Question

A company has four related product lines. Since they are aimed at different segments of the market, the company calculates separate P&L statements for each of these product lines. There are certain machining and assembly centers that work on products for each of the lines. OH costs from each of those centers are allocated to product cost of each product manufactured using rationally computed cost drivers taking total costs of each center at capacity divided by units of the driver available at capacity and then applied to each unit based on units of the driver used. (Basically an ABC approach.) The company also has a significant amount of sales and marketing and administrative OH, much of it fixed and shared by all four product lines, and which is allocated to the respective product lines based roughly on relative sales volume.

The company determines the following key numbers for each line:

                                Product A            Product B             Product C             Product D            Company Total

Total sales           $25,000,000        $20,000,000        $15,000,000        $10,000,000        $70,000,000

Mfg.Cost Alloc   $5,000,000           $4,000,000           $3,000,000           $2,000,000           $14,000,000

Corp OH Alloc    $4,000,000           $3,000,000           $2,000,000           $1,000,000           $10,000,000

Other Costs        $18,000,000        $12,000,000`       $8,000,000           $4,000,000           $42,000,000

Net Income        ($2,000,000)       $1,000,000           $2,000,000           $3,000,000           $4,000,000

Senior management decides that the Product A Line should be discontinued to eliminate the loss, and thus increase net income. A production analyst who recently graduated from the graduate business program in the managerial accounting class urged them to reconsider, arguing forcefully that this move would very likely reduce corporate net income. In fact, it would probably cause another of the lines (probably B) to then become a money loser, leading to its elimination, and subsequently making the problem even worse!

Who is right, the senior management or the analyst? Explain in detail what would most likely occur, how, and why. Use numbers to illustrate your answer, but also explain the logic of what would happen. Discuss both the shared manufacturing costs and the corporate overhead.

Answer 1

Answer:

The production analyst is correct.

Explanation:

In case, the product line A is discontinued, the profit would decrease by $ 2,000,000. It can be seen that the current profit is $ 4,000,000, and in the table below, the profit has come down to $ 2,000,000, when product A is discontinued.

Particulars	Product A	Product B	Product C	Product D	Total
Sales	$                        -	$ 20,000,000.00	$ 15,000,000.00	$ 10,000,000.00	$ 45,000,000.00
Manufacturing cost	$                        -	$   4,000,000.00	$   3,000,000.00	$   2,000,000.00	$     9,000,000.00
Corporate overheads	$     4,000,000.00	$   3,000,000.00	$   2,000,000.00	$   1,000,000.00	$ 10,000,000.00
Other costs	$                        -	$ 12,000,000.00	$   8,000,000.00	$   4,000,000.00	$ 24,000,000.00
Net Income	$   (4,000,000.00)	$   1,000,000.00	$   2,000,000.00	$   3,000,000.00	$    2,000,000.00

Shared manufacturing costs and corporate overheads are incurred in the totality basis for the company and are allocated to products on some cost drivers. Even if product A is discontinued, such corporate overheads will still be incurred.

If product A is continued, it incurs a net loss of $ 2,000,000. If it is discontinued, the allocated corporate overheads of $ 4,000,000 will still be incurred and so it is better to continue product A.

Discontinuation of product A would cause other product lines to become a money loser and the problem would get even worse.

Hence, the production analyst is absolutely correct.

In case of any doubt, please comment.