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		Plank		Parquet		Total
Sales revenue	$400,000		$200,000		$300,000		$900,000
Less: Variable expenses	225,000		120,000		250,000		595,000
Contribution margin	$175,000		$ 80,000		$ 50,000		$305,000
Less direct fixed expenses:
Machine rent	(5,000)		(20,000)		(30,000)		(55,000)
Supervision	(15,000)		(10,000)		(5,000)		(30,000)
Depreciation	(35,000)		(10,000)		(25,000)		(70,000)
Segment margin	$120,000		$ 40,000		$ (10,000)		$150,000

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 22% 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?
  by $

Answer 1

Solution

Hickory Company

Analysis of alternative – Drop parquet product line which would reduce the sales of strip line by 22% and sales of plank line by 20%:

Revised sales of strip line – 400,000 – 22% x 400,000 = $312,000

Revised sales of plank line – 200,000 – 20% x 200,000 = $160,000

Contribution format income statement:

Hickory Company
Contribution margin income statement
	Strip	Plank	Parquet	Total
Sales	$312,000	$160,000	0	$472,000
Less: Variable expenses	$175,500	$96,000	0	$271,500
Contribution margin income statement	$136,500	$64,000	0	$200,500
Less: Direct fixed expenses
machine rent	$5,000	$20,000	6,000	$31,000
Supervision	$15,000	$10,000		$25,000
Depreciation	$35,000	$10,000	$25,000	$70,000
Total direct expenses	$55,000	$40,000	$31,000	$126,000
Segment margin	$81,500	$24,000	($31,000)	$74,500

The contribution margin for the strip line is $136,500.

The contribution margin for the plank line is $64,000.

Note:

The unavoidable machine rent for parquet line = 30,000 x 20% = $6,000

The depreciation expense of parquet line is unavoidable.

The variable expenses are computed based on the original sales.

• Strip line = 312,000 x 225,000/400,000 = $175,500
• Plank line = 160,000 x 120,000/200,000 = $96,000

The resulting decrease in sales percentages for strip line and plank line due to dropping of parquet product line caused a reduction in contribution margin of strip line and parquet line.

Also, the company as a whole would lose the contribution margin of parquet product line, $50,000.

The combined segment margin is $74,500, which is less by $75,500 from the original segment margin of $150,000. Hence, dropping parquet line will drop segment margin by $75,500.

Hence, the cost effective decision is to keep parquet product line.