Chapter 7, Problem 24P

Companywide and Segment Break-Even Analysis; Decision Making L07—4, L07—5

Toxaway Company is a merchandiser that segments its business into two divisions—Commercial and Residential. The company’s accountingintern was asked to prepare segmented income statements that the company’s divisional managers could use to calculate their break-evenpoints and make decisions. She took the prior month’s companywide income statement and prepared the absorption format segmented incomestatement shown below:

In preparing these statements, the intern determined that Toxaway’s only variable selling and administrative expense is a 10% salescommission on all sales. The company’s total fixed expenses include $72,000 of common fixed expenses that would continue to be incurredeven if the Commercial or Residential segments are discontinued, $55,000 of fixed expenses that would be avoided if the Commercial segment is dropped, and $38,000 of fixed expenses that would be avoided if the Residential segment is dropped.
Required:
1. Do you agree with the intern’s decision to use an absorption format for her segmented income statement? Why?
2. Based on a review of the intern’s segmented income statement:
a. How much of the company’s common fixed expenses did she allocate to the Commercial and Residential segments?
b. Which of the following three allocation bases did she most likely use to allocate common fixed expenses to the Commercial and
Residential segments: (a) sales, (b) cost of goods sold, or (c) gross margin?
3. Do you agree with the intern’s decision to allocate the common fixed expenses to the Commercial and Residential segments? Why?
4. Redo the intern’s segmented income statement using the contribution format.
5. Compute the companywide break-even point in dollar sales.
6. Compute the break-even point in dollar sales for the Commercial Division and for the Residential Division.
7. Assume the company decided to pay its sales representatives in the Commercial and Residential Divisions a total monthly salary of$15000 and $30,000, respectively, and to lower its companywide sales commission percentage from 10% to 5%. Calculate the newbreak-even point in dollar sales for the Commercial Division and the Residential Division.

To determine

Whether absorption costing method should be used for segmented income statement

Explanation of Solution

Under absorption costing the fixed expenses get deferred to next period due to absorption in closing stock even though they have actually been incurred. As such, profit/loss shown by Absorption costing is not real profit. Hence, variable costing should be used.

To determine

Allocation of Common Fixed Costs

Answer to Problem 24P

Solution:

Particulars	Total Company	Commercial	Residential
Actual Selling expenses	$ 240,000	$ 104,000	$ 136,000
Less: Variable Selling expenses	$ (75,000)	$ (25,000)	$ (50,000)
Less: Traceable fixed selling expenses	$ (93,000)	$ (55,000)	$ (38,000)
Balance fixed expenses	$ 72,000	$ 24,000	$ 48,000
(common fixed expenses allocated)

Explanation of Solution

1. Total selling and administrative expenses are given. These are a sum total of variable selling expenses + traceable fixed selling expenses + common allocated fixed selling expenses;
2. Variable selling expenses are given as % of sales and have been computed accordingly in above working note;
3. Traceable fixed selling expenses are given in the question;
4. Balance remaining after deducting variable selling and traceable fixed expenses will give common fixed expenses allocated.

• Given
Variable Sales commission % as 10%

Sales traceable fixed selling expenses

• Formula

  $\text{Variable Selling Expenses = Sales X Variable Sales Commission \%}$

  $\begin{array}{l}\text{Common Allocated Fixed Expenses = Actual Selling Expenses - Variable Selling Expenses }\\ \text{- Traceable Fixed Selling Expense}\end{array}$

• Calculation

  $\text{Total Variable Sales Commission = \$ 750,000 }\times \text{ 10\% = \$ 75,000}$

  $\text{Total Variable Sales Commission of Commercial= \$ 250,000 }\times \text{ 10\% = \$ 25,000}$

$\text{Total Variable Sales Commission of Residential= \$ 500,000 }\times \text{ 10\% = \$ 50,000}$

Conclusion

The common fixed cost has been allocated as $ 24,000 to Commercial and $ 48,000 to Residential

To determine

Allocation basis of common fixed cost out of given options:

Answer to Problem 24P

Solution:

In order to evaluate what basis has been used, we will compute the ratio under all the options and then assess as under:

	Company	Commercial	Residential
Common Fixed Expenses allocated (as per answer 2(a))	$ 72,000	$ 24,000	$ 48,000
Ratio of Common Fixed Expenses allocated		33%	67%
Sales	$ 750,000	$ 250,000	$ 500,000
Ratio of Sales		33%	67%
Cost of Goods Sold	$ 500,000	$ 140,000	$ 360,000
Ratio of Cost of Goods Sold		28%	72%
Gross Margin	$ 250,000	$ 110,000	$ 140,000
Ratio of Gross Margin		44%	56%

As clear from above, the intern used Sales Ratio to distribute common fixed expenses.

Explanation of Solution

1. The ratio of individual common allocated fixed expenses to total common fixed expenses works out to 33% and 67% for Commercial and Residential respectively.
2. The ratio of individual sales to total sales also works out to 33% and 67% for Commercial and Residential respectively.
3. As such, sales ratio has been used for allocating common fixed expenses.

Conclusion

Sales ratio has been used to distribute common expenses

To determine

Whether fixed common expenses should be allocated to segments

Answer to Problem 24P

Solution:

Fixed Common Expenses should not be allocated to segments

Explanation of Solution

• Given :

Intern has allocated common expenses on the basis of sales to both the segments

It is not advisable to allocate common fixed costs to segments for evaluating the segment's profitability. These costs would get incurred whether segment exists or not. As such, they make a segment look less profitable and hence should be excluded while evaluating segment wise profitability. However, while deciding whether to continue or drop a segment these costs need to be considered.

Conclusion

In view of reflecting true segment margin, fixed common expenses should not be allocated to segment.

To determine

In contribution format, details are shown in the following sequence:

Sales, Total Variable cost, contribution margin, total fixed cost, Net operating Income

Segmented Income Statement in Contribution Format

Solution (a):

Toxaway Company Income statement (contribution format)
	Total Company	Commercial	Residential
Sales	$ 750,000	$ 250,000	$ 500,000
Cost of Goods Sold	$ 500,000	$ 140,000	$ 360,000
Variable selling and administrative expenses	$ 75,000	$ 25,000	$ 50,000
Contribution Margin	$ 175,000	$ 85,000	$ 90,000
Fixed Expenses	$ 165,000	$ 79,000	$ 86,000
Net Operating Income	$ 10,000	$ 6,000	$ 4,000

Explanation of Solution

• Given:

Sales and Cost of Goods Sold are given in the question

Variable selling and administrative expenses and fixed expenses have been computed in above solutions

• Formula:

  $\text{Contribution Margin = Sales - Cost of Goods Sold - Variable Selling and Administrative Expenses}$

  $\text{Net Operating income = Contribution Margin - Fixed Expenses}$

• Calculation:

  $\text{Contribution Margin of Company = \$ 750,000 - \$ 500,000 - \$ 75,000 = \$ 175,000}$

  $\text{Contribution Margin of Commercial = \$ 250,000 - \$ 140,000 - \$ 25,000 = \$ 85,000}$

  $\text{Contribution Margin of Residential = \$ 500,000 - \$ 360,000 - \$ 50,000 = \$ 90,000}$

$\text{Net Operating Income of Company = \$ 175,000 - \$ 165,000 = \$ 10,000}$

  $\text{Net Operating Income of Commercial = \$ 85,000 - \$ 79,000 = \$ 6,000}$

  $\text{Net Operating Income of Residential = \$ 90,000 - \$ 86,000 = \$ 4,000}$

Conclusion

Net Operating Income for Company is $ 10,000 and for Commercial and Residential segment is $ 6,000 and $ 4,000 respectively.

To determine

5:

Breakeven point is that level of sales at which the Company is at a No profit no loss situation. This means that the company is able to fully recover its variable cost and fixed cost but nothing above that.

Breakeven point in dollar Sales

Answer to Problem 24P

Solution:

Break-even point in dollar Sales = $ 707,243

Explanation of Solution

1. Break-even point is computed to calculate the minimum sales that must be achieved to arrive at a no profit no loss situation;
2. Break-even point in unit salesis calculated by dividing the Fixed cost with contribution per unit
Break-even point in dollar salesis calculated by dividing the Fixed cost with contribution Margin %
3. Contribution Margin is the ratio of Contribution to Sale value.

• Given:

Fixed Cost has been computed as $ 165,000

Sales is given as $ 175,000

Contribution margin has been computed as $ 175,000

• Formula:

  $\text{Contribution Margin \% = }\frac{\text{Contribution Margin}}{\text{Sales}}$

  $\text{Break-even Point in Dollar Sales = }\frac{\text{Fixed Cost}}{\text{Contribution Margin \%}}$

• Calculation:

  $\text{Contribution Margin \% = }\frac{\text{\$ 175,000}}{\text{\$ 750,000}}=23.33\%$

  $\text{Break-even Point in Dollar Sales = }\frac{\text{\$ 165,000}}{\text{33}\text{.33 \%}}=\$707,243$

Conclusion

Toxaway Company will have to make a minimum sale of $ 707,243 to be able to fully recover its variable as well as fixed cost.

To determine

Breakeven point in dollar sales for Commercial and Residential division.

Answer to Problem 24P

Solution:

Break-even point in dollar Sales = Fixed Cost/ Contribution Margin %

	Commercial	Residential
Fixed Cost (A)	$ 79,000	$ 86,000
Contribution Margin (B)	$ 85,000	$ 90,000
Sales (C)	$ 250,000	$ 500,000
Contribution Margin % (D = B / C)	34%	18%
Break even point (A / D)	$ 232,353	$ 477,778

Explanation of Solution

• Given

Fixed cost has been computed in above solutions

Sales is given in the question

• Formula

  $\text{Contribution Margin \% = }\frac{\text{Contribution Margin}}{\text{Sales}}$

  $\text{Break-even Point in Dollar Sales = }\frac{\text{Fixed Cost}}{\text{Contribution Margin \%}}$

• Calculation

  $\text{Contribution Margin \% of Commercial = }\frac{\text{\$ 85,000}}{\text{\$ 250,000}}=34\%$

  $\text{Contribution Margin \% of Residential = }\frac{\text{\$ 90,000}}{\text{\$ 500,000}}=18\%$

  $\text{Break-even Point in Dollar Sales of Commercial= }\frac{\text{\$ 79,000}}{\text{34 \%}}=\$232,353$

  $\text{Break-even Point in Dollar Sales of Residential= }\frac{\text{\$ 86,000}}{\text{18 \%}}=\$477,778$

Conclusion

Commercial will have to make a minimum sale of $ 232,353 to be able to fully recover its variable as well as fixed cost. Similarly, Residential will have to make a minimum sales of $ 477,778

To determine

To determine: Break-even point in dollar sales:

Answer to Problem 24P

Solution:

	Commercial	Residential
Sales (A)	250,000	500,000
Cost of Goods Sold (B)	140,000	360,000
Variable selling and administrative expenses (5% of sales) (C)	12,500	25,000
Contribution Margin (D = A-B-C)	97,500	115,000
Fixed Expenses (E)	94,000	116,000
Contribution Margin % (F = D / A)	39%	23%
Break even point (E / F)	241,026	504,348

Explanation of Solution

• Given:

Additional fixed cost is given as $ 15,000 for Commercial and $ 30,000 for Residential.

Variable selling and administrative expenses have been given as 5% of Sales

Cost of Goods Sold is given as $ 140,000 and $ 360,000 for Commercial and Residential respectively

• Formula:

  $\text{Variable Selling \& Administrative Expenses = Sales X New Sales Commission \%}$

  $\text{Contribution Margin = Sales - Cost of Goods Sold -Variable Selling \& Administrative Expenses }$

  $\text{Contribution Margin \% = }\frac{\text{Contribution Margin}}{\text{Sales}}$

  $\text{New Fixed Cost = Old Fixed Cost + Additional Fixed Cost}$

  $\text{Break-even Point in Dollar Sales = }\frac{\text{Fixed Cost}}{\text{Contribution Margin \%}}$

• Calculation:

  $\text{Variable Selling \& Administrative Expenses for Commercial= \$ 250,000 X 5\% = \$ 12,500}$

  $\text{Variable Selling \& Administrative Expenses for Residential= \$ 500,000 X 5\% = \$ 25,000}$

  $\text{Contribution Margin of Commercial = \$ 250,000 - \$ 140,000 - \$ 12,500 = \$ 97,500}$

  $\text{Contribution Margin of Residential = \$ 500,000 - \$ 360,000 - \$ 25,000 = \$ 115,000}$

  $\text{Contribution Margin \% of Commercial= }\frac{\text{\$ 97,500}}{\text{\$ 250,000}}=39\%$

  $\text{Contribution Margin \% of Residential= }\frac{\text{\$ 115,000}}{\text{\$ 500,000}}=23\%$

  $\text{New Fixed Cost of Commercial = \$ 79,000 + \$ 15,000 = \$ 94,000}$

  $\text{New Fixed Cost of Resindetial = \$ 86,000 + \$ 30,000 = \$ 116,000}$

  $\text{Break-even Point in Dollar Sales of Commercial = }\frac{\text{\$ 94,000}}{\text{39 \%}}=\$241,026$

  $\text{Break-even Point in Dollar Sales of Residential = }\frac{\text{\$ 116,000}}{\text{23 \%}}=\$504,348$

Conclusion

New Break-even point of Commercial is $ 241,026; New Break-even point of Residential is $ 504,348