Question

Morning Sky, Inc. (MSI), manufactures and sells computer games. The company has several product lines based on the age range of the target market. MSI sells both individual games as well as packaged sets. All games are in CD format, and some utilize accessories such as steering wheels, electronic tablets, and hand controls. To date, MSI has developed and manufactured all the CDs itself as well as the accessories and packaging for all of its products.

The gaming market has traditionally been targeted at teenagers and young adults; however, the increasing affordability of computers and the incorporation of computer activities into junior high and elementary school curriculums has led to a significant increase in sales to younger children. MSI has always included games for younger children but now wants to expand its business to capitalize on changes in the industry. The company currently has excess capacity and is investigating several possible ways to improve profitability.

MSI is considering eliminating a product from its ToddleTown Tours collection. This collection is aimed at children one to three years of age and includes “tours” of a hypothetical town. Two products, The Pet Store Parade and The Grocery Getaway, have impressive sales. However, sales for the third CD in the collection, The Post Office Polka, have lagged the others. Several other CDs are planned for this collection, but none is ready for production.

MSI’s information related to the ToddleTown Tours collection follows:

Segmented Income Statement for MSI’s
ToddleTown Tours Product Lines
	Pet Store Parade			Grocery Getaway			Post Office Polka				Total
Sales revenue	$	140,000		$	135,000		$	37,000			$	312,000
Variable costs		59,000			55,000			33,000				147,000
Contribution margin	$	81,000		$	80,000		$	4,000			$	165,000
Less: Direct Fixed costs		8,400			8,500			3,500				20,400
Segment margin	$	72,600		$	71,500		$	500			$	144,600
Less: Common fixed costs*		7,000			6,750			1,850				15,600
Net operating income (loss)	$	65,600		$	64,750		$	(1,350	)		$	129,000

*Allocated based on total sales revenue.

MSI has determined that elimination of the Post Office Polka (POP) program would not impact sales of the other two items. The remaining fixed overhead currently allocated to the POP product would be redistributed to the remaining two products.

Required:
1. Calculate the incremental effect on profit if the POP product is eliminated.

2. Should MSI drop the POP product?

3-a. Calculate the incremental effect on profit if the POP product is eliminated. Suppose that $1,200 of the common fixed costs could be avoided if the POP product line were eliminated.

3-b. Should MSI drop the POP product?

Answer 1

Answer 1:

The incremental effect on profit = ($ 500)

Explanation:

The company is earning the segment margin fo $ 500 in Post Office Polka (POP). The common fixed costs are unavoidable fixed costs which will be incurred irrespective of whether or not the POP product is eliminated. So, the profit will reduce by $ 500 if POP product is eliminated.

Answer 2:

MSI should not drop the product.

Answer 3-a:

The incremental effect on profit = $ 700

Explanation:

The company is earning the segment margin fo $ 500 in Post Office Polka (POP). The common fixed costs are avoidable to the extent of $ 1,200. So, the fixed cost will reduce by $ 1,200 and the segment margin lost will be $ 500. Hence, profit will increase by $ 700 if POP product is eliminated.

Answer 3-b:

MSI should drop the POP product.

In case of any doubt, please comment.