Central administration allocates its costs of $1 million to the two operating divisions (A and B)...

Question:

Central administration allocates its costs of {eq}\$1 {/eq} million to the two operating divisions (A and B) of the company. These costs are not avoidable if one division is dropped. With an equal allocation of these costs to both divisions, Division A has a profit of {eq}\$300,000 {/eq} and Division B has a loss of {eq}\$100,000 {/eq}. What is the profit effect of the company if Division B is dropped and all other division costs are avoidable?

Relevant Costs

Relevant costs are costs incurred specifically to a certain decision or alternative. When a certain decision is to be made concerning various options, relevant cost analysis will help in choosing the best decision available, financial-wise.

Answer and Explanation:

To determine the impact, let us first compute for the total revenue of divisions A and B:

  • Division A total revenue = Division A income + Division A cost
  • Division A total revenue = $300,000 + $500,000
  • Division A total revenue = $800,000

Note that the $500,000 cost is the amount allocated to two operating divisions. The total cost being allocated is $1 million.

  • Division B total revenue = Division B income (loss) + Division A cost
  • Dvision B total revenue = ($100,000) + $500,000
  • Division B total revenue = $400,000

Now that we already have the revenue figures, let now compute for the impact if division b is dropped:

  • Net increase (decrease) in profit = Net income if Division B is dropped - Net Income if Division B is retained
  • Net increase (decrease) in profit = (Division A revenue - Division A cost - Division B cost) - (Division A income - Division B loss)
  • Net increase (decrease) in profit = ($800,000 - $500,000 - $500,000) - ($300,000 - $100,00)
  • Net increase (decrease) in profit = ($200,000) - $200,000
  • Net increase (decrease) in profit = ($400,000)

Therefore, if Division B is dropped, the decrease in profit will be $400,000.


Learn more about this topic:

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Relevant Costs in Eliminating a Product or Segment

from Accounting 301: Applied Managerial Accounting

Chapter 9 / Lesson 12
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