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coming month) also will be charged $6 for each winter item cleaned, implying that the contribution margin on “regular” winter item business will go down by 500 ($9 – $6) = $1,500. These two numbers, coupled with the increased advertising expenditure, allow us to calculate the change in profit from running the special promotion: Balakrishnan, Sivaramakrishnan, & Sprinkle – 2eFOR INSTRUCTOR USE ONLY6-27
Incremental contribution margin from increased sales(6.00 – 3.60) 1,500$3,600Lost contribution margin on regular winter item business500 ($9 – $6)($1,500)Incremental advertisingGiven($1,000)Net change in monthly profit$1,100CleanCo should run the promotion as profit in the coming month is expected to increase by $1,100.6.54a.In this problem, it is important to recognize that all of the common fixed costs allocated to the dry cleaning operations would not disappear if the dry cleaning business were to be closed. Specifically, the dry cleaning business currently generates a segment margin of $300,000 ($800,000 – $500,000). This margin would not be available if the dry cleaning business were to close. However, the common fixed costs would decrease by $200,000; thus, the net reduction in profit is $300,000 – $200,000 = $100,000. That is, SpringFresh’s profit will decrease by $100,000 to $200,000 if it eliminates the dry cleaning department.This effect is perhaps most easily seen (and verified) by constructing an income statement without the dry cleaning business. We present such an income statementbelow: Laundry OnlyRevenue$3,000,000Variable costs$1,000,000Contribution margin$2,000,000Direct fixed costs$1,000,000Common fixed costs*$800,000Profit$200,000* = $1,000,000 – $200,000.Again, we see that SpringFresh’s overall profit decreases by $100,000 to $200,000. Assuming the accuracy of the estimate of the reduction in common fixed costs, SpringFresh should not eliminate its dry cleaning operations. This particular problem underscores that income statements can be misleading in terms of what a particular department or product actually contributes to overall Balakrishnan, Sivaramakrishnan, & Sprinkle – 2eFOR INSTRUCTOR USE ONLY6-28
profitability. The key in making this assessment is determining what revenues andcosts actually disappear if the department is eliminated.b.Increasing the volume of laundry will increase the contribution margin available to cover fixed costs. Based on the data provided, we find that each $1.00 of revenue in laundry provides $0.67 in contribution margin ($2,000,000 in contribution margin divided by $3,000,000 in revenue). Thus, an increase of 10% in laundry sales will increase the laundry contribution margin by 10% as well. This implies that the laundry contribution margin will increase to $2,200,000. Our revised income statement with laundry only looksas follows:Laundry OnlyRevenue$3,300,000$3,000,000 1.1Variable costs$1,100,000$1,000,000 1.1Contribution margin$2,200,000$2,000,000 1.1Direct fixed costs$1,000,000Common fixed costs*$800,000$1,000,000 – $200,000Profit$400,000Here, we see that SpringFresh’s overall profit increases by $100,000 to $400,000.