Question

SOUTH CAROLINA CORPORATION owns a single restaurant which has a bar primarily used to seat patrons while they wait for their tables. The company is considering eliminating the bar and adding more dining tables as the bar is showing a loss of $12,500. Segmented contribution income statements are as follows and fixed costs applicable to both segments are allocated on the basis of sales.

	Restaurant	Bar	Total
Sales	$600,000	$200,000		$800,000
Variable costs	375,000	160,000		535,000
Direct fixed costs	50,000	15,000		65,000
Segment margin	175,000	25,000		200,000
Allocated fixed costs	112,500	37,500		150,000
Operating Income	$62,500	($12,500)		$50,000

Required:

What does the term “direct fixed costs” mean, as used above? Give an example of something that would be a direct fixed cost for the Restaurant and the Bar.

How do the “direct fixed costs” above differ from the “allocated fixed costs”? Why is that important and how does it affect the handling of these items?

In plain English, what’s “Segment Margin”?

What is the contribution margin ratio of the restaurant?

Regarding the decision to eliminate the Bar, which information is relevant and why?

Should SOUTH CAROLINA eliminate the bar? Why or why not? By how much would SOUTH CAROLINA be better (or worse) off if they eliminate the bar?

NOW ASSUME that if the bar is eliminated, $15,000 of allocated fixed costs could be avoided AND restaurant sales would increase by $17,000. Should SOUTH CAROLINA eliminate the bar? Why or why not?

Answer 1

Direct fixed costs are costs which are directly related to a particular department. In this case it is the direct fixed costs related to the restaurant or the bar. For eg. direct fixed cost of the restaurant would be electricity bill of the restaurant and that of bar would be the electricity of the bar.

Allocated fixed costs are those which are common to the business and are allocated to various departments on some basis. Here, allocated fixed costs are costs not directly related to the restaurant or the bar and cannot be traced to either of them, hence they are allocated on some basis. While direct fixed costs are directly related to the departmentm, the allocated fixed costs are indirectly related.

Segment margin is the profit or loss generated by the particular segment of the business.

COntribution Margin

	Restaurant	Bar	Total
Sales	$6,00,000	$2,00,000	$8,00,000
Variable cost	$3,75,000	$1,60,000	$5,35,000
Contribution margin	$2,25,000	$40,000	$2,65,000

Contribution margin ratio of the restaurant= 265000 / 800000

= 33.125%

In order to eliminate the bar, the information regarding its costs should be available specially the fixed costs which can be avoided by eliminating the bar.

No, South Carolina should eliminate tge Bar as the total operating profit is lower in this case as shown below:

	Restaurant
Sales	$6,00,000
Variable cost	$3,75,000
Contribution margin	$2,25,000
Direct fixed costs	$50,000
Allocated fixed costs	$1,50,000
Operating income	$25,000

Here we see the net income is lower in this case as compared to when the bar is operative. South Carolina would be worse by $25000 if they eliminate the bar.

Now, if we assume that the bar elimination will increase sales of restaurant by $17000 and decrease the allocated fixed costs by $15000, the operaitng income of restaurant is:

	Restaurant
Sales	$6,17,000
Variable cost	$3,75,000
Contribution margin	$2,42,000
Direct fixed costs	$50,000
Allocated fixed costs	$1,35,000
Operating income	$57,000

Yes, South Caroline should elimnate the bar as the total income has increased by $7000.