Question

Thalassines Kataskeves, S.A., of Greece makes marine equipment. The company has been experiencing losses on its bilge pump product line for several years. The most recent quarterly contribution format income statement for the bilge pump product line follows:

Thalassines Kataskeves, S.A. Income Statement—Bilge Pump For the Quarter Ended March 31
Sales				$	410,000
Variable expenses:
Variable manufacturing expenses	$	120,000
Sales commissions		53,000
Shipping		16,000
Total variable expenses					189,000
Contribution margin					221,000
Fixed expenses:
Advertising (for the bilge pump product line)		30,000
Depreciation of equipment (no resale value)		112,000
General factory overhead		50,000	*
Salary of product-line manager		114,000
Insurance on inventories		14,000
Purchasing department		49,000	†
Total fixed expenses					369,000
Net operating loss				$	(148,000	)

*Common costs allocated on the basis of machine-hours.

†Common costs allocated on the basis of sales dollars.

Discontinuing the bilge pump product line would not affect sales of other product lines and would have no effect on the company’s total general factory overhead or total Purchasing Department expenses.

Required:

What is the financial advantage (disadvantage) of discontinuing the bilge pump product line?

*Please show work and how you got the answer :)

Answer 1

Solution:

Financial Advantage or (Disadvantage) from discontinuing a product line

This type of question has a direct relation with relevant cost.

Relevant Cost is the cost which will be incurred in future and different under each alternative course of action. The following costs are considered as relevant cost:

- Direct material cost

- Direct labor cost

- Variable manufacturing overhead

- Variable Cost of Goods Sold

- Variable selling and administrative expenses

- Fixed Cost which is directly related to the alternative course of action (traceable Fixed Cost).

The above costs are the variable cost which will vary with the production volume. Hence these costs have both the characteristic of relevant cost i.e. it is a future cost and different under each alternative course of action.

Sometimes there are some fixed costs which will directly associated with the production or increase production units and have characteristics of relevant cost. i.e. future cost and different under each alternative course of action.

Irrelevant cost is the costs which do not play any role in decision making. Irrelevant Cost is the SUNK Cost which has already been incurred and does not change whether company accept or reject the order. Hence it is treated as IRRELEVANT COST. In the given question the irrelevant cost is common fixed cost since it will continue to incur and does not have any affect from decision of continuing or discontinuing a product line.

Calculation of Financial Advantage (Disadvantage) from discontinuing Bilge Pump Product Line

	$$	$$
Loss of Contribution Margin		$221,000
Less: Saving in Fixed Costs
Advertising (since it is traceable with bilge pump product line)	($30,000)
Salary of product line manager	($114,000)
Insurance on Inventories	($14,000)
Total Saving from discontinuing product line		($158,000)
Financial Disadvantage (Net Loss)		$63,000

Note --- Depreciation is treated as sunk cost since it does not involve any cash outflow and the equipment do not have any resale value.

Financial disadvantage of discontinuing the bilge pump product line is $63,000