Question

The Regal Cycle Company manufactures three types of bicycles—a dirt bike, a mountain bike, and a racing bike. Data on sales and expenses for the past quarter follow

Dirt Bikes	Mountain Bikes	Racing Bikes	Total
Sales	$90,000	$150,000	$60,000	$300,000

Variable manufacturing and selling expenses	27,000	60,000	33,000	120,000
Contribution Margin	$63,000	$ 90,000	$27,000	$180,000
Fixed expenses
Advertising – traceable	10,000	14,000	6,000	30,000

Depreciation of special equipment	6,000	9,000	8,000	23,000
Salaries of product line managers	12,000	13,000	10,000	35,000
Allocated common fixed expense	18,000	30,000	12,000	60,000
Total fixed expenses	$46,000	$66,000	$36,000	$148,000
Net operating income (loss)	$17,000	$24,000	$ (9,000)	$ 32,000

Management is concerned about the continued losses shown by the racing bikes and wants a recommendation as to whether or not the line should be discontinued. The special equipment used to produce racing bikes has no resale value and does not wear out. Should production and sale of the racing bikes be discontinued? Explain. Show computations to support your answer.

Answer 1

Answer:

1. No, production and sale of the racing bikes should not be discontinued. If the racing bikes were discontinued, then the net operating income for the company as a whole would decrease by $11,000 each quarter:

Lost contribution margin		$(27,000)
Fixed costs that can be avoided:
Advertising, traceable	$ 6,000
Salary of the product line manager	10,000	16,000
Decrease in net operating income for the company as a whole		$(11,000)

  The depreciation of the special equipment is a sunk cost and is not relevant to the decision. The common costs are allocated and will continue regardless of whether or not the racing bikes are discontinued; thus, they are not relevant to the decision.

  Alternative Solution:

	Current Total	Total If Racing Bikes Are Dropped	Difference: Net Operating Income Increase or (Decrease)
Sales	$300,000	$240,000	$(60,000)
Variable expenses	120,000	87,000	33,000
Contribution margin	180,000	153,000	(27,000)
Fixed expenses:
Advertising, traceable	30,000	24,000	6,000
Depreciation on special equipment*	23,000	23,000	0
Salaries of product managers	35,000	25,000	10,000
Common allocated costs	60,000	60,000	0
Total fixed expenses	148,000	132,000	16,000
Net operating income	$ 32,000	$ 21,000	$ (11,000)

  *Includes pro-rated loss on the special equipment if it is disposed of.

2. The segmented report can be improved by eliminating the allocation of the common fixed expenses. Following the format introduced in Chapter 12 for a segmented income statement, a better report would be:

	Total	Dirt Bikes	Mountain Bikes	Racing Bikes
Sales	$300,000	$90,000	$150,000	$60,000
Variable manufacturing and selling expenses	120,000	27,000	60,000	33,000
Contribution margin	180,000	63,000	90,000	27,000
Traceable fixed expenses:
Advertising	30,000	10,000	14,000	6,000
Depreciation of special equipment..	23,000	6,000	9,000	8,000
Salaries of the product line managers	35,000	12,000	13,000	10,000
Total traceable fixed expenses	88,000	28,000	36,000	24,000
Product line segment margin	92,000	$35,000	$ 54,000	$ 3,000
Common fixed expenses	60,000
Net operating income	$ 32,000