Question

Members of the board of directors of Security Check have received the following operating income data for the year ended May 31, 2018:

SECURITY CHECK Income Statement For the Year Ended May 31, 2018

Product Line

Industrial Systems

Household Systems

Total

Net Sales Revenue	\( 360,000	\) 380,000	\( 740,000
Cost of Goods Sold:
Variable	37,000	47,000	84,000
Fixed	260,000	63,000	323,000
Total Cost of Goods Sold	297,000	110,000	407,000
Gross Profit	63,000	270,000	333,000
Selling and Administrative Expenses:
Variable	64,000	73,000	137,000
Fixed	44,000	26,000	70,000
Total Selling and Administrative Expenses	108,000	99,000	207,000
Operating Income (Loss)	\) (45,000)	\( 171,000	\) 126,000

Members of the board are surprised that the industrial systems product line is not profitable. They commission a study to determine whether the company should drop the line. Company accountants estimate that dropping industrial systems will decrease fixed cost of goods sold by \(80,000 and decrease fixed selling and administrative expenses by \)12,000.

Requirements

1. Prepare a differential analysis to show whether Security Check should drop the industrial systems product line.

2. Prepare contribution margin income statements to show Security Check’s total operating income under the two alternatives: (a) with the industrial systems line and (b) without the line. Compare the difference between the two alternatives’ income numbers to your answer to Requirement 1.

3. What have you learned from the comparison in Requirement 2?

Short answer

Operating lossfor the company is$41,000 if the company drops the industrial system line.

Step-by-step solution

Meaning of Contribution Margin

Contribution margin refers to the profit earned by a company after recovering all its variable costs from the revenues generated by sales. Contribution margin approach is used in amanagerial accounting branch.

  Preparation of differential analysis

Particulars	Amount ($)
Expected decrease in revenue	(360,000)
Expected decrease in variable cost (37000+64000)	101,000
Expected decrease in fixed cost (80000+12000)	92,000
Decrease in operating income	$(167,000)

Preparation of income statement

Income Statement

Particulars	With the line ($)	Without the line ($)
Sales revenue	740,000	380,000
Less: Variable costs
Cost of goods sold	(84,000)	(47,000)
Marketing and administrative expense	(137,000)	(73,000)
Contribution margin	519,000	260,000
Less: Fixed costs
Cost of goods sold	(323,000)	(243,000)
Marketing and administrative expense	(70,000)	(58,000)
Operating income/(loss)	$126,000	$(41,000)

Learning from the comparison

The product line should not be dropped because there will be an incremental loss of $167,000(i.e., the difference between the operating income with the line and the operating loss without the line).