Question

Morning Sky, Inc. (MSI), manufactures and sells computer games. The company has several product lines based on the age range of the target market. MSI sells both individual games as well as packaged sets. All games are in CD format, and some utilize accessories such as steering wheels, electronic tablets, and hand controls. To date, MSI has developed and manufactured all the CDs itself as well as the accessories and packaging for all of its products.

The gaming market has traditionally been targeted at teenagers and young adults; however, the increasing affordability of computers and the incorporation of computer activities into junior high and elementary school curriculums has led to a significant increase in sales to younger children. MSI has always included games for younger children but now wants to expand its business to capitalize on changes in the industry. The company currently has excess capacity and is investigating several possible ways to improve profitability.

MSI is considering eliminating a product from its ToddleTown Tours collection. This collection is aimed at children one to three years of age and includes “tours” of a hypothetical town. Two products, The Pet Store Parade and The Grocery Getaway, have impressive sales. However, sales for the third CD in the collection, The Post Office Polka, have lagged the others. Several other CDs are planned for this collection, but none is ready for production.

MSI’s information related to the ToddleTown Tours collection follows:

Segmented Income Statement for MSI’s
ToddleTown Tours Product Lines
	Pet Store Parade			Grocery Getaway			Post Office Polka				Total
Sales revenue	$	145,000		$	140,000		$	38,000			$	323,000
Variable costs		61,000			57,000			34,000				152,000
Contribution margin	$	84,000		$	83,000		$	4,000			$	171,000
Less: Direct Fixed costs		8,600			8,800			3,600				21,000
Segment margin	$	75,400		$	74,200		$	400			$	150,000
Less: Common fixed costs*		7,250			7,000			1,900				16,150
Net operating income (loss)	$	68,150		$	67,200		$	(1,500	)		$	133,850

*Allocated based on total sales revenue.

MSI has determined that elimination of the Post Office Polka (POP) program would not impact sales of the other two items. The remaining fixed overhead currently allocated to the POP product would be redistributed to the remaining two products.

Required:
1. Calculate the incremental effect on profit if the POP product is eliminated.

2. Should MSI drop the POP product?

3-a. Calculate the incremental effect on profit if the POP product is eliminated. Suppose that $1,200 of the common fixed costs could be avoided if the POP product line were eliminated.

3-b. Should MSI drop the POP product?

MSI’s educational products are currently sold without any supplemental materials. The company is considering the inclusion of instructional materials such as an overhead slide presentation, potential test questions, and classroom bulletin board materials for teachers. A summary of the expected costs and revenues for MSI’s two options follows:

	CD Only				CD with Instructional Materials
Estimated demand			39,000	units			39,000	units
Estimated sales price		$	35.00			$	50.00
Estimated cost per unit
Direct materials		$	6.75			$	9.25
Direct labor			9.00				13.00
Variable manufacturing overhead			9.00				12.25
Fixed manufacturing overhead			9.50				9.50
Unit manufacturing cost		$	34.25			$	44.00
Additional development cost						$	105,000

Required:
1. Based on the given data, compute the increase or decrease in profit that would result if instructional materials were added to the CDs.

2. Should MSI add the instructional materials or sell the CDs without them?

3-a. Suppose that the higher price of the CDs with instructional materials is expected to reduce demand to 21,000 units. Complete the table given below based on Requirement 1 and 2 data.

3-b. Should MSI add the instructional materials or sell the CDs without them?

Answer 1

1)
Incremental Effect of Eliminating the Post Office Polka:
Decrease in Sales Revenue	-38,000
Decrease in Variable Costs	34,000
Direct (Avoidable) Fixed Costs	3,600
Effect on Profit ((Decreased Profit)	$   (400.00)
2)
MSI should not eliminate the product line because it would lose $38,000 in revenue and only save $37,600 in costs, resulting in a $400 reduction in profit.
3)
Incremental Effect of Eliminating the Post Office Polka:
Decrease in Sales Revenue	-38,000
Decrease in Variable Costs	34,000
Direct (Avoidable) Fixed Costs (3600+1200)	4,800
Effect on Profit (increased Profit )	$     800.00
If MSI could avoid $1200 of common fixed costs, it would save $800 by eliminating the Post Office line.
MSI should eliminate the product because the decrease in revenue is more than offset by the decrease in cost.