Question

Ciena & Associates

The following customer segmented quarterly income statement is for Ciena and

Associates, a firm that performs legal services

Customers                       Koontz                             Davis                   Nello                   Total

Sales revenue                  $150,000                        $750,000              $100,000          $1,000,000

Variable costs                 125,000                           600,000               80,000                805,000

Contribution margin       $ 25,000                          $150,000              $ 20,000            $ 195,000

Direct fixed costs            7,500                                  157,500               5,000                  170,000

Allocated fixed costs      3,000                                15,000               2,000                 20,000

Profit (loss)                      $ 14,500                          $ (22,500)              $ 13,000            $ 5,000

Management is concerned about the significant losses associated with the Davis

account and would like to drop this customer. Allocated fixed costs are assigned to

customers based on sales revenue.

If Davis is dropped, total allocated fixed costs are assigned to the remaining

customers, and all variable and direct fixed costs for the Davis account will be

eliminated.

Required

a. Perform differential analysis. Assume keeping all customers is Alternative

1, and dropping the Davis account is Alternative 2.

b. Which alternative is best? Explain.

c. Summarize the result of dropping the Davis account.

d. Explain what happened to the profitability of the other two customers as a

result of dropping the Davis account.

e. Assume all the facts of this problem remain the same with one exception. As

a result of dropping the Davis account, Ciena and Associates is only able to

reduce the direct fixed costs associated with the Davis account by 90 percent.

The remaining 10 percent will not be eliminated for several more years. Does

this change Ciena's decision as to whether to drop the Davis customer?

Answer 1

a. Differential Analysis

	Alternative 1	Alternative 2	Difference
Sales revenue	1000000	250000	750000
Variable costs	805000	205000	600000
Contribution margin	195000	45000	150000
Direct fixed costs	170000	12500	157500
Segment profit	25000	32500	-7500
Allocated fixed costs	20000	20000	0
Profit / (loss)	5000	12500	-7500

Working:

	ALTERNATIVE 1					ALTERNATIVE 2
	Koontz	Davis	Nello	Total		Koontz	Nello	Total
Sales revenue	150000	750000	100000	1000000		150000	100000	250000
Variable costs	125000	600000	80000	805000		125000	80000	205000
Contribution margin	25000	150000	20000	195000		25000	20000	45000
Direct fixed costs	7500	157500	5000	170000		7500	5000	12500
Segment profit	17500	-7500	15000	25000		17500	15000	32500
Allocated fixed costs *	3000	15000	2000	20000		12000	8000	20000
Profit / (loss)	14500	-22500	13000	5000		5500	7000	12500
* The allocated fixed costs are assigned based on the sales revenue of the customers.

b. The alternative 2 is the best as it gives an additional profit of $7,500 compared to Alternative 1.

This is because the loss of $7,500 from Davis after the direct fixed costs will be avoided if Davis is dropped.

Contribution margin from Davis is $150,000 whereas the direct fixed costs relating to Davis is $157,500 which is resulting in the above loss.

c. The total profit will be $12,500 as compared to present profit of $5,000 as the loss from Davis of $7,500 will be avoided. The total allocated fixed costs will remain the same as this is to be borne by the other two customers based on their respective sles. Hence the allocated fixed costs of Koontz and Nello will go up by $9,000 and $6,000 respectively as the allocated fixed costs of Davis have to be reallocated to these two customers.

d. The profit for Koontz will go down by $9,000 and that for Nello by $6,000 due to the additional allocation of fixed costs.

e. The alternative 2 will result in a loss of $3,250. Hence Ciena will not drop Davis customer.

The total allocated fixed costs for Davis is $157,500. If 10% of this amount i.e., $15,750 cannot be eliminated , Alternative 2 will give a loss of $3,250 ($12,500 - $15,750) since the total profit with full direct fixed cost elimination is $12,500.