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:

	Total			Dirt Bikes			Mountain Bikes			Racing Bikes
Sales	$	919,000		$	262,000		$	401,000		$	256,000
Variable manufacturing and selling expenses		471,000			118,000			198,000			155,000
Contribution margin		448,000			144,000			203,000			101,000
Fixed expenses:
Advertising, traceable		69,300			8,300			40,700			20,300
Depreciation of special equipment		44,100			20,900			7,900			15,300
Salaries of product-line managers		115,700			40,600			38,200			36,900
Allocated common fixed expenses*		183,800			52,400			80,200			51,200
Total fixed expenses		412,900			122,200			167,000			123,700
Net operating income (loss)	$	35,100		$	21,800		$	36,000		$	(22,700)

*Allocated on the basis of sales dollars.

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.

Required:

1. What is the financial advantage (disadvantage) per quarter of discontinuing the Racing Bikes?

2. Should the production and sale of racing bikes be discontinued?

3. Prepare a properly formatted segmented income statement that would be more useful to management in assessing the long-run profitability of the various product lines.

Totals Dirt Bikes Mountain Bikes Racing Bikes Contribution margin (loss) Traceable fixed expenses: Total traceable fixed expenses Product line segment margin (loss) Net operating income (loss)

Answer 1

Solution

Regal Cycle Company

1. Determination of the financial advantage (disadvantage) of discontinuing the Racing Bikes:

Discontinue racing bikes -
contribution lost		($101,000)
avoidable fixed cost
advertising, traceable	$20,300
salaries of product lines manager	$36,900
		$57,200
financial disadvantage		($43,800)

Discontinuation of racing bikes would result in decrease of overall net operating income by $43,800.

Financial disadvantage per quarter of discontinuing the Racking Bikes is $43,800.

Notes:

1. All traceable fixed costs can be avoided, such as traceable advertising and salaries of line manager.
2. Depreciation is a sunk cost and hence not relevant for the decision.
3. Common fixed costs are not relevant as they are allocated and would continue regardless of the decision to continue or discontinue the racking bikes segment.

2. No, the production and sale of Racing Bikes should not be discontinued.

Explanation: The discontinuance of Racing Bikes would result in a contribution margin loss of $101,000 which makes the overall net operating income to decrease by $43,800.

3. Segmented Income Statement:

Segmented Income Statement
	Totals	Dirt Bikes	Mountain Bikes	Racing Bikes
Sales	$919,000	$262,000	$401,000	$256,000
Variable manufacturing and selling costs	$471,000	$118,000	$198,000	$155,000
Contribution Margin	$448,000	$144,000	$203,000	$101,000
Traceable fixed expenses
Advertising	$69,300	$8,300	$40,700	$20,300
Depreciation of special equipment	$44,100	$20,900	$7,900	$15,300
Salaries of product line managers	$115,700	$40,600	$38,200	$36,900
Total traceable fixed expenses	$229,100	$69,800	$86,800	$72,500
Product line segment margin	$218,900	$74,200	$116,200	$28,500
Common fixed expenses	$183,800
Net Operating Income	$35,100

Note: the segmented margin income statement indicates that Racing Bikes earns enough contribution margin to cover all its traceable fixed expenses and still leave a margin of $28,500. Hence, the product is profitable and is not advised to be discontinued. The segment margin would absorb a portion of the fixed expenses and hence the product should not be discontinued.