Mohave Corp. is considering eliminating a product from its Sand Trap line of bea

Question

Mohave Corp. is considering eliminating a product from its Sand Trap line of beach umbrellas. This collection is aimed at people who spend time on the beach or have an outdoor patio near the beach. Two products, the Indigo and Verde umbrellas, have impressive sales. However, sales for the Azul model have been dismal Mohave's information related to the Sand Trap line is shown below Segmented Income Statement for Mohave's Sand Trap Beach Umbrella Products Verde Azul Total Sales revenue Variable costs $60,000 $60,000 $30,000 $150,000 34,000 31,000 26,000 91,000 4,000 S 59,000 6,400 $24,100 $26,500 2,000 52,600 8,920 44.600 6.260 8.660 ( 8.000 $26,000 $29,000 4 Contribution margin Segment margin Net operating income (loss) Less: Direct Fixed costs 1,900 2,500 2,000 Common fixed costs 17,840 7,840 8,660 6,920 Allocated based on total sales revenue Mohave has determined that eliminating the Azul model would cause sales of the Indigo and Verde models to increase by 10 percent and 15 percent, respectively. Variable costs for these two models would increase proportionately. Although the direct fixed costs could be eliminated, the common fixed costs are unavoidable. The common fixed costs would be redistributed to the remaining two products. Required: 1-a. Complete the table given below, if Mohave Corp drops the Azul line. (Do not round intermediate calculations. Round Common Fixed Costs to the nearest whole dollar.) Indigo Verde Total Sales Revenue Variable Costs Contribution Margin Direct Fixed Costs Segment Margin

Explanation / Answer

Mohave Corp

1a. Assuming the company drops the Azul line, statement showing net operating income from other products:

Indigo

Verde

Total

Sales Revenue

$66,000

$69,000

$135,000

Variable costs

$37,400

$35,650

$73,050

Contribution margin

$28,600

$33,350

$61,950

Less: Direct fixed costs

$1,900

$2,500

$4,400

Segment margins

$26,700

$30,850

$57,550

Common fixed costs

$21,804

$22,796

$44,600

Net Operating income (Loss)

$4,896

$8,054

$12,950

1b. Mohave’s net operating income would increase by $4,950 (12,950 – 8,000) if the company eliminates the Azul line.

2.The company should drop the Azul line as the elimination of this product line would increase the overall net operating income of the company by $4,950.

Analysis –

Normally, any product that earns a contribution and segment margin is profitable and should not be eliminated. However, in the given situation elimination of Azul line would increase the sales of other product lines – Indigo and Verde, which results in increase in overall operating income. Hence, elimination of Azul line is profitable to the Mohave Corp.

3a. Assuming Mohave has no direct fixed overhead –

Change in Contribution Margin

Contribution margin gained on Indigo

$2,600

(28,600 - 26,000)

Contribution margin gained on Verde

$4,350

(33,350 - 29,000)

Contribution margin lost on Azul

($4,000)

Net increase in contribution margin

$2,950

Change in fixed costs

($6,400)

Net change in profit if Azul is eliminated

($3,450)

Assuming no direct fixed overhead, elimination of Azul line would decrease the overall operating income by $3,450. In such situation elimination of Azul line is not advisable.

The contribution margin gained on Indigo and Verde is arrived at computing the difference between original contribution margin and the contribution margin from increased sales resulting from elimination of Azul line.

Since no direct fixed cost is assumed, the direct fixed cost attributed to Azul line is no more avoidable and hence the same is allocated to Indigo and Verde product lines along with their respective direct fixed overhead allocation.

3b. No, the company should not drop the Azul line.

The above analysis indicates that elimination of Azul line would result in a loss of contribution margin of $4,000 and increase in direct fixed overhead by $2,000. Hence, Azul line should not be eliminated.

Indigo

Verde

Total

Sales Revenue

$66,000

$69,000

$135,000

Variable costs

$37,400

$35,650

$73,050

Contribution margin

$28,600

$33,350

$61,950

Common fixed costs

$24,933

$26,067

$51,000

Net Operating income (Loss)

$3,667

$7,283

$10,950

change in net operating income/(loss)

$2,000

The net operating income decreased by $2,000 when we assume the no direct fixed overhead. The direct fixed overhead of Azul line is now allocated to Indigo and Verde lines, which resulted in decrease in overall operating income by $2,000 (the direct fixed overhead of Azul line).

Indigo

Verde

Total

Sales Revenue

$66,000

$69,000

$135,000

Variable costs

$37,400

$35,650

$73,050

Contribution margin

$28,600

$33,350

$61,950

Less: Direct fixed costs

$1,900

$2,500

$4,400

Segment margins

$26,700

$30,850

$57,550

Common fixed costs

$21,804

$22,796

$44,600

Net Operating income (Loss)

$4,896

$8,054

$12,950

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