Question

The management of Fannin Corporation is considering dropping product H58S. Data from the company's accounting system appear below:

Sales	$900,000
Variable expenses	$384,000
Fixed manufacturing expenses	$366,000
Fixed selling and administrative expenses	$246,000

In the company's accounting system all fixed expenses of the company are fully allocated to products. Further investigation has revealed that $225,000 of the fixed manufacturing expenses and $186,000 of the fixed selling and administrative expenses are avoidable if product H58S is discontinued. What would be the effect on the company's overall net operating income if product H58S were dropped?

Overall net operating income would increase by $96,000.

Overall net operating income would increase by $105,000.

Overall net operating income would decrease by $96,000.

Overall net operating income would decrease by $105,000.

Answer 1

Calculation of current net operating income:

Sales $ 900,000

Less: Variable expenses $ 384,000

Less: Fixed manufacturing expenses $366,000

Less: Fixed selling and administration

expenses $246,000.

Net operating income - $ 96,000

After production of product H58S is dropped i.e. after the product is discontinued, its sales revenue will be zero since there will be no sales.

Variable expenses are directly linked to production. Therefore, since there will be no production, there will be zero variable expenses.

Out of fixed manufacturing expenses of $366,000, $225,000 is avoidable. So the new Fixed manufacturing expense is

$366,000 - $225,000 = $ 141,000 which is unavoidable cost.

Out of the fixed selling and administration expense of $ 246,000, $ 186,000 is avoidable. So the Fixed selling and administration expense which the company has to incur, even if the product is discontinued is $246,000-$186,000= $60,000 which is unavoidable cost.

Therefore the overall net profit now is:

Sales: $0

less: Variable expenses $0

Less: Fixed manufacturing expenses $141,000

Less: Fixed selling and administration

overhead $60,000

Net operating income - $ 201,000

Before discontinuation of the product, net operating income was - $96,000

After discontinuation of the product, net operating income is - $201,000

Therefore now, after discontinuation, loss has increased by ($201,000-&96,000) $105,000

So , after discontinuation of product, the overall net income has decreased by $ 105,000.

(Since loss has increased, income has decreased)