18 King Company has two divisions whose most recent financial statements are shown below: Commercial Division Residential Division Unit sales Sales Less: cost of goods sold: Unit-level production costs Depreciation, production equipment Gross margin Less: operating expenses: Unit-level selling and administrative Corporate-level facility costs (fixed) Net income (loss) Required: a. Compute the impact on profit if the Residential Division is eliminated. Commercial Division Unit sales 5,220 Sales
176,100 Depreciation, production equipment
111,000 61,100 30,500
19,400 41,100 11,100 18,000 13,000
(4,700)
The Correct Answer and Explanation is:
Based on the financial statements provided, here is the computation of the impact on profit if the Residential Division is eliminated.
Answer:
If the Residential Division is eliminated, the company’s overall profit will decrease by $38,800.
Explanation:
To determine the financial impact of eliminating a business segment, one must analyze which revenues will be lost and which costs will be avoided. The decision should not be based on the division’s reported net loss, as this figure includes allocated fixed costs that may not disappear if the division is closed. The correct approach is to calculate the division’s contribution margin.
- Identify Lost Revenue: If the Residential Division is eliminated, the company will lose the entire sales revenue generated by that division.
- Lost Sales Revenue = $111,000
- Identify Avoidable Costs: These are the costs that will no longer be incurred if the division ceases operations. Based on the provided statement, the avoidable costs are the “unit-level” costs, as they are directly tied to the division’s activity.
- Unit-level production costs: $61,100
- Unit-level selling and administrative costs: $11,100
- Total Avoidable Costs = $61,100 +
11,100=∗∗11,100=∗∗72,200**
- Identify Unavoidable Costs: The remaining costs are considered unavoidable in this decision. Depreciation is a sunk cost related to past equipment purchases, and the corporate-level facility costs are common fixed costs that will persist and be reallocated to the remaining Commercial Division. These costs are irrelevant to the elimination decision.
- Calculate the Net Impact on Profit: The impact on profit is the difference between the lost revenue and the avoided costs. This represents the contribution margin that the Residential Division was providing to cover the company’s overall fixed costs.
- Impact = Lost Sales – Avoidable Costs
- Impact = $111,000 – $72,200
- Impact = $38,800
This calculation shows that the Residential Division, despite its net loss on paper, was positively contributing $38,800 towards covering the company’s total fixed costs. Eliminating this division would remove that positive contribution, causing the company’s total profit to fall by $38,800.
