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 dollars.

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?

	Yes
	No

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?

	Yes
	No

Answer 1

Solution 1:
Incremental effect on Profit if POP is Eliminated
Particulars	Continue POP product	Discontinue POP Product	Effect on Profits of Discontinuing
Revenues	$38,000	$0	-$38,000
Variable expenses	$34,000	$0	-$34,000
Contribution Margin	$4,000	$0	-$4,000
Fixed Expenses:
Direct fixed cost	$3,600	$0	-$3,600
Common Fixed cost	$1,900	$1,900	$0
Net Income	-$1,500	-$1,900	-$400

Solution 2:

No, MSI should not drop POP Product.

Solution 3-a:
Incremental effect on Profit if POP is Eliminated
Particulars	Continue POP product	Discontinue POP Product	Effect on Profits of Discontinuing
Revenues	$38,000	$0	-$38,000
Variable expenses	$34,000	$0	-$34,000
Contribution Margin	$4,000	$0	-$4,000
Fixed Expenses:
Direct fixed cost	$3,600	$0	-$3,600
Common Fixed cost	$1,900	$700	-$1,200
Net Income	-$1,500	-$700	$800

Solution 3-b:

Yes, MSI should drop POP Product.