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

Question

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 $860,000 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 $57,000 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 $370,000 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

Explanation / Answer

1-a. Increase in rent 370000 Savings in local administrative effect 57000 1-b. Increase in rent -370000 Savings in local administrative effect 57000 Net increase in cost -313000 Profits will decline due to increased cost 1-c. Financial performance Sales 20000000 Less:Selling and administrative expenses Direct labor 12100000 Variable overhead 431000 Equipment depreciation 2248000 Facility expense * 1710000 Local administrative expense (405000-57000) 348000 Regional administrative expense 360000 Corporate administrative expense 1600000 Total operating expense 18797000 Net operating income 1203000 * 2200000-860000+370000 1-d Performance will improve Previous net operating income=656000. Revised net operating income=1203000 Increase in net operating income=1203000-656000=547000 Performance will improve

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