Question

Dropping Unprofitable Division Based on the following analysis of last year’s operations of

Groves, Inc., a financial vice president of the company believes that the firm’s total net income could

be increased by $160,000 if its design division were discontinued. (Amounts are given in thousands

of dollars.)

Totals /All Other Divisions/ Design Division

Sales. . . . . . . . . . . . . . . . . . . . . . $18,800 $14,400 $4,400

Cost of services:

Variable . . . . . . . . . . . . . . . . . . (7,600) (5,600) (2,000)

Fixed . . . . . . . . . . . . . . . . . . . . (4,800) (4,000) (800)

Gross profit . . . . . . . . . . . . . $ 6,400 $ 4,800 $1,600

Operating expenses:

Variable . . . . . . . . . . . . . . . . . . (3,360) (2,000) (1,360)

Fixed . . . . . . . . . . . . . . . . . . . . (1,600) (1,200) (400)

Net income (loss) . . . . . . . . . . . . $ 1,440 $ 1,600 $ (160)

Required

Provide answers for each of the following independent situations:

a. Assuming that total fixed costs and expenses would not be affected by discontinuing the design

division, prepare an analysis showing why you agree or disagree with the vice president.

b. Assume that discontinuance of the design division will enable the company to avoid 30% of the

fixed portion of cost of services and 40% of the fixed operating expenses allocated to the design

division. Calculate the resulting effect on net income.

c. Assume that in addition to the cost avoidance in requirement (b), the capacity released by discon-

tinuance of the design division can be used to provide 6,000 new services that would have a vari-

able cost per service of $60 and would require additional fixed costs totaling $68,000. At what

unit price must the new service be sold if Groves is to increase its total net income by $180,000?

Answer 1

a. Assuming that total fixed costs and expenses would not be affected by discontinuing the design division, prepare an analysis showing why you agree or disagree with the vice president.

Ans

If design department is discontinued the following assumptions are taken

• The total fixed cost of design department will continue in cost of service and in operating expense
• Only the variable cost of design department will be eliminated

The total net income is calculated if design department is discontinued

amount in thousands
	Total	other divisions	design division is discontinued
sales	14400	14400
cost of services	0
variable	-5600	-5600
fixed	-4800	-4000	-800
total	-10400	-9600	-800
Gross profit	4000	4800	-800
operating expenses	0
variable	-2000	-2000
fixed	-1600	-1200	-400
total	-3600	-3200	-400
Net income(loss)	400	1600	-1200

The net profit has decreased to $400,000 from earlier $1440,000 if design department is discontinued. Disagree with vice president analysis

b. Assume that discontinuance of the design division will enable the company to avoid 30% of the fixed portion of cost of services and 40% of the fixed operating expenses allocated to the design division. Calculate the resulting effect on net income.

Ans

The following assumptions are taken if design department is discontinued . the expenses of design department will have the following

• Reduction in 30% in fixed cost in cost of services
• Reduction in 40% in fixed cost in operating expenses
• Variable cost will be zero

The total net income is calculated if design department is discontinued

amount in thousands
	Total	other divisions	design division is discontinued
sales	14400	14400
cost of services	0
variable	-5600	-5600
fixed	-4560	-4000	-560
total	-10160	-9600	-560
Gross profit	4240	4800	-560
operating expenses	0
variable	-2000	-2000
fixed	-1440	-1200	-240
total	-3440	-3200	-240
Net income(loss)	800	1600	-800

The total net profit will be $800,000

c. Assume that in addition to the cost avoidance in requirement (b), the capacity released by discontinuance of the design division can be used to provide 6,000 new services that would have a variable cost per service of $60 and would require additional fixed costs totaling $68,000. At what unit price must the new service be sold if Groves is to increase its total net income by $180,000?

Ans

Requirement

• Profit of $180,000
• The fixed cost are

Cost of service = $560,000

Operative expenses = $240,000

Additional fixed cost =$68,000

The total fixed cost = $560,000+$240,000+$68,000 =$868,000

The variable cost will be = 6000 x $60 = $360,000

The total revenue to be generated = total fixed cost + total variable cost + target profit

= $868,000 + $360,000+$180,000

=$1,408,000

Per unit sales price = Total revenue / additional units of sales

= $1408000 / 6000

= 234.6667

The unit price should be $234.67