Question

1. Bed & Bath, a retailing company, has two departments—Hardware and Linens. The company’s most recent monthly contribution format income statement follows:

				Department
	Total			Hardware			Linens
Sales	$	4,180,000		$	3,150,000		$	1,030,000
Variable expenses		1,219,000			805,000			414,000
Contribution margin		2,961,000			2,345,000			616,000
Fixed expenses		2,220,000			1,400,000			820,000
Net operating income (loss)	$	741,000		$	945,000		$	(204,000	)

A study indicates that $376,000 of the fixed expenses being charged to Linens are sunk costs or allocated costs that will continue even if the Linens Department is dropped. In addition, the elimination of the Linens Department will result in a 19% decrease in the sales of the Hardware Department.

Required:

What is the financial advantage (disadvantage) of discontinuing the Linens Department?

2. Troy Engines, Ltd., manufactures a variety of engines for use in heavy equipment. The company has always produced all of the necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of carburetor to Troy Engines, Ltd., for a cost of $40 per unit. To evaluate this offer, Troy Engines, Ltd., has gathered the following information relating to its own cost of producing the carburetor internally:

	Per Unit				18,000 Units Per Year
Direct materials	$	18		$	324,000
Direct labor		9			162,000
Variable manufacturing overhead		2			36,000
Fixed manufacturing overhead, traceable		9	*		162,000
Fixed manufacturing overhead, allocated		12			216,000
Total cost	$	50		$	900,000

*One-third supervisory salaries; two-thirds depreciation of special equipment (no resale value).

Required:

1. Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 18,000 carburetors from the outside supplier?

2. Should the outside supplier’s offer be accepted?

3. Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $180,000 per year. Given this new assumption, what would be financial advantage (disadvantage) of buying 18,000 carburetors from the outside supplier?

4. Given the new assumption in requirement 3, should the outside supplier’s offer be accepted?

Answer 1

1
Loss in Contribution margin of Linens	-616000
Avoidable fixed costs	444000	=820000-376000
Loss in Contribution margin of Hardware Department	-445550	=2345000*19%
Net change in income	-617550
Financial (disadvantage) $(617550)

2
1
	Per unit		Total 18000 units
	Make	Buy	Make	Buy
Direct materials	18		324000
Direct labor	9		162000
Variable manufacturing overhead	2		36000
Fixed manufacturing overhead traceable	3		54000
Purchase cost		40		720000
Total			576000	720000
Difference = 576000-720000 = $(144000)
Financial (disadvantage) $(144000)
2
No, Reject the offer
3
	Make	Buy
Total cost	576000	720000
Opportunity cost	180000
Total relevant cost	756000	720000
Difference = 756000-720000 =$36000
Financial advantage $36000
4
Yes, Accept the offer