Question

Keep-Or-Drop Decision, Alternatives, Relevant Costs

Reshier Company makes three types of rug shampooers. Model 1 is the basic model rented through hardware stores and supermarkets. Model 2 is a more advanced model with both dry-and wet-vacuuming capabilities. Model 3 is the heavy-duty riding shampooer sold to hotels and convention centers. A segmented income statement is shown below.

		Model 1		Model 2		Model 3		Total
Sales		$275,000		$586,000		$623,500		$1,484,500
Less variable costs of goods sold		(100,000)		(177,720)		(348,000)		(625,720)
Less commissions		(5,800)		(27,000)		(23,250)		(56,050)
Contribution margin		$169,200		$381,280		$252,250		$802,730
Less common fixed expenses:
Fixed factory overhead								(395,000)
Fixed selling and administrative								(307,000)
Operating income								$100,730

While all models have positive contribution margins, Reshier Company is concerned because operating income is less than 10 percent of sales and is low for this type of company. The company’s controller gathered additional information on fixed costs to see why they were so high. The following information on activities and drivers was gathered:

						Driver Usage by Model
Activity	Activity Cost				Activity Driver	Model 1				Model 2				Model 3
Engineering		$80,000			Engineering hours		790				71				139
Setting up		177,000			Setup hours		12,200				12,800				29,139
Customer service		103,000			Service calls		13,600				1,580				19,139

In addition, Model 1 requires the rental of specialized equipment costing $25,000 per year.

1. Reformulate the segmented income statement using the additional information on activities. Use a minus sign to indicate any negative margins. Do NOT round interim calculations and, if required, round your answer to the nearest dollar. Reshier Company Segmented Income Statement Model 1 Model 2 Model 3 Total $   $   $   $   Contribution margin $   $   $   $   Less traceable fixed expenses: Product margin $   $   $   $   Less common fixed expenses: Operating income $

2. Using your answer to Requirement 1, assume that Reshier Company is considering dropping any model with a negative product margin. What are the alternatives?
- Select your answer -Keeping Model 1Dropping Model 1Keeping Model 1 or dropping itCorrect 1 of Item 2

Which alternative is more cost effective and by how much? (Assume that any traceable fixed costs can be avoided.) Do NOT round interim calculations and, if required, round your answer to the nearest dollar.
- Select your answer -Keeping Model 1Dropping Model 1Correct 2 of Item 2 will add $ to operating income

3. What if Reshier Company can only avoid 188 hours of engineering time and 5,350 hours of setup time that are attributable to Model 1? How does that affect the alternatives presented in Requirement 2? Which alternative is more cost effective and by how much? Do NOT round interim calculations and, if required, round your answer to the nearest dollar.

- Select your answer -Keeping Model 1Dropping Model 1Correct 4 of Item 2 will add $ to operating income

Answer 1

1.

	Model 1	Model 2	Model 3	Total
Sales	275000	586000	623500	1484500
Less variable cost of goods sold	-1,00,000	-1,77,720	-3,48,000	-6,25,720
Less commissions	-5,800	-27,000	-23,250	-56,050
Contribution margin	169200	381280	252250	802730
Less traceable fixed expenses:
Engineering (WN 1)	-63200	-5680	-11120	-80000
Setting up (WN 1)	-39886.2	-41848	-95266	-177000
Equipment rental	-25000	0	0	-25000
Customer service (WN 1)	-40817	-4741.98	-57441	-103000
Product margin	296.74	329010.2	88423.07	417730
Less common fixed expenses:
Factory overhead (WN 2)				-113000
Selling and admin expense (WN 2)				-204000
Operating income				100730

WN 1:

	Activity Cost (A)	Driver Usage		Activity Rate (A/B)
Activity	Model 1	Model 2	Model 3	Total (B)
Engineering	80000	790	71	139	1000	80
Setting up	177000	12200	12800	29139	54139	3.27
Customer service	103000	13600	1580	19139	34319	3

		Engineering		Setting Up		Customer Service
Model 1	80*790	63200	3.27*12200	39886.219	3*13600	40817.04012
Model 2	80*71	5680	3.27*12800	41848	3*1580	4741.979661
Model 3	80*139	11120	3.27*29139	95266	3*19139	57441
Total		80000		177000		103000

WN 2:

	Manufacturing	Selling and admin
Total Fixed Expense	395000	307000
Less: Equipment Rental	-25000
Less: Traceable	-257000	-103000
Common	113000	204000

2. None of the products will be dropped as all result in a positive product margin

3.

	Model 1	Model 2	Model 3	Total
Sales	275000	586000	623500	1484500
Less variable cost of goods sold	-1,00,000	-1,77,720	-3,48,000	-6,25,720
Less commissions	-5,800	-27,000	-23,250	-56,050
Contribution margin	169200	381280	252250	802730
Less traceable fixed expenses:
Engineering (WN 1)	-15040*	-5680	-11120	-31840
Setting up (WN 1)	-17491.1**	-41848	-95266	-154605
Equipment rental	-25000	0	0	-25000
Customer service (WN 1)	-40817	-4741.98	-57441	-103000
Product margin	70851.87	329010.2	88423.07	488285.1
Less common fixed expenses:
Factory overhead (WN 2)				-113000
Selling and admin expense (WN 2)				-204000
Operating income				171285.1

* (188 * $80)

** (5,350 * 3.27)

Model 1 will add $70,555.13 ($70,851.87 - $296.74) to total income of company