
Contribution margin $190,000 / $190,000 / $380,000
1$500,000 × 95%
2$400,000 × 95%
3$300,000 × 95%
4$200,000 × 95%
A furniture manufacturer currently has three divisions: Maple, Oak, and Cherry. The oak furniture line does not seem to be doing well, and the president of the manufacturer is considering dropping this line. If it is dropped, the revenues associated with the Oak Division will be lost and the related variable costs saved. Also, 50% of the fixed costs allocated to the oak furniture line would be eliminated. The income statements, by divisions, are as follows:
Maple / Oak / Cherry Sales $55,000 / $85,000 / $100,000 Variable costs 40,000 / 72,000 / 82,000 Contribution margin $15,000 / $13,000 / $ 18,000 Fixed costs 10,000 / 14,000 / 10,200 Operating profit (loss) $5,000 / $ (1,000) / $7,800
Which one of the following options should be recommended to the president of the manufacturer?
A. Discontinue the Oak Division which would result in a $1,000 increase in operating profits.
B. Discontinue the Oak Division which would result in a $7,000 increase in operating profits.
C. Continue operating the Oak Division as discontinuance would result in a total operating loss of $1,200.
D. Continue operating the Oak Division as discontinuance would result in a $6,000 decline in operating profits.
D. Continue operating the Oak Division as discontinuance would result in a $6,000 decline in operating profits.
There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Oak $(13,000)
Fixed cost savings ($14,000 × 50%) 7,000
Increase (decrease) in operating income $ (6,000)
Approach 2: New Income Statement
Maple / Cherry / Total
Sales $55,000 / $100,000 / $155,000
Variable costs 40,000 / 82,000 / 122,000
Contribution margin $15,000 / $ 18,000 / $ 33,000
Fixed costs 27,200*
Operating income $ 5,800
*Maple $10,000 + Oak’s remaining $7,000 + Cherry $10,200
The change in operating income is a decrease of $6,000 ($11,800 – $5,800).
A corporation manages five apartment complexes in a three-state area. Summary income statements for each apartment complex are shown as follows:
Summary Income Statements (in thousands)
Complex One
Rental Income: $1,000
Expenses: 800
Profit: 200
Complex Two
Rental Income: $1,210
Expenses: 1,300
Profit: (90)
Complex Three
Rental Income: $2,347
Expenses: 2,600
Profit: (253)
Complex Four
Rental Income: $1,878
Expenses: 2,400
Profit: (522)
Complex Five
Rental Income: $1,065
Expenses: 1,300
Profit: (235)
Included in the expenses is $1,200,000 of corporate overhead allocated to the apartment complexes based on rental income. The apartment complex(es) that the corporation should consider selling is (are)
A. Apartment complex Four.
B. Apartment complexes Three, Four, and Five.
C. Apartment complexes Four and Five.
D. Apartment complexes Two, Three, Four, and Five.
C. Apartment complexes Four and Five.
The amount of corporate overhead allocated to each complex is calculated below.
Complex One
Income: $1,000
Percentage: 13.33%
Allocation: $160
Complex Two
Income: $1,210
Percentage: 16.13%
Allocation: $194
Complex Three
Income: $2,347
Percentage: 31.29%
Allocation: $375
Complex Four
Income: $1,878
Percentage: 25.04%
Allocation: $300
Complex Five
Income: $1,065
Percentage: 14.21%
Allocation: $171
Total
Income: $7,500
Percentage: 100.00%
Allocation: $1,200
The revised profits would be as follows:
Complex One
Original $200
Allocation $160
Adjusted $360
Complex Two
Original (90)
Allocation 194
Adjusted 104
Complex Three
Original (253)
Allocation 375
Adjusted 122
Complex Four
Original (522)
Allocation 300
Adjusted (222)
Complex Five
Original (235)
Allocation 171
Adjusted (64)
The following information is available on Crain Co.’s two product lines:
Chairs / Tables
Sales $180,000 / $ 48,000
Variable costs (96,000) / (30,000)
Contribution margin $ 84,000 / $ 18,000
Fixed costs:
Avoidable (36,000) / (12,000)
Unavoidable (18,000) / (10,800)
Operating income (loss) $ 30,000 / $ (4,800)
Assuming the tables line is discontinued and the factory space previously used to make tables is rented for $24,000 per year, operating income will increase by what amount?
A. $18,000
B. $28,800
C. $24,000
D. $13,200
A. $18,000
When making a decision, the only relevant revenues and costs are those that will change depending on which choice is made. There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Table $(18,000)
Rental income gained 24,000
Fixed cost savings – Avoidable fixed costs 12,000
Increase (decrease) in operating income $ 18,000
Approach 2: New Income Statement
Total revenues1 $204,000
Variable costs 96,000
Contribution margin $108,000
Fixed costs2 64,800
Operating income $ 43,200
1$180,000 chairs sales + $24,000 rental income
2$36,000 chairs + $18,000 chairs + $10,800 tables unavoidable = $64,800
Operating income in total was $25,200 ($30,000 – $4,800). The change in operating income is an increase of $18,000 ($43,200 – $25,200).
The management accountant for a bookstore has prepared the following income statement for the most current year:
Cook Book
Sales $60,000
Cost of goods sold 36,000
Contribution margin $24,000
Order and delivery processing 18,000
Rent (per sq. ft. used) 2,000
Allocated corporate costs 7,000
Operating profit $ (3,000)
Travel Books
Sales $100,000
Cost of goods sold 65,000
Contribution margin $35,000
Order and delivery processing 21,000
Rent (per sq. ft. used) 1,000
Allocated corporate costs 7,000
Operating profit $ 6,000
Classics
Sales $40,000
Cost of goods sold 20,000
Contribution margin $20,000
Order and delivery processing 8,000
Rent (per sq. ft. used) 3,000
Allocated corporate costs 7,000
Operating profit $ 2,000
Total
Sales $200,000
Cost of goods sold 121,000
Contribution margin $79,000
Order and delivery processing 47,000
Rent (per sq. ft. used) 6,000
Allocated corporate costs 21,000
Operating profit $ 5,000
If the company drops Cook Book, the square footage used will return to the landlord. Dropping Cook Book will cause the company’s operating profit to be
A. $7,000 higher.
B. $4,000 lower.
C. $4,000 higher.
D. $6,000 lower.
B. $4,000 lower.
There are two approaches to solving this question, and candidates could use either.
Approach 1: Incremental Method
Lost contribution margin – Cook $(24,000)
Fixed cost savings – Processing and Rent 20,000
Increase (decrease) in operating income $ (4,000)
Approach 2: New Income Statement
Travel Books / Classics / Total
Sales $100,000 / $40,000 / $140,000
Cost of goods sold 65,000 / 20,000 / 85,000
Contribution margin $ 35,000 / $20,000 / $ 55,000
Order and delivery processing 21,000 / 8,000 / 29,000
Rent 1,000 / 3,000 / 4,000
Allocated corporate costs 21,000
Operating profit $ 1,000
The change in operating income is a decrease of $4,000 ($5,000 – $1,000).
