Question

Diego Company manufactures one product that is sold for $79 per unit in two geographic regions—the East and West regions. The following information pertains to the company’s first year of operations in which it produced 50,000 units and sold 45,000 units.

  

Variable costs per unit:
Manufacturing:
Direct materials	$	29
Direct labor	$	16
Variable manufacturing overhead	$	2
Variable selling and administrative	$	4
Fixed costs per year:
Fixed manufacturing overhead	$	800,000
Fixed selling and administrative expenses	$	516,000

  

The company sold 35,000 units in the East region and 10,000 units in the West region. It determined that $240,000 of its fixed selling and administrative expenses is traceable to the West region, $190,000 is traceable to the East region, and the remaining $86,000 is a common fixed cost. The company will continue to incur the total amount of its fixed manufacturing overhead costs as long as it continues to produce any amount of its only product. 1. Diego is considering eliminating the West region because an internally generated report suggests the region’s total gross margin in the first year of operations was $80,000 less than its traceable fixed selling and administrative expenses. Diego believes that if it drops the West region, the East region's sales will grow by 3% in Year 2. Using the contribution approach for analyzing segment profitability and assuming all else remains constant in Year 2, what would be the profit impact of dropping the West region in Year 2? 2. Assume the West region invests $40,000 in a new advertising campaign in Year 2 that increases its unit sales by 20%. If all else remains constant, what would be the profit impact of pursuing the advertising campaign?

Answer 1

Calculation of net profit (loss) of Year 1
	East Region	West Region	Total
	35000 units	10000 units
Sales ($79 per unit)	$2,765,000.00	$790,000.00	$3,555,000.00
Less : Variable cost ($51 per unit)	$1,785,000.00	$510,000.00	$2,295,000.00
Contribution Margin	$980,000.00	$280,000.00	$1,260,000.00
Less : Traceable Fixed selling and administrative exp.	$190,000.00	$240,000.00	$430,000.00
Segment profit Margin	$790,000.00	$40,000.00	$830,000.00
Less : Common Fixed Cost
- Common Fixed Manufacturing Overheads			$800,000.00
- Common selling and administrative expenses			$86,000.00
Net Profit / (loss)			-$56,000.00
Calculation of the profit impact of dropping the West region in Year 2
	East Region	West Region	Total
	36050 units	0 units
Sales ($79 per unit)	$2,847,950.00		$2,847,950.00
Less : Variable cost ($51 per unit)	$1,838,550.00		$1,838,550.00
Contribution Margin	$1,009,400.00	$0.00	$1,009,400.00
Less : Traceable Fixed selling and administrative exp.	$190,000.00		$190,000.00
Segment profit Margin	$819,400.00	$0.00	$819,400.00
Less : Common Fixed Cost
- Common Fixed Manufacturing Overheads			$800,000.00
- Common selling and administrative expenses			$86,000.00
Net Profit / (loss)			-$66,600.00
The profit impact of dropping the West region in Year 2 = Total Profit will fall by $10600 in year 2 [-$56000+$66600]
Calculation of the profit impact if West region invests $40,000 in a new advertising campaign in Year 2 that increases its unit sales by 20% (Year 2)
	East Region	West Region	Total
	35000 units	12000 units
Sales ($79 per unit)	$2,765,000.00	$948,000.00	$3,713,000.00
Less : Variable cost ($51 per unit)	$1,785,000.00	$612,000.00	$2,397,000.00
Contribution Margin	$980,000.00	$336,000.00	$1,316,000.00
Less : Traceable Fixed selling and administrative exp.	$190,000.00	$280,000.00	$470,000.00
Segment profit Margin	$790,000.00	$56,000.00	$846,000.00
Less : Common Fixed Cost
- Common Fixed Manufacturing Overheads			$800,000.00
- Common selling and administrative expenses			$86,000.00
Net Profit / (loss)			-$40,000.00
The profit impact of pursuing the advertising campaign = Total profit will increase by $16000 [-$56000+$40000]