Question

Morning Sky, Inc. (MSI), manufactures and sells computer games. The company has several product lines based on the age range of the target market. MSI sells both individual games as well as packaged sets. All games are in CD format, and some utilize accessories such as steering wheels, electronic tablets, and hand controls. To date, MSI has developed and manufactured all the CDs itself as well as the accessories and packaging for all of its products.

The gaming market has traditionally been targeted at teenagers and young adults; however, the increasing affordability of computers and the incorporation of computer activities into junior high and elementary school curriculums has led to a significant increase in sales to younger children. MSI has always included games for younger children but now wants to expand its business to capitalize on changes in the industry. The company currently has excess capacity and is investigating several possible ways to improve profitability.

E7-7 Analyzing Keep-or-Drop Decision [LO 7-2, 7-5]

MSI is considering eliminating a product from its ToddleTown Tours collection. This collection is aimed at children one to three years of age and includes “tours” of a hypothetical town. Two products, The Pet Store Parade and The Grocery Getaway, have impressive sales. However, sales for the third CD in the collection, The Post Office Polka, have lagged the others. Several other CDs are planned for this collection, but none is ready for production.

MSI’s information related to the ToddleTown Tours collection follows:

Segmented Income Statement for MSI’s
ToddleTown Tours Product Lines
	Pet Store Parade			Grocery Getaway			Post Office Polka				Total
Sales revenue	$	65,000		$	60,000		$	22,000			$	147,000
Variable costs		29,000			25,000			14,000				68,000
Contribution margin	$	36,000		$	35,000		$	8,000			$	79,000
Less: Direct Fixed costs		5,400			4,000			4,200				13,600
Segment margin	$	30,600		$	31,000		$	3,800			$	65,400
Less: Common fixed costs*		13,000			12,000			4,400				29,400
Net operating income (loss)	$	17,600		$	19,000		$	(600	)		$	36,000
*Allocated based on total sales dollars. MSI has determined that elimination of the Post Office Polka (POP) program would not impact sales of the other two items. The remaining fixed overhead currently allocated to the POP product would be redistributed to the remaining two products. Required: 1. Calculate the incremental effect on profit if the POP product is eliminated. Effect on Profit 2. Should MSI drop the POP product? Yes No 3-a. Calculate the incremental effect on profit if the POP product is eliminated. Suppose that $4,000 of the common fixed costs could be avoided if the POP product line were eliminated. Effect on Profit 3-b. Should MSI drop the POP product? Yes No

Answer 1

Req 1:
Incremntal Effect on profit if POP is eliminated:
				before Elimination		After Elimination		Incremntal
Sales				147000		125000		-22000
Less: variable cost				68000		54000		-14000
Contribution margin				79000		71000		-8000
Less: Direct Fixed cost				13600		9400		-4200
Segment margin				65400		61600		-3800
Less: Common Fixed cost				29400		29400		0
Net income				36000		32200		-3800
Effect on profit is ($3800)
Decrease
Req 2: NO, POP should not dropped
Req 3:
Incremntal Effect on profit if POP is eliminated:
				before Elimination		After Elimination		Incremntal
Sales				147000		125000		-22000
Less: variable cost				68000		54000		-14000
Contribution margin				79000		71000		-8000
Less: Direct Fixed cost				13600		9400		-4200
Segment margin				65400		61600		-3800
Less: Common Fixed cost				29400		25400		-4000
Net income				36000		36200		200
Effect on profit is 200
Increase
Req 3-b	YES, POP shall be drpped