EXERCISE 122 Dropping or Retaining a Segment [LO2]

Cumberland County Senior Services is a non-profit organization devoted to providing essential services to seniors who live in their own homes within the Cumberland County area. Three services are provided for seniorshome nursing, Meals on Wheels, and housekeeping. In the home nursing program, nurses visit seniors on a regular basis to check on their general health and to perform tests ordered by their physicians. The Meals on Wheels program delivers a hot meal once a day to each senior enrolled in the program. The housekeeping service provides weekly housecleaning and maintenance services. Data on revenue and expenses for the past year follow: Meals on Wheels $400,000 210,000 190,000 40,000 7,000 38,000 80,000 165,000 $ 25,000 Housekeeping $240,000 160,000 80,000 20,000 15,000 37,000 48,000 120,000 $(40,000)

Revenues Variable expenses Contribution margin Fixed expenses: Depreciation Liability insurance Program administrators' salaries General administrative overhead* Total fixed expenses Operating income (loss)

Total $900,000 490,000 410,000 68,000 42,000 115,000 180,000 405,000 $ 5,000

Nursing $260,000 120,000 140,000 8,000 20,000 40,000 52,000 120,000 $ 20,000

*Allocated on the basis of program revenues. The head administrator of Cumberland County Senior Services, Judith Ewa is concerned about the organization's finances and considers the operating income of $5,000 last year to be razorthin. (Last year's results were very similar to the results for previous years and are representative of what would be expected in the future.) She feels that the organization should be building its financial reserves at a more rapid rate in order to prepare for the next inevitable recession. After seeing the above report, Ewa asked for more information about the financial advisability of perhaps discontinuing the housekeeping program. Page 580 The depreciation in the housekeeping category is for a small van that is used to carry the housekeepers and their equipment from job to job. If the program was discontinued, the van would be donated to a charitable organization. Depreciation charges assume zero salvage value. None of the general administrative overhead would be avoided if the housekeeping program was dropped, but the liability insurance and the salary of the program administrator would be avoided.

Required: 1. Should the housekeeping program be discontinued? Explain. Show computations to support your answer. 2. Recast the above data in a format that would be more useful to management in assessing the long-run financial viability of the various services.

SOLUTION Exercise 12-2 (30 minutes) 1. No, the housekeeping program should not be discontinued. It is actually generating a positive program segment margin and is, of course, providing a valuable service to seniors. Computations to support this conclusion follow: Contribution margin lost if the housekeeping program is dropped .......................................... Fixed costs that can be avoided: Liability insurance ............................................. $15,000 Program administrators salary ........................... 37,000 Decrease in operating income for the organization as a whole........................................................ $(80,000) 52,000 $(28,000)

Depreciation on the van is a sunk cost and the van has no salvage value since it would be donated to another organization. The general administrative overhead is allocated and none of it would be avoided if the program were dropped; thus it is not relevant to the decision. The same result can be obtained with the alternative analysis below:

Revenues .................................... $900,000 Variable expenses........................ 490,000 Contribution margin..................... 410,000 Fixed expenses: Depreciation ............................. 68,000 Liability insurance ..................... 42,000 Program administrators salaries 115,000 General administrative overhead 180,000 Total fixed expenses .................... 405,000 Operating income (loss) ............... $ 5,000

Current Total

Difference: Total If Operating HouseIncome keeping Is Increase or Dropped (Decrease)

$660,000 330,000 330,000

$(240,000) 160,000 (80,000)

68,000 27,000 78,000 180,000 353,000 $(23,000)

0 15,000 37,000 0 52,000 $ (28,000)

Exercise 12-2 (continued) 2. To give the administrator of the entire organization a clearer picture of the financial viability of each of the organizations programs, the general administrative overhead should not be allocated. It is a common cost that should be deducted from the total program segment margin. Following the format introduced in Chapter 11 for a segmented income statement, a better income statement would be:

Revenues ............................ $900,000 Less Variable expenses ........ 490,000 Contribution margin............. 410,000 Traceable fixed expenses: Depreciation ..................... 68,000 Liability insurance ............. 42,000 Program administrators salaries .......................... 115,000 Total traceable fixed expenses .......................... 225,000 Program segment margins ... 185,000 General administrative overhead .......................... 180,000 Operating income (loss) ....... $ (5,000)

Total

$260,000 $400,000 120,000 210,000 140,000 190,000 8,000 20,000 40,000 40,000 7,000 38,000

Home Nursing

Meals on Wheels

Housekeeping

$240,000 160,000 80,000 20,000 15,000 37,000 72,000 $ 8,000

68,000 85,000 $ 72,000 $105,000