Question

The president of Ravens Inc. attended a seminar about the contribution margin model and returned to her company full of enthusiasm about it. She requested that last year’s traditional model income statement be revised, and she received the following report: Division Total Company A B C Sales $ 472,000 $ 184,000 $ 124,000 $ 164,000 Variable expenses 262,000 108,000 66,000 88,000 Contribution margin $ 210,000 $ 76,000 $ 58,000 $ 76,000 Fixed expenses 166,000 52,000 66,000 48,000 Net income (loss) $ 44,000 $ 24,000 $ (8,000 ) $ 28,000 The president was told that the fixed expenses of $166,000 included $91,500 that had been split evenly between divisions because they were general corporate expenses. After looking at the statement, the president exclaimed, "I knew it! Division B is a drag on the whole company. Close it down!"

Required: a. Evaluate the president's remark. The president's remark ignores the misleading result of arbitrarily allocated fixed expenses. The president's remark ignores the misleading result of arbitrarily allocated variable expenses.

b. Calculate what the company's net income would be if Division B were closed down.

c. What is the policy statement related to the allocation of fixed expenses. Never arbitrarily allocate fixed expenses. Never arbitrarily allocate variable expenses.

Answer 1

The Report received by the President of Ravens Inc is as under

Ravens Inc
Performance of Divisions
	As Received by the President
Particulars	Total	A	B	C
Sales	4,72,000	1,84,000	1,24,000	1,64,000
Variable Expenses	2,62,000	1,08,000	66,000	88,000
Contribution Margin	2,10,000	76,000	58,000	76,000
Fixed Expenses	1,66,000	52,000	66,000	48,000
Net Income / (Loss)	44,000	24,000	-8,000	28,000

Based on the report received the president observed that Division B has a Loss of 8,000 and exclaimed, "I knew it! Division B is a drag on the whole company. Close it down!. However the President ignored the information that  "fixed expenses of $166,000 included $91,500 that had been split evenly between divisions because they were general corporate expenses" The Allocation of General Corporate Expenses for Division B was $ 30,500. If we do not allocate / Split the expenses then all the Division will be in profit including Division B.

The performance of the Division before the allocation of General Corporate Expenses of $ 91,500 and Performance of the Company as a Whole is as under.

Ravens Inc
Performance of Divisions
	Ignoring General Corporate Expenses from Divison Performance
Particulars	Total	A	B	C
Sales	4,72,000	1,84,000	1,24,000	1,64,000
Variable Expenses	2,62,000	1,08,000	66,000	88,000
Contribution Margin	2,10,000	76,000	58,000	76,000
Fixed Expenses (Pertaining to Division) - as per Note 1 Below	74,500	21,500	35,500	17,500
Net Income / (Loss)	1,35,500	54,500	22,500	58,500
Fixed Expenses - General Corporate Expenses	91,500
Net Income of the Company	44,000
Note 1
Particulars	Total	A	B	C
Fixed Expenses - As given in report to president	1,66,000	52,000	66,000	48,000
Less : Fixed Expenses - General Corporate Expenses	91,500	30,500	30,500	30,500
Fixed Expenses (Pertaining to Division)	74,500	21,500	35,500	17,500

B - Calculation of  the Company's net income if Division B is closed Down is as under

Ravens Inc
Performance of Divisions
	Ignoring General Corporate Expenses from Divison Performance
Particulars	Total	A	B - Closed Down	C
Sales	3,48,000	1,84,000		1,64,000
Variable Expenses	1,96,000	1,08,000		88,000
Contribution Margin	1,52,000	76,000	-	76,000
Fixed Expenses (Pertaining to Division) -	39,000	21,500		17,500
Net Income / (Loss)	1,13,000	54,500	-	58,500
Fixed Expenses - General Corporate Expenses	91,500
Net Income of the Company	21,500

if the Division B is closed down then the Net Income of the Company will be $ 21,500 reduced from $ 44,000 i.e. reduction of $ 22,500 which is the Actual Net Income of Division B.

C. Policy Statement related to allocation of fixed expenses are Fixed expenses pertaining to General Corporate Expenses will always be incurred till the Company is in existence and hence such expenses allocations should be excluded during policy decisions like Closing down of a Particular Divisions. More the revenue and Contribution margins, more will be the overall Profits (Net Income ) of the Company. Per unit Fixed expenses will reduce on higher revenue of the Company.