Question

Keep-Or-Drop Decision, Alternatives, Relevant Costs

Reshier Company makes three types of rug shampooers. Model 1 is the basic model rented through hardware stores and supermarkets. Model 2 is a more advanced model with both dry-and wet-vacuuming capabilities. Model 3 is the heavy-duty riding shampooer sold to hotels and convention centers. A segmented income statement is shown below.

		Model 1		Model 2		Model 3		Total
Sales		$255,000		$570,000		$628,500		$1,453,500
Less variable costs of goods sold		(93,000)		(179,480)		(354,000)		(626,480)
Less commissions		(4,600)		(38,000)		(21,250)		(63,850)
Contribution margin		$157,400		$352,520		$253,250		$763,170
Less common fixed expenses:
Fixed factory overhead								(405,000)
Fixed selling and administrative								(275,000)
Operating income								$83,170

While all models have positive contribution margins, Reshier Company is concerned because operating income is less than 10 percent of sales and is low for this type of company. The company’s controller gathered additional information on fixed costs to see why they were so high. The following information on activities and drivers was gathered:

						Driver Usage by Model
Activity	Activity Cost				Activity Driver	Model 1				Model 2				Model 3
Engineering		$77,000			Engineering hours		790				80				130
Setting up		176,000			Setup hours		12,600				12,900				29,130
Customer service		101,000			Service calls		13,000				1,600				19,130

In addition, Model 1 requires the rental of specialized equipment costing $18,500 per year.

Required:

1. Reformulate the segmented income statement using the additional information on activities. Use a minus sign to indicate any negative margins. Do NOT round interim calculations and, if required, round your answer to the nearest dollar. If amount box does not require an entry, leave it blank or enter "0".

Reshier Company
Segmented Income Statement
	Model 1	Model 2	Model 3	Total
	$	$	$	$
Contribution margin	$	$	$	$
Less traceable fixed expenses:
Product margin	$	$	$	$
Less common fixed expenses:
Operating income				$

2. Using your answer to Requirement 1, assume that Reshier Company is considering dropping any model with a negative product margin. What are the alternatives?

Which alternative is more cost effective and by how much? (Assume that any traceable fixed costs can be avoided.) Do NOT round interim calculations and, if required, round your answer to the nearest dollar.
will add $ to operating income

3. What if Reshier Company can only avoid 168 hours of engineering time and 5,450 hours of setup time that are attributable to Model 1? How does that affect the alternatives presented in Requirement 2? Which alternative is more cost effective and by how much? Do NOT round interim calculations and, if required, round your answer to the nearest dollar.

will add $ to operating income

Answer 1

2.) It is clearly seen that Model 1 is having negative Product Margin of $1450. Hence it should consider dropping Model 1.

3.) If 168 hours of engineering time and 5450 hours of set up time can be avoided for Model 1,

Revised Engineering Cost = $77000*622/832

= $ 57565

Revised Set up cost = $176000*7150/49180

= $ 25588

Revised Product Margin= $157400-(57565+25588+38927+18500)

= $16820

Thus Model 1 turns into positive Product Margin if the given hours can be avoided.

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