# Members of the board of directors of Safety Step have received the following operating income...

## Question:

Members of the board of directors of Safety Step have received the following operating income data for the year ended May 31, 2018.

 Safety Step Income Statement For the Year Ended May 31, 2018, Product Line Industrial Household Systems Systems Total Net Sales Revenue $310,000$330,000 640,000 Cost of Goods Sold Variable 33,000 48,000 81,000 Fixed 230,000 68,000 298,000 Total Cost of Goods Sold 263,000 116,000 379,000 Gross Profit 47,000 214,000 261,000 Selling and Administrative Expenses Variable 68,000 72,000 140,000 Fixed 43,000 28,000 71,000 Total Selling and Administrative Expenses 111,000 100,000 211,000 Operating Income (Loss) $(64,000)$114,000 $50,000 Members of the board are surprised that the industrial systems product line is not profitable. They commission a study to determine whether the company should drop the line. Company accountants estimate that dropping industrial systems will decrease the fixed cost of goods sold by$82,000 and decrease fixed selling and administrative expenses by $15,000. 1. Prepare a differential analysis to show whether Safety Step should drop the industrial systems product line. 2. Prepare contribution margin income statements to show Safety Step's total operating income under the two alternatives: (a) with the industrial systems line and (b) without the line. Compare the difference between the two alternatives' income numbers to your answer to Requirement 1. 3. What have you learned from the comparison in Requirement 2? ## Differential Analysis - Dropping a Product: When considering eliminating a product or department, the profit or loss as reported in the financial statements is often misleading, because usually not all costs allocated to the product or department are avoidable. ## Answer and Explanation: 1. Safety Step Differential Analysis - Dropping Industrial system Line Total with Industrial systems Total without Industrial systems Difference Net Sales Revenue$640,000 $330,000$(310,000)
Cost of Goods Sold
Variable 81,000 48,000 33,000
Fixed 298,000 216,000 82,000
Variable 140,000 72,000 68,000
Fixed 71,000 56,000 15,000
Operating Income (Loss) $50,000$(62,000) $(112,000) 2. Safety Step Contribution Margin Income Statement Total with Industrial systems Total without Industrial systems Net Sales Revenue$640,000 $330,000 Variable costs Variable Cost of Goods Sold 81,000 48,000 Variable Selling and Administrative Expenses 140,000 72,000 Total Variable Cost$221,000 $120,000 Contribution Margin$419,000 $210,000 Fixed Cost of goods sold 298,000 216,000 Fixed Selling and Administrative Expenses 71,000 56,000 Total Fixed Cost$369,000 $272,000 Operating Income (Loss)$50,000 $(62,000) The difference between the two alternative is$112,000, which is the same as the difference in 1.

3. From the above we can see that the advantage or disadvantage of dropping a product is equal to the loss in contribuiotn margin less the saving in avoidable fixed costs.