Question

The president of Ravens, Inc., attended a seminar about the contribution margin model and returned to her company full of enthusiasm about it. She requested that last year’s traditional model income statement be revised, and she received the following report:

							Division
		Total Company				A				B				C
Sales		$	448,000			$	176,000			$	116,000			$	156,000
Variable expenses			258,000				110,000				64,000				84,000
Contribution margin		$	190,000			$	66,000			$	52,000			$	72,000
Fixed expenses			148,000				48,000				56,000				44,000
Net income (loss)		$	42,000			$	18,000			$	(4,000	)		$	28,000

The president was told that the fixed expenses of $148,000 included $85,500 that had been split evenly between divisions because they were general corporate expenses. After looking at the statement, the president exclaimed, "I knew it! Division B is a drag on the whole company. Close it down!"

Required:

a. Evaluate the president's remark.

	The president's remark ignores the misleading result of arbitrarily allocated fixed expenses.
	The president's remark ignores the misleading result of arbitrarily allocated variable expenses.

b. Calculate what the company's net income would be if Division B were closed down.

c. What is the policy statement related to the allocation of fixed expenses.

	Never arbitrarily allocate fixed expenses.
	Never arbitrarily allocate variable expenses.

Answer 1

a. The president's remark ignores the misleading result of arbitrarily allocated fixed expenses.

b.

		Division
	Total Company	A	C
Sales	332000	176000	156000
Variable expenses	194000	110000	84000
Contribution margin	138000	66000	72000
Fixed expenses	148000
Net income (loss)	-10000

If Division B were closed down, the contribution margin earned by Division B would be lost due to which the total net income of the company would be reduced to that extent.

c.  Never arbitrarily allocate fixed expenses.