Structuring a Keep-or-Drop Product Line Problem with Complementary Effects Shown
ID: 2404505 • Letter: S
Question
Structuring a Keep-or-Drop Product Line Problem with Complementary Effects Shown below is a segmented income statement for Hickory Company's three wooden flooring product lines: Strip $400,000 225,000 $175,000 Plank $200,000 120,000 80,000 Total $900,000 595,000 $305,000 Parquet Sales revenue Less: Variable expenses Contribution margin Less direct fixed expenses $300,000 250,000 $50,000 (5,000) (15,000) (35,000) $120,000 (20,000) (10,000) (10,000) $40,000 (30,000) (5,000) (25,000) $ (10,000) (55,000) (30,000) (70,000) $150,000 Machine rent Supervision Depreciation Segment margin Hickory's management is deciding whether to keep or drop the parquet product line. Hickory's parquet flooring product line has a contribution margin of $50,000 (sales of $300,000 less total variable costs of $250,000). All variable costs are relevant. Relevant fixed costs associated with this line include 80% of parquet's machine rent and all of parquet's supervision salaries. In addition, assume that dropping the parquet product line would reduce sales of the strip line by 24% and sales of the plank line by 20%. All other information remains the same Required 1. If the parquet product line is dropped, what is the contribution margin for the strip line? For the plank line? 2. Which alternative (keep or drop the parquet product line) is now more cost effective and by how much? DropExplanation / Answer
1.) First we will find out the percentage of Variable Expense to Sales Revenue when Parquet line is in operation.
Particulars Strip Plank
1. Sales Revenue $ 400,000 $ 200,000
2. Variable Expenses $ 225,000 $ 120,000
3. Percentage of Variable Cost to Sales $225,000 X 100 $ 120,000 X 100
$400,000 $ 200,000
= 56.25 % = 60 %
Dropping the Parquet product line would reduce the sales of the Strip Line by 24% and sales of the Plank line by 20%. So, the new contribution will be as follows when Parquet lines gets dropped -
Particulars Strip Plank
1. New Sales Revenue $ 304,000 $ 160,000
2. Variable Expenses (% of Sales as calculated $ 171,000 $ 96,000
above )
3. Contribution Magin $ 133,000 $ 24,000
2.) It is mentioned in the question that the relevant fixed costs associated with this line include 80% of parquet's machine rent and all of parquet's supervision salaries. Therefore the fixed expenses that will continue even when parquet line is dropped will be as folows-
= 80 % of Parquet's Machine Rent + All of Parquet's Supervision Expenses
= 80% of $ 30,000 + $ 5,000
= $ 24,000 + $ 5,000
= $ 29,000
Total new contribution margin (from answer 1 above ) =$ 133,000 + $ 64,000
= $ 197,000
Total direct fixed expenses = Machine rent + Supervision + Depreciation
= ($5,000 + $20,000 + $24,000) +( $15,000 + $10,000 + $5,000 ) + ( $35,000+ $10,000+ $25,000)
= $49,000 + $30,000 + $70,000
= $149,000
Total Profit Margin = Total Contribution Margin - Total Direct Fixed Expenses
= $197,000 - $149,000
= $48,000
If we look at parquet it does have a positive contribution margin . This is important because the product is covering all of it's variable costs and it is contributing towards fixed costs.While the contribution margin is not high enough to cover all the fixed costs. Increasing the sales of parquet will increase contribution margin and lower the loss. Since the segment has positive contribution margin , continue the product.
If we discontinue parquet line , the sales of strip line and plank line will decline by 24% and 20% respectively, and will have a total profit margin of 48,000 , which is way worse then before.
Hence it is not advisable to drop the parquet line as it will reduce the sales of other two lines and the overall profit will also drop considerably by $102,000.