Question

Keep-or-Drop for Service Firm, Complementary Effects, Traditional Analysis

Devern Assurance Company provides both property and automobile insurance. The projected income statements for the two products are as follows:

	Property Insurance		Automobile Insurance
Sales	$4,200,000		$12,000,000
Less variable expenses	3,830,000		9,600,000
Contribution margin	$370,000		$2,400,000
Less direct fixed expenses	400,000		500,000
Segment margin	$(30,000)		$1,900,000
Less common fixed expenses (allocated)	100,000		200,000
Operating income (loss)	$(130,000)		$1,700,000

The president of the company is considering dropping the property insurance. However, some policyholders prefer having their property and automobile insurance with the same company, so if property insurance is dropped, sales of automobile insurance will drop by 12 percent. No significant non-unit-level activity costs are incurred.

Required:

1. If Devern Assurance Company drops property insurance, by how much will income increase or decrease?

Decrease  by $

Feedback

Prepare the segmented income statement to determine the effect of dropping the segment of the business.

As a supporting computation, prepare a segmented income statement for the keep-or-drop decision.

Devern Assurance Company
Keep-or-Drop For Service Firm
Segmented Income Statement
	Keep	Drop
Sales	$	$
Less variable expenses
Contribution margin	$	$
Less direct fixed expenses
Segment margin	$	$

Feedback

Prepare an income statement for the company if the property insurance were to be dropped. Compare that to the existing income statement for the entire company. Common fixed expenses are not traceable to the segments. They would remain even if one of the segments were eliminated.

2. Assume that dropping all advertising for the property insurance line and increasing the corporate advertising budget by $450,000 will increase sales of property insurance by 10 percent and automobile insurance by 8 percent. Prepare a segmented income statement that reflects the effect of increased advertising.

Devern Assurance Company
Keep-or-Drop For Service Firm
Segmented Income Statement
	Property Insurance	Automobile Insurance	Total
Sales	$	$	$
Less variable costs
Contribution margin	$	$	$
Less direct fixed expenses
Segment margin	$	$	$
Less common fixed costs
Operating income			$

Feedback

Review what you have learned about segmented income statements in the chapter. Common fixed expenses are not traceable to the segments. They would remain even if one of the segments were eliminated.

Should advertising be increased?

Yes

Answer 1

1.

	Keep	Drop
Sales	$16,200,000	$10,560,000 (12,000,000-12%)
Less; Variable expenses	13,430,000	8,448,000 (9,600,000-12%)
Contribution margin	2,770,000	2,112,000
Less:Direct fixed expenses	900,000	500,000
Segment margin	$1,870,000	$1,612,000

As per above result if property insurance is dropped then income decrease by $258,000.

2.

	Property insurance	Automobile insurance	Total
Sales	$4,620,000 (4,200,000+10%)	$12,960,000 (12,000,000+8%)	$17,580,000
Less: Variable expenses	4,213,000 (3,830,000+10%)	10,368,000 (9,600,000+8%)	14,581,000
Contribution margin	407,000	2,592,000	2,999,000
Less: Direct fixed expenses	0	500,000	500,000
Segment margin	407,000	2,092,000	$2,499,000
Less: Common fixed costs			750,000
Operating income			$1,749,000

3.

Yes