Question

Advanced Electronics Ltd (Advanced) manufactures and sells high-end electronic components. Three major product lines, namely, HW-01, HW-02 and HW-03 are now being reviewed by the CEO. The following is the contribution margin income statement of the three products for year ended 31 December 2019: HW-01 HW-02 HW-03 $ $ $ Sales 250,000 140,000 75,000 Cost of goods sold 87,500 70,000 33,750 Variable costs 12,500 25,000 3,750 Contribution margin 150,000 45,000 37,500 Fixed costs Salaries 30,000 30,000 17,500 Marketing 10,000 7,500 5,000 Depreciation – Property, plant and equipment 15,000 12,500 5,000 Warehouse rent 11,644 6,520 3,493 Insurance 5,000 2,250 1,500 General administration 5,829 3,264 1,749 Allocated corporate-office costs 26,882 15,054 8,064 Total fixed costs 104,355 77,088 42,306 Operating income/(loss) 45,645 (32,088) (4,806) The CEO is concerned about the performances of the HW-02 and HW-03 product lines. The two product lines have been struggling with poor financial results in the past two years. Given that there is no sign of turnaround in 2020, the CEO is considering dropping the two products. The management accountant of Advanced has analyzed the costs incurred for the three product lines in 2019. The following are her findings:

1. Variable costs are distribution and other selling expenses incurred specifically for the sales of each product.

2. Salaries are paid to employees working directly on the product. All of the employees working for the product line would be laid off if the product is dropped.

3. Marketing are advertising and promotion expenses that are specific to each product line.

4. Depreciation – Property, plant and equipment are depreciation on the fixed assets acquired for manufacturing all three products. These fixed assets have a remaining useful life of around two years with zero disposal value. All unused assets will remain idle.

5. Warehouse rent expense is for rental of a warehouse under a two-year lease agreement expiring in 2021. The rental amount is allocated to the product lines on the basis of sales revenue. Advanced will continue to rent the warehouse till the lease expires as early termination will involve a significant penalty.

6. The insurance expense is for insurance carried on inventories within each of the three product lines. The insurance premium is expected to be decreased proportionately if the inventories of certain product lines are eliminated.

7. Advanced allocates general administrative expense to product lines based on sales revenue.

8. Advanced allocates corporate-office costs to product lines on the basis of sales revenue. By dropping the HW-02 product line, the company can reduce overall corporate overhead costs by $10,000 per year.

Required:

(a) Advise the CEO whether it a good decision for Advanced to drop both the HW-02 and HW-03 product lines. Explain with calculations.

(b) Which item of the costs incurred in the HW-02 and HW-03 product lines is irrelevant in the analysis? Why is it irrelevant?

(c) What other factors should the management of Advanced consider before making a decision?

Answer 1

a. No, it is not a good decision to drop both HW-2 and HW-3 product lines, as overall profit will decrease by $ 8,750.

	HW-02	HW-03	Total
Contribution Margin Lost	$ (45,000)	$ (37,500)	$ (82,500)
Costs avoided
Salaries	30,000	17,500	47,500
Marketing costs	7,500	5,000	12,500
Insurance	2,250	1,500	3,750
Total direct costs avoided	39,750	24,000	63,750
	(5,250)	(13,500)	(18,750)
Corporate office costs		10,000	10,000
Financial advantage ( disadvantage) of eliminating the product lines	(5,250)	(3,500)	(8,750)

b. Depreciation expense is irrelevant since it is a sunk cost.

Warehouse rent is irrelevant, as the lease cannot be broken without penalty, and therefore the management has decided to continue to rent the warehouse. Therefore, it is an unavoidable cost.

Allocated general administrative expenses will continue regardless of whether the products are dropped or not. Hence, they are irrelevant.

Allocated corporate office costs are relevant only up to $ 10,000, as that amount can be avoided by dropping HW-02.

c. Other factors to be considered:

• What to do with the facilities ( including the idle workforce) rendered idle by dropping the two product lines.
• The contribution made by the two products in absorbing the allocated fixed costs.
• Customers of HW-01 might stop patronising Advanced, as some of them might also have been customers of HW-02 or HW-03 or both. Therefore, there could be decreased sales of HW-01 as a result.