Question

Cornerstone Exercise 17.2 (Algorithmic)
Keep-Or-Drop Decision, Alternatives, Relevant Costs

Reshier Company makes three types of rug shampooers. Model 1 is the basic model rented through hardware stores and supermarkets. Model 2 is a more advanced model with both dry-and wet-vacuuming capabilities. Model 3 is the heavy-duty riding shampooer sold to hotels and convention centers. A segmented income statement is shown below.

		Model 1		Model 2		Model 3		Total
Sales		$275,000		$550,000		$621,000		$1,446,000
Less variable costs of goods sold		(98,000)		(154,840)		(330,400)		(583,240)
Less commissions		(6,000)		(39,500)		(18,000)		(63,500)
Contribution margin		$171,000		$355,660		$272,600		$799,260
Less common fixed expenses:
Fixed factory overhead								(395,000)
Fixed selling and administrative								(283,000)
Operating income								$121,260

While all models have positive contribution margins, Reshier Company is concerned because operating income is less than 10 percent of sales and is low for this type of company. The company’s controller gathered additional information on fixed costs to see why they were so high. The following information on activities and drivers was gathered:

						Driver Usage by Model
Activity	Activity Cost				Activity Driver	Model 1				Model 2				Model 3
Engineering		$76,000			Engineering hours		710				73				217
Setting up		179,000			Setup hours		12,800				12,300				29,217
Customer service		107,000			Service calls		14,300				1,580				19,217

In addition, Model 1 requires the rental of specialized equipment costing $20,500 per year.

3. What if Reshier Company can only avoid 182 hours of engineering time and 5,050 hours of setup time that are attributable to Model 1? How does that affect the alternatives presented in Requirement 2? Which alternative is more cost effective and by how much? Do NOT round interim calculations and, if required, round your answer to the nearest dollar.

Answer 1

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Part 1
			Model 1	Model 2	Model 3	Total
	Sales		$               275,000	$     550,000	$     621,000	$   1,446,000
	Less variable COGS		$               (98,000)	$   (154,840)	$   (330,400)	$     (583,240)
	Less commissions		$                  (6,000)	$     (39,500)	$     (18,000)	$       (63,500)
	Contribution margin		$               171,000	$     355,660	$     272,600	$       799,260
	Less traceable Fixed Expense:
	Engineering	Working-1	$               (53,960)	$       (5,548)	$     (16,492)	$       (76,000)
	Setting up	Working-1	$               (42,182)	$     (40,534)	$     (96,284)	$     (179,000)
	Equipment rental		$               (20,500)			$       (20,500)
	Customer service	Working-1	$               (43,596)	$       (4,817)	$     (58,587)	$     (107,000)
	Product margin		$                  10,762	$     304,761	$     101,238	$       416,760
	Less common Fixed Expense:
	Factory overhead	$395,000-$76,000-$179,000-$20,500				$     (119,500)
	Selling and admin. Expense	$283,000-$107,000				$     (176,000)
	Operating income					$       121,260
	Working-1
	Activity	Activity Cost	Activity Driver	Model 1	Model 2	Model 3	Total	Rate
	Engineering	$                                                                76,000	Engineering hours	710	73	217	1,000	$        76.00
	Setting up	$                                                              179,000	Setup hours	12,800	12,300	29,217	54,317	$          3.30
	Customer service	$                                                              107,000	Service calls	14,300	1,580	19,217	35,097	$          3.05
	Allocation:
	Activity	Rate	Model 1	Model 2	Model 3
	Engineering	$                                                                  76.00	$                  53,960	$          5,548	$       16,492
	Setting up	$                                                                     3.30	$                  42,182	$       40,534	$       96,284
	Customer service	$                                                                     3.05	$                  43,596	$          4,817	$       58,587
Part 2
	Since all traceable fixed expense assumed to be avoidable, dropping Model 1 will reduce
	operating income by $10,762.
Part 3			Model 1
	Sales		$               275,000
	Less variable COGS		$               (98,000)
	Less commissions		$                  (6,000)
	Contribution margin		$               171,000
	Less traceable Fixed Expense:
	Engineering	182 Hours*$76	$               (13,832)
	Setting up	5,050 Hours*$3.30	$               (16,665)
	Equipment rental		$               (20,500)
	Customer service	Working-1	$               (43,596)
	Product margin		$                  76,407
	In this case, Product margin is higher than alternative two by $76,407-$10,762=$65,645
	The best strategy in this case would be to focus on reducing other costs and using excess capacity in a productive way.