Chapter 13, Problem 27P

Effect of activity level and opportunity cost on segment elimination decision

Lenox Manufacturing Co. produces and sells specialized equipment used in the petroleum industry. The company is organized into three separate operating branches: Division A, which manufactures and sells heavy equipment; Division B, which manufactures and sells hand tools; and Division C, which makes and sells electric motors. Each division is housed in a separate manufacturing facility. Company headquarters is located in a separate building. In recent years, Division B has been operating at a net loss and is expected to continue to do so. Income statements for the three divisions for 2017 follow:

Required

1. a. Based on the preceding information, recommend whether to eliminate Division B. Support your answer by preparing companywide income statements before and after eliminating Division B.
2. b. During 2017, Division B produced and sold 20,000 units of hand tools. Would your recommendation in response to Requirement a change if sales and production increase to 30,000 units in 2018? Support your answer by comparing differential revenue and avoidable cost for Division B, assuming that it sells 30,000 units.
3. c. Suppose that Lenox could sublease Division B’s manufacturing facility for $160,000. Would you operate the division at a production and sales volume of 30,000 units, or would you close it? Support your answer with appropriate computations.

To determine

Identify whether Division B is eliminated or not.

Explanation of Solution

Special order decisions: Special order decisions include circumstances in which the board must choose whether to acknowledge abnormal customer orders. These requests or orders normally necessitate special dispensation or include a demand for lesser price.

Outsourcing: It can be termed as conveying all or part of an activity to a supplier or a provider. While outsourcing was initially limited to fundamental activities, it as of now invades the administration of numerous organizations.

Opportunity cost: Opportunity cost is the forfeit of certain benefits such as cost savings, incomes, which is surrendered by not picking an option. Opportunity costs are applicable in decisions where the acknowledgment of one option disqualifies the likelihood of selecting different alternatives.

Determine the contribution to profit

$\begin{array}{c}Contibutionto\mathrm{Pr}ofit=\left[\begin{array}{l}Sales\mathrm{Re}venue-Manufacturing\mathrm{Cos}ts-\\ \mathrm{Re}ntonFacility-UnitLevelSelling\&Ad\min \mathrm{Cos}ts-\\ DivisionLevelSelling\&Ad\min \mathrm{Cos}ts\end{array}\right]\\ =\left[\begin{array}{l}\$300,000-\$200,000-\$75,000-\$14,000-\\ \$20,000\end{array}\right]\\ =(\$9,000)\end{array}$

Therefore the contribution to profit is ($9,000).

Prepare the companywide income statement before and after eliminating Division B.

The company wide income statement before eliminating Division B is as follows:

Companywide Income Statement before Division B is eliminated
Sales	S2,550,000
Less: Cost of goods sold
Unit level manufacturing costs	$1,550,000
Rent on manufacturing facility	$310,000
Gross margin	$690,000
Less: Operating expenses
Unit level selling & administrative costs	$154,500
Division level fixed selling & administrative costs	$200,000
Headquarters facility-level costs	$150,000
Net income (loss)	$185,500

         Table (1)

The company wide income statement after eliminating Division B is as follows:

Companywide Income Statement after Division B is eliminated
Sales	$2,250,000
Less: Cost of goods sold
Unit level manufacturing costs	$ 1,350,000
Rent on manufacturing facility	$235,000
Gross margin	$665,000
Less: Operating expenses
Unit level selling & administrative costs	$140,500
Division level fixed selling & administrative costs	$180,000
Headquarters facility-level costs	$ 150,000
Net income (loss)	$194,500

Table (2)

From the results obtained above, the contribution to profit is negative at ($9,000). Hence the Division B should be eliminated.

Therefore, Division B should be eliminated.

To determine

Identify whether the recommendations in Requirement A changes if the units increased to 30,000 units by comparing Division B’s differential avoidable costs and revenue.

Explanation of Solution

Initiate by calculating the cost price per unit and the selling per unit that will change in respect to the quantity of units produced and traded. The result is divided with the total cost for respective group by 20,000 units to get cost per unit. The headquarters facility-level costs are not considered from the investigation since these costs are not avoidable.

Determine the selling price per unit

$\begin{array}{c}SellingPriceperunit=\left[\frac{Sales}{NumberofUnits}\right]\\ =\left[\frac{\$300,000}{20,000}\right]\\ =\$15\end{array}$

Therefore, the selling price per unit is $15.

Determine the unit level manufacturing costs

$\begin{array}{c}UnitLevelManufacturing\mathrm{Cos}ts=\left[\frac{Actual\mathrm{Cos}ts}{NumberofUnits}\right]\\ =\left[\frac{\$200,000}{20,000}\right]\\ =\$10\end{array}$

Therefore, the unit level manufacturing costs is $10.

Determine the unit level selling and administrative costs

$\begin{array}{c}UnitLevelAd\min istrative\mathrm{Cos}ts=\left[\frac{Actual\mathrm{Cos}ts}{NumberofUnits}\right]\\ =\left[\frac{\$14,000}{20,000}\right]\\ =\$0.70\end{array}$

Therefore, the unit level selling and administrative costs is $0.70.

Determine the contribution to profit

The comparison between differential revenue and avoidable cost is determined in the below step.

$\begin{array}{c}Contibutionto\mathrm{Pr}ofit=\left[\begin{array}{l}Sales-Manufacturing\mathrm{Cos}ts-\\ \mathrm{Re}ntonFacility-UnitLevelSelling\&Ad\min \mathrm{Cos}ts-\\ DivisionLevelSelling\&Ad\min \mathrm{Cos}ts\end{array}\right]\\ =\left[\begin{array}{l}\left(\$15\times 30,000\right)-\left(\$10\times 30,000\right)-\$75,000-\\ \left(\$0.70\times 30,000\right)-\$20,000\end{array}\right]\\ =\left[\$450,000-\$300,000-\$75,000-\$21,000-\$20,000\right]\\ =\$34,000\end{array}$

Therefore, the contribution to profit is $34,000.

Conclusion

From the results obtained above, the profit contributed by Division B would be 30,000 units. Hence the division should not be eliminated. Additionally, it is vital to contemplate development prospective before choosing to eliminate a segment.

Therefore, Division B should not be eliminated.

To determine

Identify whether to operate the division with volume of 30,000 units or it should be closed.

Explanation of Solution

Determine the profit or loss of the division

$\begin{array}{c}\mathrm{Pr}ofitorLoss=\left[\mathrm{Pr}ofit-Opportunity\mathrm{Cos}t\right]\\ =\left[\$34,000-\$85,000\right]\\ =-\$51,000\end{array}$

Therefore, the loss of the division is $51,000.

The reasons on whether to operate the division with volume of 30,000 units or it should be closed is as follows:

• It is mentioned that Company LM is paying $75,000 to lease the manufacturing facility for Division B.
• The business could earn $85,000 $\left(\$160,000-\$75,000\right)$ by subleasing the manufacturing facility.
• By operating the division, the organization is allowing up the chance to sublease the office.
• This is an opportunity cost that would be avoidable by eradicating Division B.
• Consequently, it must be incorporated into the investigation. If the volume is 30,000 units Division B contributes $34,000 as profit.

Conclusion

When considering opportunity cost, the profit turns into a loss of $51,000. According to these conditions, Division B should be eliminated.

Therefore, Division B should be eliminated.