Pepper's Automotive produces auto parts for various automotive retailers. Pepper's is evaluating...

Question:

Pepper's Automotive produces auto parts for various automotive retailers. Pepper's is evaluating the exhaust system division of the company and has come up with the following data for the year: net revenues are $1,480,000, variable costs are $524,000, and fixed costs are $608,000.

Of the fixed costs, controllable fixed costs are $132,000 and noncontrollable fixed costs are $476,000.

Pepper's Automotive has further analyzed the exhaust division into three products: exhaust pipes, intake valves, and intake pipes.

The income statement is available below.

What is the change in profit in both the short run and long run by dropping intake valves from its product line?

Exhaust pipes Intake valves Intake pipes
Net revenues $660,000 $460,000 $360,000
Variable costs 66,000 230,000 228,000
Contribution margin 594,000 230,000 132,000
Controllable fixed costs 66,000 66,000 0
Controllable margin 528,000 164,000 132,000
Noncontrollable fixed costs 180,000 230,000 66,000
Contribution by profit center $348,000 $(66,000) $66,000

Relevant Costs In Eliminating A Product Or Segment:

When deciding whether to eliminate a product, the company must always work on cost dynamics of the product in question. Sometimes, costs related to products are controllable and at other times, costs are non-controllable. Relevant costs change as cost dynamics vary at different stages.

Answer and Explanation:


Computation of operating income after dropping the product line 'Intake valves' in the short run:


Exhaust pipes Intake valves Intake pipes Total
Net revenues $660,000 $0 $360,000 $1,020,000
Variable costs $66,000 $0 $228,000 $294,000
Contribution margin $594,000 $0 $132,000 $726,000
Controllable fixed costs $66,000 $0 $0 $66,000
Controllable margin $528,000 $0 $132,000 $660,000
Noncontrollable fixed costs $180,000 $230,000 $66,000 $476,000
Contribution by profit center $348,000 -$230,000 $66,000 $184,000


The current overall profit of the company is $348,000. However if the product line 'intake valves' is discontinued, the company's overall profit would fall to $184,000 in the short run.

This is because, in the short run, controllable costs of $66,000 can be avoided but non-controllable costs of $230,000 remain unchanged.


Computation of operating income after dropping the product line 'Intake valves' in the long run:


Exhaust pipes Intake valves Intake pipes Total
Net revenues $660,000 $0 $360,000 $1,020,000
Variable costs $66,000 $0 $228,000 $294,000
Contribution margin $594,000 $0 $132,000 $726,000
Controllable fixed costs $66,000 $0 $0 $66,000
Controllable margin $528,000 $0 $132,000 $660,000
Noncontrollable fixed costs $180,000 $0 $66,000 $246,000
Contribution by profit center $348,000 $0 $66,000 $414,000

In the long run, the overall profit of the exhaust system division would be $414,000, if the product line 'intake valves' is dropped.

This is because, in the long run, even the non-controllable costs of $230,000 can be avoided or redirected to other production facilities and hence increasing the overall income.


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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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