Question

McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a new policy that if a product cannot earn a margin of at least 15 percent, it will be dropped. The margin is computed as product gross profit divided by reported product cost.

Manufacturing overhead for year 1 totaled $910,000. Overhead is allocated to products based on direct labor cost. Data for year 1 show the following.

	Chairs			Desks
Sales revenue	$	1,112,100		$	2,570,400
Direct materials		603,000			990,000
Direct labor		170,000			480,000

Required:

a-1. Based on the CFO's new policy, calculate the profit margin for both chairs and desks.

	Profit Margin Chairs % Desks %

a-2. Which of the two products should be dropped, chairs or desks?

b. Regardless of your answer in requirement (a), the CFO decides at the beginning of year 2 to drop the chair product. The company cost analyst estimates that overhead without the chair line will be $840,000. The revenue and costs for desks are expected to be the same as last year. What is the estimated margin for desks in year 2?

	Estimated margin for desks - Year 2 %

Answer 1

a-1.

(i)	Sales Revenue	$ 1,112,100	$ 2,570,400
	Direct material	$ 603,000	$ 990,000
	Direct labor	$ 170,000	$ 480,000
	Overhead	$ 238,000	$ 672,000
(ii)	Total cost	$ 1,011,000	$ 2,142,000
(iii) = (i) - (ii)	Gross Profit	$          101,100	$ 428,400
(iii) / (ii)	Profit Margin	10%	20%

Manufacturing overhead allocated to chairs = $910,000 /($170,000+$480,000) × $170,000

                                                                                = $238,000

Manufacturing overhead allocated to desks = $910,000 /($170,000+$480,000) × $480,000

                                                                                = $672,000

a-2.

As the gross margin ratio of chairs is less as compared to desks, it should be dropped.

b.

DESKS

(i)	Sales Revenue	$ 2,570,400
	Direct material	$   990,000
	Direct labor	$   480,000
	Overhead	$ 8,40,000
(ii)	Total cost	$ 2,310,000
(iii) = (i) - (ii)	Gross Profit	$ 260,400
(iii) / (ii)	Profit Margin	11.27%

hope you got the answer, please comment for any clarification

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