Question

Adm2341 Co. manufactures and sells two products (A and B). Projected data for next year are: Product A Product B Sales in units 15,000 10,000 Sale price per unit $100 $160 Variable costs manufacturing 50% of sales 60% of sales Sales commissions 20% of sales 20 % of sales Advertising $100,000 $120,000 Other fixed costs (note 1) $240,000 $240,000 Note 1: Each amount of "Other fixed costs" includes $100,000 fixed general overhead allocated by the Headquarter of Adm2341 Co. to each product. The remaining costs are traceable fixed costs to each product. Adm2341 Co. anticipates no change in the operating result for Product B in the foreseeable future if the product is manufactured. However, Adm2341 Co. is re-examining all of its products and is trying to decide whether or not to discontinue Product B. REQUIRED: 1. Prepare an income statement in Contribution margin format showing the segment margin for each product and operating income for Adm2341 Co. as a whole. 2. Assume that discontinuing the production and sale of Product B will not affect the sale of Product A. If the company drops Product B, what will be the change in annual operating income due to this decision? Would you recommend dropping or not product B? Why? 3. Assume that discontinuing Product B result in an increase of $200,000 in sales of Product A. There will be no increase in advertising expenses. The variable cost structure stays unchanged. If Adm2341 Co. drops Product B, what will be the impact in operating income next year due to this decision? Would you recommend dropping or not product B? Why? 4. Top management of Adm2341 Co. decided not to drop Product B. Assume that the maximum production capacity of Adm2341 Co. is limited to 18,000 Hours and the production of one unit of Product A requires 0.50 hours and one unit of Product B requires 1.25 Hours. The market demand is 15,000 units for Product A and 10,000 units for Product B. a) Is here enough capacity to meet the market demand for each product? b) Compute the contribution margin per hour for each product? c) What is the optimal solution do you suggest for Product A and Product B d) Present the income statement according to your optimal solution.

Answer 1

1. Segment margin for each product

	Product A	Product B
Sales	$ 1500000	$ 1600000
Variable costs manufacturing	($ 750000)	($ 960000)
Sales commission	($ 300000)	($ 320000)
Advertising	($ 100000)	($ 120000)
Other fixed costs	($ 240000)	($ 240000)
Contribution margin	$ 110000	($ 40000)

Operating income as a whole $ 70000.

2. If product B is discontinued the general allocated fixed costs for B would still be incurred by the company as a whole. The net operating income from A which is $ 110000 will be reduced by $ 100000 (general allocated fixed overhead) and leave an income of $ 10000 for Adm2341 co. Thus, there is a reduction in overall income.

In my opinion product B should not be dropped.

3. If there is an increase of $200000 in sales of A by discontinuing B, we should calculate the increased contribution margin. Advertising and other fixed costs remain same. The general allocated fixed cost of B should also be reduced from the overall income since it is not product based but general.

Increased sales	$ 200000
Variable costs manufacturing	($100000)
Sales commission	($ 40000)
Contribution margin	$ 60000

Overall contribution margin = original margin of A + new increased margin of A - General fixed costs of B

=$(110000+60000-100000) = $70000

It is the same as net operating income with continuing B. Thus, it is indifferent. The company may or may not make B.

4. a. Total hours available = 18000 hours

	Product A	Product B
Hours required for 1 unit	0.50	1.25
Market demand	15000	10000
Total hours needed	7500	12500

Total hours needed to fulfill market demand us 20000 hours. No there is not enough capacity to fulfill market demand.

b. Contribution margin per hour for each product

	Product A	Product B
Contribution margin	$110000	($40000)
Hours needed for same	(15000 x 0.50)= 7500	(10000 x 1.25) = 12500
Contribution margin per hour	$ 14.67	($3.20)

c. Optimal solution

	Product A	Product B
Contribution margin per hour	$ 14.67	($ 3.20)
Ranking in terms of profitability	1	2

First we make A, 15000 units of A will consume (15000 x 0.50) = 7500 hours. The remaining hours (18000-7500) = 10500 hours are given to B. Units made of B = 10500/1.25 = 8400 units.

Optimal solution:

15000 units of A

8400 units of B

d. Income statement

	Product A	Product B
Sales	$1500000	$1344000
Variable costs manufacturing	($750000)	($806400)
Sales commission	($300000)	($268800)
Advertising	($100000)	($120000)
Other fixed costs	($240000)	($240000)
Contribution margin	$110000	($91200)

Net operating income = $ 18800