Question

Building Your Skills Analytical Thinking [LO7-4]

Diversified Products, Inc., has recently acquired a small publishing company that offers three books for sale—a cookbook, a travel guide, and a handy speller. Each book sells for $13. The publishing company’s most recent monthly income statement is shown below.

				Product line
	Total Company			Cookbook					Travel Guide			Handy Speller
Sales	$	315,000		$	96,000			$	156,000		$	63,000
Expenses:
Printing costs		105,000			30,000				63,300			11,700
Advertising		39,000			13,800				21,000			4,200
General sales		18,900			5,760				9,360			3,780
Salaries		36,000			21,000				9,300			5,700
Equipment depreciation		6,600			2,200				2,200			2,200
Sales commissions		31,500			9,600				15,600			6,300
General administration		42,900			14,300				14,300			14,300
Warehouse rent		12,600			3,840				6,240			2,520
Depreciation—office facilities		3,900			1,300				1,300			1,300
Total expenses		296,400			101,800				142,600			52,000
Net operating income (loss)	$	18,600		$	(5,800	)		$	13,400		$	11,000

The following additional information is available:

1. Only printing costs and sales commissions are variable; all other costs are fixed. The printing costs (which include materials, labor, and variable overhead) are traceable to the three product lines as shown in the income statement above. Sales commissions are 10% of sales.

2. The same equipment is used to produce all three books, so the equipment depreciation expense has been allocated equally among the three product lines. An analysis of the company’s activities indicates that the equipment is used 30% of the time to produce cookbooks, 50% of the time to produce travel guides, and 20% of the time to produce handy spellers.

3. The warehouse is used to store finished units of product, so the rental cost has been allocated to the product lines on the basis of sales dollars. The warehouse rental cost is $3 per square foot per year. The warehouse contains 50,400 square feet of space, of which 7,800 square feet is used by the cookbook line, 24,600 square feet by the travel guide line, and 18,000 square feet by the handy speller line.

4. The general sales cost above includes the salary of the sales manager and other sales costs not traceable to any specific product line. This cost has been allocated to the product lines on the basis of sales dollars.

5. The general administration cost and depreciation of office facilities both relate to administration of the company as a whole. These costs have been allocated equally to the three product lines.

6. All other costs are traceable to the three product lines in the amounts shown on the income statement above.

The management of Diversified Products, Inc., is anxious to improve the publishing company’s 6% return on sales.

Required:

1. Prepare a new contribution format segmented income statement for the month. Adjust allocations of equipment depreciation and of warehouse rent as indicated by the additional information provided.

2. Based on the segmented income statements given in the problem, management plans to eliminate the cookbook because it is not returning a profit, and to focus all available resources on promoting the travel guide. However, based on the new contribution format segmented income statement that you prepared:

a. Do you agree with management's plan to eliminate the cookbook?

b-1. Compute the contribution margin ratio for each product.

b-2. Based on the statement you have prepared, do you agree with the decision to focus all available resources on promoting the travel guide?

Answer 1