Question

Peter John Star, owner of The Big Star Hotel, is confused by the fully allocated financial statements that suggest The Big Star Hotel's lounge is losing money. As he sees it there are three alternatives:

1. Continue the lounge operation as is.

2. Close the lounge and expand the restaurant.

3. Lease the space to Philip, Inc., a management company.

The following table summarizes the Big Star Hotel's fully allocated monthly income statements.

Revenues	Rooms	Restaurant	Lounge	Total
	$250,000	$100,000	$40,000	$390,000
Departmental Expenses*	100,000	70,000	20,000	190,000
Departmental Profit	150,000	30,000	20,000	200,000
Allocated Overhead	100,000	25,000	30,000	155,000
Pretax income	$50,000	$5,000	($10,000)	45,000
Income Taxes				20,000
Net Income				$25,000

*All departmental expenses are assumed to be variable.

Additional Information:

1. Closing the lounge would reduce monthly overhead costs by $10,000. Leasing the lounge Philip, Inc., would reduce monthly overhead costs by $5,000

2. The Space can be leased to Philip, Inc., for 10 percent of sales. Philip, Inc. is a reputable operator, and Peter John believes that it will operate the lounge as effectively as The Big Star Hotel has done in the past. Annual forecasted lounge sales are expected to be $550,000.

3. If the lounge is closed, room profits are expected to decrease by 2 percent, while food departmental sales are expected to increase by 20 percent.

4. The cost to convert the lounge for alternative use is expected to be $60,000. Assume that the life of the equipment is five years, and that it will have no salvage value.

5. If the lounge is closed, the unneeded equipment can be sold on a contract over five years and $500 will be received each month.

Required:

Based on the above, advise Peter John Star. Use relevant numbers to support your recommendation.

Answer 1

	Existing Position of Peter John Star:
		Rooms	Restaurant	Lounge	Total
	Revenues	$250,000	$100,000	$40,000	$390,000
	Departmental Expenses*	100,000	70,000	20,000	190,000
	Departmental Profit/ Contribution	150,000	30,000	20,000	200,000
	P/V Ratio	60.00%	30.00%	50.00%	51.28%
	Allocated Overhead	100,000	25,000	30,000	155,000
	Pretax income	$50,000	$5,000	($10,000)	45,000
	Income Taxes				20,000
	Net Income				$25,000
	Peter John Star has three alternatives:
1	Continue to Lounge Operations as is.
2	Close the lounge and expand the restaurant.
3	Lease the space to Philip, Inc., a management company.
	Let's analyse the profit from all three alternatives by using CVP technique:
1	Continue to Lounge Operations as is.
	Revenue	40000
Less:	Variable Cost(Departmental Exp)	20000
	Contribution	20000
2	Close the lounge and expand the restaurant.
	Reduction in Overheads	10000
Less	Decrease in Room Profits	-1000
	(2% * 50000)
Add	Increase in Food Department Sale(contribution)	6000
	(20% * 30000)
Less	Increase in Amortisation cost of Equipment	-1000
	(60000/5/12)
Add	Revenue from sale of unneeded Equipment	500
	Net Benefit	14500
3	Lease the space to Philip, Inc., a management company.
	Reduction in Overheads	5000
Add:	Lease Revenue(monthly)	4583
	(550000*10%/12)
	Net Benefit	9583
	In view of above, it can be inferred that peter Star should continue to lounge operations as is.
Note:	Since, Overheads are fixed, therefore, irrelevant and not considered for decision making