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)

	Product A		Product B		Total
Sales in units		15000		10000
Selling Price per unit		100		160
Sales Revenue (A)		$ 15,00,000		$ 16,00,000	$ 31,00,000
Variable Cost
Manufacturing cost
50% of $1500000	$ 7,50,000				$   7,50,000
50% of $ 1600000			$ 8,00,000		$   8,00,000
Sales commissions
20% of $1500000	$ 3,00,000				$   3,00,000
20% of $ 1600000			$ 3,20,000		$   3,20,000
Total Variable Cost (B)		$ 10,50,000		$ 11,20,000	$ 21,70,000
Contribution (A - B) - (C)		$   4,50,000		$   4,80,000	$   9,30,000
Less: Traceable cost:
Advertisement	$ 1,00,000		$ 1,20,000		$   2,20,000
Other Fixed costs	$ 1,40,000		$ 1,40,000		$   2,80,000
Total Traceable fixed cost (D)		$   2,40,000		$   2,60,000	$   5,00,000
Segment Margin (C - D)		$   2,10,000		$   2,20,000	$   4,30,000
Less: Common Fixed Cost					$   2,00,000
(as allocated)
Operating Income for the Adm2341 Co.					$   2,30,000

Working Note:

	Product A	Product B	Total
Other Fixed Cost	$ 2,40,000	$ 2,40,000	$ 4,80,000
Less: Allocated General overhead	$ 1,00,000	$ 1,00,000	$ 2,00,000
Traceable Fixed Cost	$ 1,40,000	$ 1,40,000	$ 2,80,000

2)

	Product A		Total
Sales in units		15000
Selling Price per unit		100
Sales Revenue (A)		$ 15,00,000	$ 15,00,000
Variable Cost
Manufacturing cost
50% of $1500000	$ 7,50,000		$   7,50,000
50% of $ 1600000			$                -
Sales commissions
20% of $1500000	$ 3,00,000		$   3,00,000
20% of $ 1600000			$                -
Total Variable Cost (B)		$ 10,50,000	$ 10,50,000
Contribution (A - B) - (C)		$   4,50,000	$   4,50,000
Less: Traceable cost:
Advertisement	$ 1,00,000		$   1,00,000
Other Fixed costs	$ 1,40,000		$   1,40,000
Total Traceable fixed cost (D)		$   2,40,000	$   2,40,000
Segment Margin (C - D)		$   2,10,000	$   2,10,000
Less: Common Fixed Cost			$   2,00,000
(as allocated)
Operating Income for the Adm2341 Co.			$       10,000

Annual Operating Income for the company will decrease by $2,30,000 - $10,000 = $2,20,000

Dropping of B is not recommended as it is generating a positive segment margin of $ 2,20,000

3)

	Product A		Total
Sales in units		15000
Selling Price per unit		100
Sales Revenue (A)		$ 17,00,000	$ 17,00,000
Variable Cost
Manufacturing cost
50% of $1500000	$   8,50,000		$   8,50,000
50% of $ 1600000			$                -
Sales commissions
20% of $1500000	$   3,40,000		$   3,40,000
20% of $ 1600000			$                -
Total Variable Cost (B)		$ 11,90,000	$ 11,90,000
Contribution (A - B) - (C)		$   5,10,000	$   5,10,000
Less: Traceable cost:
Advertisement	$   1,00,000		$   1,00,000
Other Fixed costs	$   1,40,000		$   1,40,000
Total Traceable fixed cost (D)		$   2,40,000	$   2,40,000
Segment Margin (C - D)		$   2,70,000	$   2,70,000
Less: Common Fixed Cost			$   2,00,000
(as allocated)
Operating Income for the Adm2341 Co.			$       70,000

The operating income will decrease by $2,30,000 - $70,000 = $1,60,000

The increase in sale of A by $200000 will increase the Contribution by $510000 - $450000 = $60000 whereas there will be a loss of contribution by $480000 because of dropping of Product B.

4)

	Product A		Product B		Total
Sales in units		15000		10000
Selling Price per unit		100		160
Sales Revenue (A)		$ 15,00,000		$ 16,00,000	$ 31,00,000
Variable Cost
Manufacturing cost
50% of $1500000	$ 7,50,000				$   7,50,000
50% of $ 1600000			$ 8,00,000		$   8,00,000
Sales commissions
20% of $1500000	$ 3,00,000				$   3,00,000
20% of $ 1600000			$ 3,20,000		$   3,20,000
Total Variable Cost (B)		$ 10,50,000		$ 11,20,000	$ 21,70,000
Contribution (A - B) - (C)		$   4,50,000		$   4,80,000	$   9,30,000
Contribution per unit (E)		$               30		$               48
(Total Contribution / units sold)
Hours per unit (F)		0.50		1.25
Contribution per hour (E/F)		$               60		$               38
Market Demand (units) (G)		15,000		10,000
Total Hours required (F x G)		$         7,500		$       12,500	$       20,000

a ) Total available capacity is 18000 hours whereas total capacity required is 20000 hours to produce 15000 units of A and 10000 units of B. So there is not enough capacity.

b) Contribution margin per hour for Product A is $ 60 and that for product B is $ 38

c) As the contribution per hour for product A is greater than that for product B and number of hours available is the limiting factor, it is recommended to produce 15000 units of A and then product B with balance hours.

Hours required to produce 15000 units of A = 15000 x 0.50 = 7500 hours

Balance hours available = 18000 - 7500 = 10500 hours.

Number of units of B that could be produced with 10500 hours = 10500 / 1.25 = 8400 units

d)

	Product A		Product B		Total
Sales in units		15000		8400
Selling Price per unit		100		160
Sales Revenue (A)		$ 15,00,000		$ 13,44,000	$ 28,44,000
Variable Cost
Manufacturing cost
50% of $1500000	$ 7,50,000				$   7,50,000
50% of $ 1600000			$ 6,72,000		$   6,72,000
Sales commissions
20% of $1500000	$ 3,00,000				$   3,00,000
20% of $ 1600000			$ 2,68,800		$   2,68,800
Total Variable Cost (B)		$ 10,50,000		$   9,40,800	$ 19,90,800
Contribution (A - B) - (C)		$   4,50,000		$   4,03,200	$   8,53,200
Less: Traceable cost:
Advertisement	$ 1,00,000		$ 1,20,000		$   2,20,000
Other Fixed costs	$ 1,40,000		$ 1,40,000		$   2,80,000
Total Traceable fixed cost (D)		$   2,40,000		$   2,60,000	$   5,00,000
Segment Margin (C - D)		$   2,10,000		$   1,43,200	$   3,53,200
Less: Common Fixed Cost					$   2,00,000
(as allocated)
Operating Income for the Adm2341 Co.					$   1,53,200