Question

McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a new policy that if a product cannot earn a margin of at least 30 percent, it will be dropped. The margin is computed as product gross profit divided by reported product cost. Manufacturing overhead for year 1 totaled $915,000. Overhead is allocated to products based on direct labor cost. Data for year 1 show the following. Sales revenue Direct materials Direct labor Chairs $1,220,000 601,000 150,000 Desks $2,862,000 970,000 460,000 Required: a-1. Based on the CFO's new policy, calculate the profit margin for both chairs and desks. a-2. Which of the two products should be dropped? b. Regardless of your answer in requirement (a), the FO decides at the beginning of year 2 to drop the chair product. The company cost analyst estimates that overhead without the chair line will be $820,000. The revenue and costs for desks are expected to be the same as last year. What is the estimated margin for desks in year 2?

Answer 1

Answer-a(1):

Chairs 1,220,000 Desks 2,862,000 Sales revenue $ $ $ Direct material Direct labour Manufacturing overhead Total cost 601,000 $ 150,000 $ 225,000 $ 976,000 $ 970,000 460,000 690,000 2,120,000 $ Ć Gross profit $ 244,000 $ 742,000 Gross margin ratio 357

Note: Manufacturing overhead allocated to chairs = $915,000/($150,000+$460,000) × $150,000

                                                                                = $225,000

         Manufacturing overhead allocated to desks = $915,000/($150,000+$460,000) × $460,000

                                                                                = $690,000

Answer-a(2):

As the gross margin ratio of chairs is less as compared to desks, it should be dropped.

Answer-b:

Desks 2,862,000 Sales revenue $ Direct material Direct labour Manufacturing overhead Total cost $ $ $ $ 970,000 460,000 820,000 2,250,000 Gross profit $ 612,000 Gross margin ratio 27.20

The estimated margin for desks in year 2 is 27.20%