Question

ABC Retail is deciding whether or not to close a store that has negative operating income.

			ALBERTA Store		ONTARIO Store		Total
Revenues			1,000,000.00		625,000.00		1,625,000.00
Operating Costs
	Cost of Goods Sold		700,000.00		450,000.00		1,150,000.00
	Lease		85,000.00		90,000.00		175,000.00
	Hourly Labour Costs		40,000.00		42,000.00		82,000.00
	Equipment Amortization		35,000.00		40,000.00		75,000.00
	Allocated Corporate Overhead		45,000.00		40,000.00		85,000.00
		Total Operating Costs	905,000.00		662,000.00		1,567,000.00
Operating Income			95,000.00		-37,000.00		58,000.00
Notes:		- Lease may be cancelled at any time without additional expenses
		- Equipment in Ontario store has a salvage value of $0
		- Corporate Overhead will decrease by $35,000 if Ontario Store is closed
		Should Ontario store be closed? Why ?

Answer 1

COMPARATIVE ANALYSIS STATEMENT :

		Keep Store	Drop Store
	Revenue	625000	0
Less :	Variable costs
	Cost of Goods Sold	450000	0
	Hourly Labour Costs	42000	0
Less:		133000	0
	Direct Fixed costs (Avoidable)
	Lease	90000	0
	Allocated Corporate Overhead	35000	0
	Common Fixed costs (Unavoidable/Sunk Costs)
	Equipment Amortization Allocated	0	40000
	Allocated Corporate Overhead	0	5000
	Net Operating Income	8000	-45000

Analysis :

While making keep or drop the decision of unprofitable segment, entity should not consider unavoidable or allocated or sunk costs

1. In the given case, after removing the common fixed costs the ONTARIO STORE is showing a positive contribution margin and if the entity chooses to drop this store the positive contribution $8000 towards common fixed costs will be lost and then the total loss will be the amount incurred for common fixed costs i.e., 40000+5000 = 45000, i.e., the loss will increase from $37000 to $45000 and it is not beneficial to the entity dropping the ONTARIO STORE.
2. While making these types of decisions only relevant costs are to be considered.
3. If still entity decides to drop the store, it has to consider the negative impact on Sales of ALBERTA STORE and also on employee cost due to layoffs.

Conclusion :

Since the ONTARIO STORE has a positive contribution even after considering avoidable fixed costs it is better not to drop the store

(Hope you will understand this, please give your valuable feedback and if you have any query regarding this kindly mention in comment section)