Question

Diego Company manufactures one product that is sold for $78 per unit in two geographic regions—the East and West regions. The following information pertains to the company’s first year of operations in which it produced 49,000 units and sold 44,000 units.

Variable costs per unit:
Manufacturing:
Direct materials$28
Direct labor$14
Variable manufacturing overhead$4
Variable selling and administrative$6
Fixed costs per year:
Fixed manufacturing overhead$686,000
Fixed selling and administrative expenses$510,000

The company sold 32,000 units in the East region and 12,000 units in the West region. It determined that $230,000 of its fixed selling and administrative expenses is traceable to the West region, $180,000 is traceable to the East region, and the remaining $100,000 is a common fixed cost. The company will continue to incur the total amount of its fixed manufacturing overhead costs as long as it continues to produce any amount of its only product.

Diego is considering eliminating the West region because an internally generated report suggests the region’s total gross margin in the first year of operations was $14,000 less than its traceable fixed selling and administrative expenses. Diego believes that if it drops the West region, the East region's sales will grow by 5% in Year 2. Using the contribution approach for analyzing segment profitability and assuming all else remains constant in Year 2, what would be the profit impact of dropping the West region in Year 2?

How much will the profit increase/decrease by?

Assume the West region invests $39,000 in a new advertising campaign in Year 2 that increases its unit sales by 20%. If all else remains constant, what would be the profit impact of pursuing the advertising campaign?

How much will the profit increase/decrease by?

Answer 1

Existing scenario
Net income:
			East Region	West Region	Total
Units sold			32000	12000	44000
Sales	at $78 per unit		2496000	936000	3432000
Less: Variable cost
Direct materials		at $28 per unit	896000	336000	1232000
Direct labor		at $14 per unit	448000	168000	616000
Variable manufacturing overhead
At $4 per unit			128000	48000	176000
Variable selling and administrative
At $6 per unit			192000	72000	264000
			1664000	624000	2288000
Contribution margin			832000	312000	1144000
Less:Fixed selling & admin expense			230000	180000	410000
Gross margin			602000	132000	734000
Less:Common expenses
Fixed selling & admin expense					100000
Fixed manufacturing overhead					686000
Net loss					-52000
If we drop West region:
Net income:
Units sold		(32000*1.05)	33600
Sales	at $78 per unit		2620800
Less: Variable cost
Direct materials		at $28 per unit	940800
Direct labor		at $14 per unit	470400
Variable manufacturing overhead
At $4 per unit			134400
Variable selling and administrative
At $6 per unit			201600
			1747200
Contribution margin			873600
Less:Fixed selling & admin expense			230000
Gross margin			643600
Less:Common expenses
Fixed selling & admin expense			100000
Fixed manufacturing overhead			686000
Net loss			-142400
If we drop west region,company's overll profit will decrease by $90400 (142400-52000)
If west region invest in new advertising campaign,
			East Region	West Region	Total
Units sold			32000	14400	44000
				(12000*1.20)
Sales	at $78 per unit		2496000	1123200	3619200
Less: Variable cost
Direct materials		at $28 per unit	896000	403200	1299200
Direct labor		at $14 per unit	448000	201600	649600
Variable manufacturing overhead
At $4 per unit			128000	57600	185600
Variable selling and administrative
At $6 per unit			192000	86400	278400
			1664000	748800	2412800
Contribution margin			832000	374400	1206400
Less:Fixed selling & admin expense			230000	219000	449000
				(180000+39000)
Gross margin			602000	155400	757400
Less:Common expenses
Fixed selling & admin expense					100000
Fixed manufacturing overhead					686000
Net loss					-28600
If west region invest in new advertising campaign, overall profit will increase by $23400 (52000-28600)