Question

Tracey Douglas is the owner and managing director of Heritage Garden Furniture Ltd., a South African company that makes museum-quality reproductions of antique outdoor furniture. Tracey would like advice concerning the advisability of eliminating the model C3 lawn chair. These lawn chairs have been among the company's best-selling products, but they seem unprofitable. A condensed statement of operating income for the company and for the model C3 lawn chair for the quarter ended June 30 follows: Model Lawn Char All Products R2.200,000 R8,600,000 Cost of sales: Fringe benefits 20% of direct labour) Variable manufacturing overhead Building and maince Depreciation Total cost of sales 1.709 400 4.995,600 Gross margin 490.000 3.603.400 Seling and administrative expenses Product managers Sales commissions (5% of sales) Fringe benefits (20% of salaries and commissions) General administrative expenses Total selling and administrative expenses Net operating income foss) R (109.520) R1,109.400 *The currency in South Africa is the rand, denoted here by R. The following additional data have been supplied by the company: a Direct labour is a variable cost at Heritage Garden Furniture. All of the company's products are manufactured in the same facility and use the same equipment. Building rent, maintenance, and depreciation are allocated to products using various bases. The equipment does not wear out through use; it eventually becomes obsolete. There is ample capacity to fill all orders Dropping the model C3 lawn chair would have no effect on sales of other product lines. Inventories of work in process or finished goods are insignificant Shipping costs are traced directly to products. General administrative expenses are allocated to products on the basis of sales dollars. There would be no effect on the total general administrative expenses if the model C3 lawn chair were dropped. If the model C3 lawn chair were dropped, the product manager would be laid off. Required: 14 At current level of sales, compute the effect of net operating income if the Model C3 lawn chair is dropped net operating income by R

Answer 1

Requirement 1a: Compute increase or decrease in operating income as follows

Particulars	Amount
Lost sales revenue	R 2,200,000
Total avoidable costs	R 1,788,120
Decrease in operating income	R 411,880

Notes: compute total avoidable costs as follows

Particulars	Amount
Direct material	R 880,000
Direct labor	R 528,000
Direct labor - Fringe benefits	R 105,600
Variable manufacturing overhead	R 26,400
Product manger's salary	R 72,600
Sales commission	R 110,000
Sales salaries - Fringe benefits	R 36,520
Shipping	R 29,000
Total avoidable costs	R 1,788,120

Requirement 1b: No, the company should not drop the product as it would result in decreased operating income to the extent of R 411,880.

Requirement 2: Compute the sales volume as follows

Break-even sales volume = Fixed costs c Contribution margin ratio

= R 87,120 ÷ 22.68%

= R 384,127.

Notes: Compute contribution margin ratio as follows

Particulars	Amount	Amount
Sales revenue		R 2,200,000
Variable costs
Direct material	R 880,000
Direct labor	R 528,000
Direct labor - Fringe benefits	R 105,600
Variable manufacturing overhead	R 26,400
Sales commission	R 110,000
Fringe benefits (110,000 × 20%)	R 22,000
Shipping	R 29,000
Total variable costs		R 1,701,000
Contribution margin		R 499,000
Contribution margin ratio (499,000 ÷ 2,200,000)	22.68%

Compute total fixed costs as follows

Particulars	Amount
Product manger's salary	R 72,600
Fringe benefits (72,600 × 20%)	R 14,520
Total fixed costs	R 87,120