Lovell will compare the contribution margin that

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Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped.
Adding/Dropping Segments Segment Income Statement Digital Watches Sales 500,000 $ Less: variable expenses Variable manufacturing costs 120,000 $ Variable shipping costs 5,000 Commissions 75,000 200,000 Contribution margin 300,000 $ Less: fixed expenses General factory overhead 60,000 $ Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss (100,000) $
Adding/Dropping Segments Segment Income Statement Digital Watches Sales 500,000 $ Less: variable expenses Variable manufacturing costs 120,000 $ Variable shipping costs 5,000 Commissions 75,000 200,000 Contribution margin 300,000 $ Less: fixed expenses General factory overhead 60,000 $ Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss (100,000) $
Adding/Dropping Segments Segment Income Statement Digital Watches Sales 500,000 $ Less: variable expenses Variable manufacturing costs 120,000 $ Variable shipping costs 5,000 Commissions 75,000 200,000 Contribution margin 300,000 $ Less: fixed expenses General factory overhead 60,000 $ Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss (100,000) $
A Contribution Margin Approach Retain Retain Contribution Margin Solution Contribution margin lost if digital watches are dropped (300,000) $ Less fixed costs that can be avoided Salary of the line manager 90,000 $ Advertising - direct 100,000 Rent - factory space 70,000 260,000 Net disadvantage (40,000) $
Comparative Income Approach The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. Let’s look at this second approach. The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. Let’s look at this second approach.
If the digital watch line is dropped, the company loses $300,000 in contribution margin.
On the other hand, the general factory overhead would be the same under both alternatives, so it is irrelevant.
The salary of the product line manager would disappear, so it is relevant to the decision. Comparative Income Approach Solution Keep Digital Watches Drop Digital Watches Difference Sales 500,000 $ - $ (500,000) $ Less variable expenses: - Manufacturing expenses 120,000 - 120,000 Shipping 5,000 - 5,000 Commissions 75,000 - 75,000 Total variable expenses 200,000 - 200,000 Contribution margin 300,000 - (300,000) Less fixed expenses: General factory overhead 60,000 60,000 - Salary of line manager 90,000 - 90,000 Depreciation 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss (100,000) $
The depreciation is a sunk cost. Also, remember that the equipment has no resale value or alternative use, so the equipment and the depreciation expense associated with it are irrelevant to the decision.

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