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 $300,000 $200,000 120,000 $900,000 595,000 Less: Variable expenses 225,000 250,000 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 20% 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? $ 157,500 x For the plank line? $ 76,000 x 2. Which alternative (keep or drop the parquet product line) is now more cost effective and by how much? Keep by $ 1,500 x Feedback Check My Work 1. Look at contribution margin and adjust for dropping product line. 2. Set up four columns. First column lists the income statement information starting with contribution margin. Second and third columns are for alternatives, keep or drop, and list all amounts. Fourth column is the differential amount to keep.

Answer 1

Solution:

Current Situation

	Strip	Plank	Parquet	Total
Sales Revenue	4,00,000	2,00,000	3,00,000	9,00,000
Less: Variable Expenses	2,25,000	1,20,000	2,50,000	5,95,000
Contribution Margin	1,75,000	80,000	50,000	3,05,000
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
Total Direct Fixed Expenses	55,000	40,000	60,000	1,55,000
Segment Margin	1,20,000	40,000	(10,000)	1,50,000

If Parquet product line is discontinued, 80% of the Parquet’s Machine rent will be discontinued

= 80% of $30,000 = $24,000

Also, 100% of Supervision salaries of Parquet will be discontinued = $5,000

Also, there will be reduction of Sales of Strip and Plank by 20%

New sales of Strip = $400,000 - 20% = $320,000
New Variable cost of Strip = $225,000 – 20% = $180,000

New sales of Plank = $200,000 – 20% = $160,000
New Variable cost of Plank = $120,000 – 20% = $96,000

Also, the variable cost will be reduced proportionately.

	Strip $	Plank $	Parquet $	Total $
Sales Revenue	3,20,000	1,60,000	-	4,80,000
Less: Variable Expenses	1,80,000	96,000	-	2,76,000
Contribution Margin	1,40,000	64,000	-	2,04,000
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 Fixed Expenses	55,000	40,000	31,000	1,26,000
Segment Margin = Contribution Margin - Total Direct Fixed Expenses	85,000	24,000	(31,000)	78,000

Note: Parquet’s Machine rent $6,000 and Depreciation $25,000 being irrelevant fixed cost will be charged in spite of discontinuing the Parquet product line.

Solution 1) If the Parquet product line is dropped, the contribution margin for the Strip line will be $140,000.

If the Parquet product line is dropped, the contribution margin for the Plank line will be $64,000.

Solution 2)

	Keep Parquet Product Line	Drop Parquet Product Line	Differential = Drop - Keep
Sales Revenue	9,00,000.00	4,80,000.00	(4,20,000.00)
Less: Variable Expenses	5,95,000.00	2,76,000.00	(3,19,000.00)
Contribution Margin	3,05,000.00	2,04,000.00	(1,01,000.00)
Less: Direct Fixed Expenses
Machine Rent	55,000.00	31,000.00	(24,000.00)
Supervision	30,000.00	25,000.00	(5,000.00)
Depreciation	70,000.00	70,000.00	-
Total Direct Fixed Expenses	1,55,000.00	1,26,000.00	(29,000.00)
Segment Margin	1,50,000.00	78,000.00	(72,000.00)

Alternative of Keeping Parquet Product Line is more cost effective as it increases the total profits of the company by $72,000.