Question

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 46,000 units and sold 42,000 units.

Variable costs per unit:
Manufacturing:
Direct materials	$	25
Direct labor	$	20
Variable manufacturing overhead	$	2
Variable selling and administrative	$	4
Fixed costs per year:
Fixed manufacturing overhead	$	644,000
Fixed selling and administrative expense	$	388,000

The company sold 31,000 units in the East region and 11,000 units in the West region. It determined that $200,000 of its fixed selling and administrative expense is traceable to the West region, $150,000 is traceable to the East region, and the remaining $38,000 is a common fixed expense. 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.

11a. What would have been the company’s absorption costing net operating income (loss) if it had produced and sold 42,000 units? You do not need to perform any calculations to answer this question.

11b. If the company produces 4,000 fewer units than it sells in its second year of operations, will absorption costing net operating income be higher or lower than variable costing net operating income in Year 2?

11c. Prepare a contribution format segmented income statement that includes a Total column and columns for the East and West regions.

11d. 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 $46,000 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?

11e. Assume the West region invests $36,000 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

Answer 11(a):

Given that this is company's first year of operation (Beginning inventory = $0). If the company had produced and sold 42,000 units, its absorption costing net operating income (loss), would have been same as net operating income (loss) as per variable costing system.

If it had produced and sold 42,000 units, loss under both methods would have been ($24,000) as calculated below:

Answer 11(b):

If the company produces 4,000 fewer units than it sells in its second year of operations, absorption costing net operating income will be lower than variable costing net operating income in Year 2.

In first year of operation the company has Ending FG inventory of 4,000 units. The valuation of ending FG inventory will higher in absorption costing by fixed manufacturing overhead per unit ($ 644,000 /46,000 = ) $14 than the valuation under variable costing.

As in 2nd year of operation, production is 4,000 fewer units than sales (hence no ending inventory), the higher valuation of finished goods (by amount of 4,000 * $14=$56,000) in its beginning FG inventory will reduce the net operating income under absorption and hence it will be lower than variable costing net operating income.

Answer 11(c):

Answer 11(d):

Profit Impact of dropping West region =- $50,800 - (-$24,000) = -$26,800

It has increased loss by $26,800

Net Impact can also be calculated by:

Loss of contribution from west region net of traceable fixed cost = $264,000 - $200,000 =$64,000

Increase in contribution from east region from 5% increase in sales = (31,000 * 5%) * $24 =$37,200

Impact on profit/loss = $32,550 - $37,200 = ($26,800)

Answer 11(e):

Net Increase in sales quantity = 11,000 * 20% =2,200

Increase in contribution = 2,200 * $24 = $52,800

Less, advertisement cost = $36,000

Profit Impact = $52,800 - $36,000 = $16,800