Question

Agnew Manufacturing produces and sells three models of a single product, Standard, Superior, and DeLuxe, in a local market and in a regional market. At the end of the first quarter of the current year, the following income statement (in thousands of dollars) has been prepared.

	Total			Local			Regional
Sales revenue	$	15,300		$	11,790		$	3,510
Cost of goods sold		12,105			9,315			2,790
Gross margin	$	3,195		$	2,475		$	720
Marketing costs		1,230			705			525
Administrative costs		606			465			141
Total marketing and administrative	$	1,836		$	1,170		$	666
Operating profits	$	1,359		$	1,305		$	54

Management has expressed special concern with the regional market because of the extremely poor return on sales. This market was entered a year ago because of excess capacity. It was originally believed that the return on sales would improve with time, but after a year, no noticeable improvement can be seen from the results as reported in the preceding quarterly statement.

In attempting to decide whether to eliminate the regional market, the following information has been gathered.

	Products
	Standard			Superior			DeLuxe
Sales revenue	$	5,900		$	4,700		$	4,700
Variable manufacturing costs as a percentage of sales revenue		60	%		70	%		60	%
Variable marketing costs as a percentage of sales revenue		2			2			2

Product Sales by Markets	Local			Regional
Standard	$	4,730		$	1,170
Superior		3,530			1,170
DeLuxe		3,530			1,170

All administrative costs and fixed manufacturing costs would not be affected by eliminating the regional market. Marketing costs that are not listed as variable are fixed for the period and separable by market. Fixed marketing costs assigned to the regional market would be saved if that market were eliminated.

Required:

a. Assuming there are no alternative uses for Agnew's present capacity, would you recommend dropping the regional market?

b. Prepare the quarterly income statement showing contribution margins by products. Do not allocate fixed costs to products.

c. It is believed that a new model can be ready for sale next year if Agnew decides to go ahead with continued research. The new product would replace DeLuxe and can be produced by simply converting equipment presently used in producing the DeLuxe model. This conversion will increase fixed costs by $117,000 per quarter. What must be the minimum contribution margin per quarter for the new model to make the changeover financially feasible?

Answer 1

a.No, Should not be dropped as it is providing positive margin. Since allocated fixed cost is not avoidable, dropping the market will lead to higher loss of profits

Income Statement
	Standard	Superior	Deluxe	Total
Sales Revenue	5,900	4,700	4,700	15,300
Less: Variable costs
Manufacturing	3,540	3,290	2,820	9,650
Marketing	118	94	94	306
Total variable costs	3,658	3,384	2,914	9,956
Contribution margin	2,242	1,316	1,786	5,344
c.Minimum Contribution margin from new product = Contribution margin from Deluxe + Increase in fixed costs
=1786,000+117,000
i.e. $1,903,000