Question

[The following information applies to the questions displayed below.]

Diego Company manufactures one product that is sold for $75 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 57,000 units and sold 52,000 units.

Variable costs per unit:
Manufacturing:
Direct materials	$	25
Direct labor	$	18
Variable manufacturing overhead	$	3
Variable selling and administrative	$	5
Fixed costs per year:
Fixed manufacturing overhead	$	627,000
Fixed selling and administrative expenses	$	645,000

The company sold 36,000 units in the East region and 16,000 units in the West region. It determined that $310,000 of its fixed selling and administrative expenses is traceable to the West region, $260,000 is traceable to the East region, and the remaining $75,000 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.   

Question 1. 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 $22,000 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?

Question 2: Assume the West region invests $47,000 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?

Answer 1

Solution 1:

Divisional contribution format income statement - Diego Company
Particulars	Total Company	Divisions
		East	West
Sales	$3,900,000.00	$2,700,000.00	$1,200,000.00
Variable Expenses	$2,652,000.00	$1,836,000.00	$816,000.00
Contribution Margin	$1,248,000.00	$864,000.00	$384,000.00
Traceable Fixed Expenses	$570,000.00	$260,000.00	$310,000.00
Divisional net operating income	$678,000.00	$604,000.00	$74,000.00
Common Fixed Expense	$702,000.00
Overall Net Operating Income	-$24,000.00

Contribution format income statement - Diego Company -Year 2 (West division eliminated)
Particulars	Amount
Sales (37800 * $75)	$2,835,000.00
Variable expenses (37800 * $51)	$1,927,800.00
Contribution margin	$907,200.00
Fixed manufacturing overhead	$627,000.00
Fixed selling and adminstrative expenses ($260000+$75000)	$335,000.00
Net Income	-$54,800.00

Profit impact on dropping West region in year 2 = -$54800 - (-$24,000) = -$30,800

Hence profit will decrease by $30,800 on dropping west region

Solution 2:

Divisional contribution format income statement - Diego Company (After incresing expense on advertisement in West Division)
Particulars	Total Company	Divisions
		East	West
Sales	$4,140,000.00	$2,700,000.00	$1,440,000.00
Variable Expenses	$2,815,200.00	$1,836,000.00	$979,200.00
Contribution Margin	$1,324,800.00	$864,000.00	$460,800.00
Traceable Fixed Expenses	$617,000.00	$260,000.00	$357,000.00
Divisional net operating income	$707,800.00	$604,000.00	$103,800.00
Common Fixed Expense	$702,000.00
Overall Net Operating Income	$5,800.00

Profit imapct of pursuing advertising compaign = $5,800 - (-$24,000) = $29,800

Hence profit will increase by $29,800 by doing advertising compaign.