Each branch (division) operates its own facility. The administative offices are
ID: 2620190 • Letter: E
Question
Each branch (division) operates its own facility. The administative offices are located in a separate building and the Administrative-Facility Level Costs are allocated among X. Y and Z The branch income statements are presented for the year 20X8Branch (Division) Z has experienced a Net Loss Branch Z has suffered losses in recent years and the company expects Z to continue to operate at a loss Here are the data: (Note: no formulas have been used to present the data) Division Division Division 2,000,000 1,600,000 1,710,000 Sales Less: Cost of Goods Sold Unit-level Manufacturing Costs Rent on Manufacturing Facility 1,100,000)(580,000)900,000) 240 220 Gross Margin Less: Operating Expenses 660,000800,000 360,000 Unit-Level Selling and Admin. Expenses (60,000) 45,000)150,000) Division-Level Fixed Selling and Admin. Expenses140,000) (125,000)(240,000) Administrative Facility-Level Costs (80,000) (80,000) (80,000) Net Income (loss) 380,000550,000 (110,000 a. Based on the information above, recommend whether Division Z should be eliminated Support your answer by preparing companywide income statements-one with Division Z and one without Division Z. Use the Excel spreadsheet we have included in the folder with the instructions During 20X8, Division Z produced and sold 30,000 units of product. Would your recommendation in part a change if sales and production increase to 45,000 units in 2009? Support your answer by comparing differential revenue and avoidable cost for Division Z, assuming that 45,000 units are sold. Use the same Excel spreadsheet as you used in part a (above c. Suppose that the company could sublease Division Z's manufacturing facility for $910,000. Would you operate the division at a production and sales volume of 45,000 units or would you sublease? Support your answer with appropriate computations using Excel! (Again, use the same Excel spreadsheet as used in parts a & b above.) Also determine which costs are relative costs and which are not for the companyExplanation / Answer
Hello,
a) In finance, any decision should be based on relevant costs and irrelevant costs have to be ignored altogether. For instance - if we are planning to buy a machine costing $1000000 then it is a relevant cost as buying such a machine would increase our cash outflow by $1000000. However suppose we have already bought such a machine and now thinking whether to discontinue using that machine or not, now such cost of $1000000 is irrelevant for all the decisions as such cost has already been incurred and we can't do anything about it. We call it sunk cost in finance. Continuing with our example -
Entity as a whole -
Sales 5,310,000
Less - COGS
Manufacturing expenses 2,580,000
Rent 910,000
Gross Margin. 1,820,000
Less - operating expenses
Selling and Admin. (Unit Level) 255,000
Selling and Admin (Fixed). 505,000
Admin Facility Costs. 240,000
Net Income . 820,000
Entity without Z
Sales 3,600,000
Less - COGS
Manufacturing Expenses 1,680,000
Rent. 460,000
Gross Margin . 1,460,000
Less -Operating expenses
Unit level S&A . 105,000
Fixed S&A. 265,000
Admin Facility Costs. 240,000
Net Income. 850,000
Decision - We should discontinue division Z as profit has increased by 30000 when we ignored it. Admin facility costs are sunk costs and it will remain at level of 240000 only even if we discontinue division Z. Rest all the costs are relevant as they can be avoided if we discontinue Z. So we could straightway conclude on the basis of income of division Z after excluding effect of sunk cost ie 110000-80000= 30000 loss produced by division Z reflected in two income statement s above (820000-850000).
b) For Z,
sales price per unit in 2008 =1710000/30000= 57
Unit level manufacturing cost in 2008=900000/30000=30
Unit level selling and admin expenses = 150000/30000=5
Rest all other expenses are fixed and would not change due to increase in units sold.
Incremental Revenue = 15000*57 = 855000
Incremental Costs = 15000*(30+5)= 525000
Incremental Profit = 330000 v/s Original Loss of 30000
So there is improvement in profitability of Z by 360000 so we should not discontinue Z at levels of 45000 units
c) If we sublease the division Z then all variable production expenses will be avoided but all fixed expenses would continue to be incurred.
Option A - Lease
Lease Rental . 910,000
Less -fixed expenses (450000+240000) 690,000*
Net Income. 220,000
*Sunk Cost is to be ignored in all cases =80000
Option B - Operate at level of 45000 units
Original Profit (30000)
Extra Profit . 330000
Net Income. 300000
So we shall not sublease but operate at level of 45000 units as it gives extra income of 80000.
Alternatively, we could proceed withour conconsidering fixed costs of 690000 as it will be same in both the alternatives
Lease 910000
Production = 45000*(57-35)= 990000
Extra Income from operation instead of leasing = 80000
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