Managerial Accounting: Solution to the Problem Essay Example

profit of the company?

Note: This is a problem that will challenge the very best students’ conceptual and analytical skills. However, working through this case will yield substantial dividends in terms of a much deeper understanding of critical management accounting concepts.

The overall break-even sales can be determined using the CM ratio. The issue is what to do with the common fixed cost when computing the break-evens for the individual products. The correct approach is to ignore the common fixed costs. If the common fixed costs are included in the computations, the break-even points will be overstated for individual products and managers may drop products that in fact are profitable.

If the company were to sell exactly the break-even quantities computed above, the company would lose $240,000—the amount of the common fixed cost. This can be verified as follows: At this point, many students conclude that something is wrong with their answer to part because a result in which the company loses money operating at the break-evens for the individual products does not seem to make sense. They also worry that managers may be lulled into a false sense f security if they are given the break-evens computed in part.

Total sales at the individual product break-evens is only $317,500 whereas the total sales at the overall break-even computed in part  is $732,000. Many students (and managers, for that matter) attempt to resolve this apparent paradox by allocating the common fixed costs among the products prior to computing the break-evens for individual products. Any of a number of allocation bases could be used for this purpose—sales, variable expenses, product-specific fixed expenses, contribution margins, etc. We usually take a tally

of how many students allocated the common fixed costs using each possible allocation base before proceeding. ) For example, the common fixed costs are allocated on the next page based on sales. Allocation of common fixed expenses on the basis of sales revenue:

Therefore, the total fixed expenses are $300,000 rather than $400,000. By dropping the two products, the company would go from making a profit of $40,000 to suffering a loss of $60,000.

The reason is that the two dropped products were contributing $100,000 toward covering common fixed expenses and toward profits. This can be verified by looking at a segmented income statement like the one that will be introduced in a later chapter.