The Milham Company has two divisions – East and West The Divisions have the following expenses and revenues.
East West Sales [• 5720,000 $350,000 Variable Costs … $370,000 $240,000 Traceable fixed costs $130,000 $80,000 Allocated common costs $120,000 $50,000 Net operating income (loss) $100,000 ($20,000)
Management at Milham is pondering the elimination of the West Division since it has shown an operating loss for the past several years. If the West Division were eliminated, its traceable fixed costs could be avoided. Total common corporate costs would be unaffected by this decision. Given these data, how would the elimination of the West Division affect overall company net operating income?
The Correct Answer and Explanation is:
Answer:
If the West Division were eliminated, the overall company net operating income would decrease by $30,000.
Explanation
To assess how eliminating the West Division would affect the Milham Company’s total net operating income (NOI), we need to distinguish between avoidable and unavoidable costs:
- Variable Costs and Traceable Fixed Costs are avoidable, i.e., they go away with the division.
- Allocated Common Costs are unavoidable – they remain even if the division is shut down. These are not relevant for decision-making in this context.
Let’s break down the current net operating income of the West Division:
- Sales: $350,000
- Variable Costs: $240,000
- Traceable Fixed Costs: $80,000
- Allocated Common Costs: $50,000
- Net Operating Income: ($20,000) Loss
However, since the $50,000 in allocated common costs would remain even if the West Division is eliminated, removing the division would mean the company no longer earns $350,000 in revenue, saves $240,000 in variable costs, and saves $80,000 in traceable fixed costs.
So, what is the net benefit/loss from keeping the division?
Let’s calculate the contribution margin of the West Division:
Contribution Margin = Sales – Variable Costs = $350,000 – $240,000 = $110,000
Then subtract traceable fixed costs:
Segment Margin = Contribution Margin – Traceable Fixed Costs = $110,000 – $80,000 = $30,000
This $30,000 represents the segment margin, i.e., the amount the West Division contributes toward covering common fixed costs and profit.
If the West Division is eliminated, the company loses this $30,000 contribution, and the $50,000 in allocated common costs will still be there, reducing the company’s overall profitability.
Conclusion: Eliminating the West Division will decrease the overall company’s net operating income by $30,000, and thus it should not be eliminated, even though it shows a loss after allocation.
