25-3TI - Horngren'S Financial And Managerial Accounting

Question

 McCollum Company manufactures two products. Both products have the same sales price, and the volume of sales is equivalent. However, due to the difference in production processes, Product A has higher variable costs and Product B has higher fixed costs. Management is considering dropping Product B because that product line has an operating loss.

MCCOLLUM COMPANY

Income Statement

Month Ended June 30, 2018

Total              Product A                 Product B

Net Sales Revenue                                                \(150,000       \)75,000                      \(75,000

Variable Costs                                            90,000            55,000                        35,000

Contribution Margin                                  60,000            20,000                        40,000

Fixed Costs                                                 50,000            5,000                          45,000

Operating Income/(Loss)                         \)10,000          \(15,000                      \)(5,000)

 

1. If fixed costs cannot be avoided, should McCollum drop Product B? Why or why not?
2. If 50% of Product B’s fixed costs are avoidable, should McCollum drop Product B? Why or why not?

 

Step-by-Step Solution

Answer

1. Yes, the company should drop product B because it is incurring losses to the company.
2. The product should be kept if fixed costs are avoidable. 

Meaning of Operating Income

Operating income refers to the amount of money left with a business entity after the settlement of all the variable and fixed costs associated with a product's sales process. Operating income includes the core operations of an entity. 

 

Decision of dropping the product

The company should drop product B because it incurs losses to the company and decreases the overall operating income of the product line. Hence, the product should be dropped if fixed costs cannot be avoided. 

Decision taken in case fixed cost can be avoided

Particulars	Amount ($)
Net sales revenue	75,000
Less: Variable costs	(35,000)
Contribution margin	40,000
Less: Fixed costs (45,000*50%)	(22,500)
Operating income	$17,500

 

The company should keep product B in its product line if the fixed costs associated with the same are 50% avoidable. This will generate revenues for the company and result in an overall increase in the product line’s operating income.