Question

Test company supplies furniture to three local retailers, Hanson, Penner, and Yorkville Inc. The following exhibit presents representative revenues and costs of Test by customers for the year 2019. Additional information on Test’s costs for different activities at various levels of the cost hierarchy is as follows:

	Hanson	Penner	Yorkville	Total
Sales	$750,000	$360,000	$340,000	$1,450,000
Cost of goods sold	470,000	260,000	230,000	$960,000
Materials-handling labour	47,000	22,000	48,000	$117,000
Materials-handling equipment (Cost written off as amortization)	11,000	6,000	10,000	$27,000
Rent	16,000	8,000	19,000	$43,000
Marketing support	12,000	9,000	11,000	$32,000
Purchase orders and delivery processing	13,000	7,000	12,000	$32,000
General administration	20,000	12,000	16,000	$48,000
Total operating costs	589,000	324,000	346,000	$1,259,000
Operating income	$161,000	$36,000	-$6,000	$191,000

1. Materials-handing labour costs vary with the number of units of furniture shipped to customers.

2. Different areas of the warehouse stock furniture for different customers. Materials-handling equipment in an area and amortization costs on the equipment are identified with individual customer accounts. Any equipment not used remains idle. The equipment has a one-year useful life and zero disposal price.

3. Test allocates rent to each customer account on the basis of the amount of warehouse space occupied by the products to be shipped to that customer.

4. Marketing costs vary with the number of sales visits made to customers.

5. Purchase order costs vary with the number of purchase orders received; delivery processing costs vary with the number of shipments made.

6. Test allocates fixed general administration costs to customers on the basis of dollar sales made to each customer.

Required:

1. What are the relevant costs and relevant revenues when Test company considers dropping the Yorkville Inc. as a custom because of COVID-19?

2. Please calculate the operating income(loss) if Test drop Yorkville Inc. as a custom.

3. Should Test keep Yorkville as a customer or just drop it? Why?

Answer 1

1 Only variable cost are relevant Common cost are fixed cost which is unavoidable and not relevant for decision making Sales Relevant revenue Cost of goods sold Relevant costs Materials-handling labor costs Relevant costs Marketing support Relevant costs Purchase order and delivery processing Relevant costs Material handling equipment Relevant costs Variable costs Variable costs Variable costs Variable costs Avoidable cost 2 Operating Income if Yorkville is dropped $162,000 Evaluation of continue or discontinue Customer Continue Yorkville Drop Yorkville Differential Analysis (Decrease) -$340,000 $1,450,000 $1,110,000 Sales Variable expenses: Cost of goods sold Material handling labor costs Marketing support Purchase order and delivery processing Total variable expenses Contribution margin Fixed cost: Material handling equipment Rent General Administration Total Fixed cost Net Operating Income $960,000 $117,000 $32,000 $32,000 $1,141,000 $309,000 $730,000 $69,000 $21,000 $20,000 $840,000 $270,000 -$230,000 -$48,000 $11,000 -$12,000 $301,000 -$39,000 $27,000 $43,000 $48,000 $118,000 $191,000 $17,000 $43,000 $48,000 $108,000 $162,000 -$10,000 $0 $0 -$10,000 -$29,000 There is decrease in Operating Income if Yorkville is dropped Decrease in Net Operating Income -$29,000 3 Yorkville should be retained as Customer since there is drop in net operating income if dropped The contribution margin is higher than avoidable fixed cost hence dropping customer is unprofitable Common fixed cost are irrelevant cost in decision making since they are sunk cost The customer should be dropped only if contribution margin is lower than avoidable fixed cost