Question

Tracey Douglas is the owner and managing director of Heritage Garden Furniture Ltd., a South African company that makes museum-quality reproductions of antique outdoor furniture. Tracey would like advice concerning the advisability of eliminating the model C3 lawn chair. These lawn chairs have been among the company’s best-selling products, but they seem unprofitable.

A condensed statement of operating income for the company and for the model C3 lawn chair for the quarter ended June 30 follows:

  

		Model C3 Lawn Chair			All Products
Sales		R	1,000,000*		R	5,000,000
Cost of sales:
Direct materials			400,000			1,300,000
Direct labour			240,000			1,150,000
Fringe benefits (20% of direct labour)			48,000			230,000
Variable manufacturing overhead			12,000			50,000
Building rent and maintenance			13,000			50,000
Depreciation			64,000			125,000
Total cost of sales			777,000			2,905,000
Gross margin			223,000			2,095,000
Selling and administrative expenses:
Product managers’ salaries			33,000			125,000
Sales commissions (5% of sales)			50,000			250,000
Fringe benefits (20% of salaries and commissions)			16,600			75,000
Shipping			17,000			200,000
General administrative expenses			160,000			800,000
Total selling and administrative expenses			276,600			1,450,000
Net operating income (loss)		R	(53,600)		R	645,000

*The currency in South Africa is the rand, denoted here by R.

  

The following additional data have been supplied by the company:

a.	Direct labour is a variable cost at Heritage Garden Furniture.
b.	All of the company’s products are manufactured in the same facility and use the same equipment. Building rent, maintenance, and depreciation are allocated to products using various bases. The equipment does not wear out through use; it eventually becomes obsolete.
c.	There is ample capacity to fill all orders.
d.	Dropping the model C3 lawn chair would have no effect on sales of other product lines.
e.	Inventories of work in process or finished goods are insignificant.
f.	Shipping costs are traced directly to products.
g.	General administrative expenses are allocated to products on the basis of sales dollars. There would be no effect on the total general administrative expenses if the model C3 lawn chair were dropped.
h.	If the model C3 lawn chair were dropped, the product manager would be laid off.

  

Required:

1-a.	At current level of sales, compute the effect of net operating income if the Model C3 lawn chair is dropped

1-b.	Would you recommend that the model C3 lawn chair be dropped?
	Yes No

2.	What would sales of the model C3 lawn chair have to be, at minimum, in order to justify retaining the product? (Hint: Set this up as a break-even problem, but include only the relevant costs from part (1).)(Round "Contribution margin ratio" to 2 decimal places and final answer to the nearest whole number.)

Answer 1

1)
Sales revenue lost if the Model C3 lawnchair is dropped		R 1,000,000.00
Less: Avoidable Cost
Direct materials	R 400,000.00
Direct labour	R 240,000.00
Fringe benefits (20% of direct labour)	R 48,000.00
Variable manufacturing overhead	R 12,000.00
Product managers’ salaries	R 33,000.00
Sales commissions (5% of sales)	R 50,000.00
Fringe benefits (20% of salaries and commissions)	R 16,600.00
Shipping	R 17,000.00
Total avoidable cost		R 816,600.00
Decrease in overall company net operating income if the Model C3 lawnchair is dropped		R 183,400.00
No, the model C3 lawn chair should not be dropped .
2)
	Variable cost	Fixed Cost
Direct materials	R 400,000.00
Direct labour	R 240,000.00
Fringe benefits (20% of direct labour)	R 48,000.00
Variable manufacturing overhead	R 12,000.00
Product managers’ salaries		R 33,000.00
Sales commissions (5% of sales)	R 50,000.00
Fringe benefits (16600 - (33000 x 20% = 6600))	R 10,000.00	R 6,600.00
Shipping	R 17,000.00
Total Cost	R 777,000.00	R 39,600.00
Contribution Margin Ratio = (Sales - Variable Cost)/Sales
Contribution Margin Ratio = (R1,000,000 - R777,000)/R1,000,000	22.30%
Break-even point = Fixed Cost / CM Ratio = R39,600 /22.30%	R 177,578