Question

Haley Romeros had just been appointed vice president of the Rocky Mountain Region of the Bank Services Corporation (BSC). The company provides check processing services for small banks. The banks send checks presented for deposit or payment to BSC, which records the data on each check in a computerized database. BSC then sends the data electronically to the nearest Federal Reserve Bank check-clearing center where the appropriate transfers of funds are made between banks. The Rocky Mountain Region has three check processing centers, which are located in Billings, Montana; Great Falls, Montana; and Clayton, Idaho. Prior to her promotion to vice president, Ms. Romeros had been the manager of a check processing center in New Jersey.

     Immediately after assuming her new position, Ms. Romeros requested a complete financial report for the just-ended fiscal year from the region’s controller, John Littlebear. Ms. Romeros specified that the financial report should follow the standardized format required by corporate headquarters for all regional performance reports. That report follows:

  

Bank Services Corporation (BSC) Rocky Mountain Region Financial Performance
			Check Processing Centers
	Total		Billings		Great Falls		Clayton
Sales	$	20,000,000	$	7,000,000	$	8,000,000	$	5,000,000
Operating expenses:
Direct labor		11,380,000		3,600,000		4,600,000		3,180,000
Variable overhead		438,000		175,000		165,000		98,000
Equipment depreciation		2,542,000		956,000		906,000		680,000
Facility expense*		2,410,000		840,000		640,000		930,000
Local administrative expense**		426,000		142,000		172,000		112,000
Regional administrative expense†		400,000		140,000		160,000		100,000
Corporate administrative expense‡		1,600,000		560,000		640,000		400,000
Total operating expense		19,196,000		6,413,000		7,283,000		5,500,000
Net operating income (loss)	$	804,000	$	587,000	$	717,000	$	(500,000)

*Includes building rental expense for the Billings and Great Falls locations and building depreciation for the Clayton location.

**Local administrative expenses are the administrative expenses incurred at the check processing centers.

†Regional administrative expenses are allocated to the check processing centers based on sales.

‡Corporate administrative expenses are charged to segments of the company such as the Rocky Mountain Region and the check processing centers at the rate of 8% of their sales.

  

    Upon seeing this report, Ms. Romeros summoned John Littlebear for an explanation.

Romeros:	What’s the story on Clayton? It didn’t have a loss the previous year did it?
Littlebear:	No, the Clayton facility has had a nice profit every year since it was opened six years ago, but Clayton lost a big contract this year.
Romeros:	Why?
Littlebear:	One of our national competitors entered the local market and bid very aggressively on the contract. We couldn’t afford to meet the bid. Clayton’s costs—particularly their facility expenses— are just too high. When Clayton lost the contract, we had to lay off a lot of employees, but we could not reduce the fixed costs of the Clayton facility.
Romeros:	Why is Clayton’s facility expense so high? It’s a smaller facility than either Billings or Great Falls and yet its facility expense is higher.
Littlebear:	The problem is that we are able to rent suitable facilities very cheaply at Billings and Great Falls. No such facilities were available at Clayton; we had them built. Unfortunately, there were big cost overruns. The contractor we hired was inexperienced at this kind of work and in fact went bankrupt before the project was completed. After hiring another contractor to finish the work, we were way over budget. The large depreciation charges on the facility didn’t matter at first because we didn’t have much competition at the time and could charge premium prices.
Romeros:	Well we can’t do that anymore. The Clayton facility will obviously have to be shut down. Its business can be shifted to the other two check processing centers in the region.
Littlebear:	I would advise against that. The $930,000 in depreciation at the Clayton facility is misleading. That facility should last indefinitely with proper maintenance. And it has no resale value; there is no other commercial activity around Clayton.
Romeros:	What about the other costs at Clayton?
Littlebear:	If we shifted Clayton’s business over to the other two processing centers in the region, we wouldn’t save anything on direct labor or variable overhead costs. We might save $68,000 or so in local administrative expense, but we would not save any regional administrative expense and corporate headquarters would still charge us 8% of our sales as corporate administrative expense.
	In addition, we would have to rent more space in Billings and Great Falls in order to handle the work transferred from Clayton; that would probably cost us at least $480,000 a year. And don’t forget that it will cost us something to move the equipment from Clayton to Billings and Great Falls. And the move will disrupt service to customers.
Romeros:	I understand all of that, but a money-losing processing center on my performance report is completely unacceptable.
Littlebear:	And if you shut down Clayton, you are going to throw some loyal employees out of work.
Romeros:	That’s unfortunate, but we have to face hard business realities.
Littlebear:	And you would have to write off the investment in the facilities at Clayton.
Romeros:	I can explain a write-off to corporate headquarters; hiring an inexperienced contractor to build the Clayton facility was my predecessor’s mistake. But they’ll have my head at headquarters if I show operating losses every year at one of my processing centers. Clayton has to go. At the next corporate board meeting, I am going to recommend that the Clayton facility be closed.

  

Required:

1-a.

What costs and benefits are relevant in the decision to shut down the Clayton facility? (Enter decreases or reductions with a minus sign.)

  

1-b.

What is the impact on overall profits of FSC if Clayton Processing center is shut down?

	Profits will decline
	Profits will increase

1-c.

What would be the net operating income of Rocky Mountain Region if Clayton Processing center is shut down? Note: Ignore the costs of moving equipment and potential loss of revenues.

  

1-d.

What is the impact on performance of Rocky Mountain Region if Clayton Processing center is shut down? Note: Ignore the costs of moving equipment and potential loss of revenues.

	Performance will improve
	Performance will decline

Answer 1

1a . The original cost of the facilities at Clayton is a sunk cost and should be ignored in any decision. The decision being considered here is whether to continue operations at Clayton. The only relevant costs are the future facility costs that would be affected by this decision. If the facility were shut down, the Clayton facility has no resale value. In addition, if the Clayton facility were sold, the company would have to rent additional space at the remaining processing centers. The costs that are relevant in the decision to shut down the Clayton facility are:

Increase in rent at Billings and Great Falls	480,000.00
Decrease in local administrative expenses	-68,000.00
Net increase in costs	412,000.00

B: If the Clayton facility is shut down, BSC’s profits will decline due to the increased costs, employees will lose their jobs, and customers will at least temporarily suffer some decline in service.

Hence "profits will decline".

c.

	Total
Sales	20,000,000.00
Selling and administrative expenses:
Direct labor	11,380,000.00
Variable overhead	438,000.00
Equipment depreciation	2,542,000.00
Facility expense (2,410,000-930,000+480,000)	1,960,000.00
Local administrative expense (426,000-68,000)	358,000.00
Regional administrative expense	400,000.00
Corporate administrative expense	1,600,000.00
Total operating expense	18,678,000.00
Net operating income	1,322,000.00

d: Thus "performance will improve". This is because  net operating income increases.