Question

Keep-or-Drop for Service Firm, Complementary Effects, Traditional Analysis Devern Assurance Company provides both property and automobile insurance. The projected income statements for the two products are as follows: Property Insurance Automobile Insurance Sales $4,200,000 $12,000,000 Less variable expenses 3,830,000 9,600,000 Contribution margin $370,000 $2,400,000 Less direct fixed expenses 400,000 500,000 Segment margin $(30,000) $1,900,000 Less common fixed expenses (allocated) 100,000 200,000 Operating income (loss) $(130,000) $1,700,000 The president of the company is considering dropping the property insurance. However, some policyholders prefer having their property and automobile insurance with the same company, so if property insurance is dropped, sales of automobile insurance will drop by 12 percent. No significant non-unit-level activity costs are incurred. Required: 1. If Devern Assurance Company drops property insurance, by how much will income increase or decrease? Decrease by $ Feedback Prepare the segmented income statement to determine the effect of dropping the segment of the business. As a supporting computation, prepare a segmented income statement for the keep-or-drop decision. Devern Assurance Company Keep-or-Drop For Service Firm Segmented Income Statement Keep Drop Sales $ $ Less variable expenses Contribution margin $ $ Less direct fixed expenses Segment margin $ $ Feedback Prepare an income statement for the company if the property insurance were to be dropped. Compare that to the existing income statement for the entire company. Common fixed expenses are not traceable to the segments. They would remain even if one of the segments were eliminated. 2. Assume that dropping all advertising for the property insurance line and increasing the corporate advertising budget by $450,000 will increase sales of property insurance by 10 percent and automobile insurance by 8 percent. Prepare a segmented income statement that reflects the effect of increased advertising. Devern Assurance Company Keep-or-Drop For Service Firm Segmented Income Statement Property Insurance Automobile Insurance Total Sales $ $ $ Less variable costs Contribution margin $ $ $ Less direct fixed expenses Segment margin $ $ $ Less common fixed costs Operating income $ Feedback Review what you have learned about segmented income statements in the chapter. Common fixed expenses are not traceable to the segments. They would remain even if one of the segments were eliminated. Should advertising be increased? Yes Feedback Does income increase or decrease as a result of the decision? Feedback Partially correct

Answer 1

Part 1

	With property insurance	without property insurance
Sales	16200000 (4200000+12000000)	10560000 (12000000*(1-12%))
Less: variable expenses	13430000 (3830000+9600000)	8448000 (9600000*(1-12%))
Contribution margin	2770000	2112000
Less: direct fixed expenses	90000	500000
Segment margin	1870000	1612000

If the company drops property insurance, the income will decrease by $258,000 (1870000-1612000). So, the company should not drop the property insurance.

Part 2

	Property insurance	automobile insurance
Sales	46200000 (4200000*1.10)	12960000 (12000000*1.08)
Less: variable expenses	4213000 (3830000*1.10)	10368000 (9600000*108)
Contribution margin	407000	2592000
Less: direct fixed expenses	-	500000
Segment margin	407000	2092000	2499000
Less : common fixed expenses			750000 (100000+200000+450000)
Operating income (loss)			1749000

Income before any change in advertising budget = - 130000 +1700000 =1570000

Income after change in advertising budget = 1749000

Increase in profit = 1749000-1570000=179000

Yes advertising should be increased