Question

Esme Company’s management is trying to decide whether to eliminate Department Z, which has produced

low profits or losses for several years. The company’s 2017 departmental income statements show

the following.

ESME COMPANY

Departmental Income Statements

For Year Ended December 31, 2017

Dept. A Dept. Z Combined

Sales . \(700,000 \)175,000 \(875,000

Cost of goods sold 461,300 125,100 586,400

Gross profit 238,700 49,900 288,600

Operating expenses

Direct expenses

Advertising 27,000 3,000 30,000

Store supplies used 5,600 1,400 7,000

Depreciation—Store equipment . 14,000 7,000 21,000

Total direct expenses 46,600 11,400 58,000

Allocated expenses

Sales salaries . 70,200 23,400 93,600

Rent expense 22,080 5,520 27,600

Bad debts expense 21,000 4,000 25,000

Office salary . 20,800 5,200 26,000

Insurance expense . 4,200 1,400 5,600

Miscellaneous office expenses . 1,700 2,500 4,200

Total allocated expenses 139,980 42,020 182,000

Total expenses . 186,580 53,420 240,000

Net income (loss) . \) 52,120 \( (3,520) \) 48,600

In analyzing whether to eliminate Department Z, management considers the following items:

a. The company has one office worker who earns \(500 per week or \)26,000 per year and four salesclerks

who each earns \(450 per week, or \)23,400 per year for each salesclerk.

b. The full salaries of three salesclerks are charged to Department A. The full salary of one salesclerk is

charged to Department Z.

c. Eliminating Department Z would avoid the sales salaries and the office salary currently allocated to it.

However, management prefers another plan. Two salesclerks have indicated that they will be quitting

soon. Management believes that their work can be done by the two remaining clerks if the one office

worker works in sales half-time. Eliminating Department Z will allow this shift of duties. If this

change is implemented, half the office worker’s salary would be reported as sales salaries and half

would be reported as office salary.

d. The store building is rented under a long-term lease that cannot be changed. Therefore, Department A

will use the space and equipment currently used by Department Z.

e. Closing Department Z will eliminate its expenses for advertising, bad debts, and store supplies; 65%

of the insurance expense allocated to it to cover its merchandise inventory; and 30% of the miscellaneous

office expenses presently allocated to it.

Required

1. Prepare a three-column report that lists items and amounts for (a) the company’s total expenses (including

cost of goods sold)—in column 1, (b) the expenses that would be eliminated by closing

Department Z—in column 2, and (c) the expenses that will continue—in column 3.

2. Prepare a forecasted annual income statement for the company reflecting the elimination of

Department Z assuming that it will not affect Department A’s sales and gross profit. The statement

should reflect the reassignment of the office worker to one-half time as a salesclerk.

Analysis Component

3. Reconcile the company’s combined net income with the forecasted net income assuming that

Department Z is eliminated (list both items and amounts). Analyze the reconciliation and explain why

you think the department should or should not be eliminated.

Short answer

The forecasted net income of the company is $47,400.

Step-by-step solution

Definition of cost of goods sold

The cost of goods sold is the cost that is incurred during the making of goods.

Preparation of three-column report

Esme Company
Analysis of Expenses under Elimination of Department Z
	Total Expense	Eliminated Expenses	Continuing Expense
Cost of Goods Sold	$586,400	$125,100	$461,300
Direct Expenses:
Advertising	$30,000	$3,000	$27,000
Store Supplies Used	$7,000	$1,400	$5,600
Depreciation- Store Equipment	$21,000	$0	$21,000
Allocated Expenses:
Sales Salaries	$93,600	$23,400	$70,200
Rent Expense	$27,600	$0	$27,600
Bad Debt Expense	$25,000	$4,000	$21,000
Office Salary	$26,000	$13,000	$13,000
Insurance Expense	$5,600	$1,400	$4,200
Miscellaneous Office Expense	$4,200	$2,500	$1,700
Total Expense	$826,400	$173,800	$652,600

Under the plan to eliminate department Z

Esme Company
Forecasted Annual Income Statement
Under Plan to Eliminate Department Z
Particulars	Amount
Sales	$700,00
Cost of Goods Sold	($461,300)
Gross Profit	$238,700
Operating Expenses:
Advertising	$27,000
Store Supplies Used	$5,600
Depreciation- Store Equipment	$21,000
Sales Salaries	$70,200
Rent Expense	$27,600
Bad Debt Expense	$21,000
Office Salary	$13,000
Insurance Expense	$4,200
Miscellaneous Office Expense	$1,700
Total Operating Expenses	$191,300
Net Operating Income	$47,400

Reconciliation of combined income with forecasted income

Esme Company
Reconciliation of Combined Income with Forecasted Income
Particulars	Amount
Combined Net Income	$48,600
Add: Eliminated Expenses	$173,800
Less: Department Z’s Lost Sale	$175,000
Forecasted Net Income	$47,400

The company should eliminate the department because the department decreases the net income from $48,600 to $47,400