Question

Smith Corporation runs two convenience stores, one in Chicago and one in Denver. Operating income for each store in 2019 is as follows. Each store faces different competitive challenges. In a senior management meeting, you make the following statement, "we face two options: a) keep both stores open and try to increase profits in Denver or b) close the Denver store and keep the Chicago store.”

Your statement is based on an analysis where equipment has a zero disposal value and leased on an annual contract. A further estimate is that sales, product mix and variable cost in Chicago and Denver are approximately the same for the foreseeable future. Allocated corporate cost will decrease by $30,000 if the Denver store is closed.

Requirement:

Prepare two reports in proper decision-making format on separate sheets showing the two options. Write a one-page memo supporting your decision, a or b, assuming profit maximization and qualitative issues are taken into consideration in making the decision. In answering take into consideration the careful discussion we had in class regarding the use of the contribution margin ratio in decision-making and the best approach in serving a customer/client.

	Chicago	Denver
Revenue	$       1,070,000	$   860,000
Operating expenses
Cost of goods sold (all variable)	750,000	660,000
Store security system (contract, avoidable)	90,000	75,000
Labor costs (paid on an hourly basis)	42,000	42,000
Equipment lease (contract, avoidable)	25,000	22,000
Utilities (heating, cooling, all variable)	43,000	46,000
Allocated corporate overhead	50,000	40,000
Total operating expenses	1,000,000	885,000
Operating income (loss)	$            70,000	$          (25,000)

Turn in order:

1. Memo
2. Option a
3. Option b

For option A and B, please include contribution margin and contribution margin percentage,

Answer 1

Solution

Smith Corporation

Option A –

Keep both store open

Contribution margin format income statement:

	Chicago Store	Denver Store	Total
Revenue	$1,070,000	$860,000	$1,930,000
Variable cost of goods sold	$750,000	$660,000	$1,410,000
Variable labor costs	$42,000	$42,000	$84,000
Variable Utilities	$43,000	$46,000	$89,000
total variable costs	$835,000	$748,000	$1,583,000
Contribution Margin	$235,000	$112,000	$347,000
Avoidable fixed costs:
Store security system	$90,000	$75,000	$165,000
Equipment lease	$25,000	$22,000	$47,000
total avoidable fixed costs	$115,000	$97,000	$212,000
Store Margin	$120,000	$15,000	$135,000
Allocated corporate overhead	$50,000	$40,000	$90,000
Operating Income	$70,000	($25,000)	$45,000

Contribution margin and contribution margin percentage –

Chicago Store

Contribution margin = $235,000

Contribution margin percentage = 235,000/1,070,000 = 21.96%

Denver Store

Contribution margin = $112,000

Contribution margin percentage = 112,000/860,000 = 13.02%

Option B –

Close the Denver Store and Keep the Chicago Store

Contribution margin format income statement:

	Chicago Store	Denver Store	Total
Revenue	$1,070,000	0	$1,070,000
Variable cost of goods sold	$750,000	0	$750,000
Variable labor costs	$42,000	0	$42,000
Variable Utilities	$43,000	0	$43,000
total variable costs	$835,000	0	$835,000
Contribution Margin	$235,000	0	$235,000
Avoidable fixed costs:
Store security system	$90,000	0	$90,000
Equipment lease	$25,000	0	$25,000
total avoidable fixed costs	$115,000	0	$115,000
Store Margin	$120,000	0	$120,000
Allocated corporate overhead	$50,000	$10,000	$60,000
Operating Income	$70,000	($10,000)	$60,000

Contribution margin –

Chicago Store $235,000

Denver Store = 0

Contribution margin percentage –

Chicago Store = 235,000/1,070,000 = 21.96%

Denver store =0

Memo –

Considering the contribution format income statement for both options, the operating income for Option B, $60,000 is higher compared to Option A, $45,000.

Basing on the operating income, the company’s operating income would increase if the Denver Store is closed.

However, considering the contribution margin and segment margin analysis, the Denver Store earns a contribution margin of $112,000, about 13% contribution margin store. As per the contribution margin analysis, any unit or service or store should be retained or continued operations as long as it earns a contribution margin. Hence, Denver Store should be continued and not closed.

Also, though the Denver Store earns a store (segment) margin of $15,000, the Store incurs loss of $25,000 owing to the presence of allocated corporate overhead of $40,000. But closing down the Denver store results in decrease in allocated overhead cost by $30,000, which results in increase in operating income by $15,000 (60,000 – 45,000). Basing, on this analysis, the Denver Store should be closed. The company’s decision would to go with Option B.