McNulty, Inc., produces desks and chairs. A new CFO has just been hired and announces a new policy that, if a product cannot earn a margin on sales of at least 20 percent, it will be dropped.
The margin is computed as product gross profit divided by reported product cost.
Manufacturing overhead for year 1 totaled $800,000. Overhead is allocated to products based on direct labor cost.
Data for year 1 show the following:
Chairs Desks
Sales revenue $1,150,000 $2,105,000
Direct materials 584,000 800,000
Direct labor 160,000 340,000
a-1. Based on the CFO's new policy, calculate the profit margin for both chairs and desks.
Profit Margin (%)
Chairs
Desks
a-2. Which of the two products should be dropped?
b. Regardless of your answer in requirement a, the CFO decides at the beginning of year 2 to drop the chair product. The company cost analyst estimates that overhead without the chair line will be $650,000. The revenue and costs for desks are expected to be the same as last year.
What is the estimated margin for desks in year 2?
Gross Profit Margin:
Gross Profit margin is given as the gross profit divided by the sales of the company multiplied by 100. It is calculated to compare the results of the company from the past year and also from other companies in the industry.

Answer:

a-1. Profit Margin:

Chairs = 15%

Desks = 25%

a-2. Chair should be dropped.

b. The estimated margin for desks in year 2 is 18%.

Explanation:

a-1. Based on the CFO's new policy, calculate the profit margin for both chairs and desks.

McNulty, Inc.

Calculation of the profit margin for both chairs and desks for year 1.

Details                                      Chairs ($)              Desks ($)  

Sales revenue (A)                    1,150,000              2,105,000

Direct materials (B)                   584,000              800,000

Direct labor (C)                          160,000               340,000

Manufacturing overhead (D)    256,000               544,000

Product cost (E = B+C+D)       1,000,000            1,684,000

Gross profit (F = A-E)                  150,000               421,000

Profit Margin (G = F/E)                   15%                      25%

Expected margin                            20%                    20%

Workings:

Chairs Manufacturing overhead = ($160,000 / ($160,000 + $340,000)) * $800,000 = $256,000

Desks Manufacturing overhead = ($340,000 / ($160,000 + $340,000)) * $800,000 = $544,000

a-2. Which of the two products should be dropped?

Chair should be dropped. This is because its estimated profit margin of 15% is less than the expected margin of 20%.

b. Regardless of your answer in requirement a, the CFO decides at the beginning of year 2 to drop the chair product. The company cost analyst estimates that overhead without the chair line will be $650,000. The revenue and costs for desks are expected to be the same as last year. What is the estimated margin for desks in year 2?

The estimated margin for desks in year 2 can be calculated as follows:

McNulty, Inc.

Estimation of margin for desks in year 2

Details                                                   Desks ($)    

Sales revenue (A)                                  2,105,000

Direct materials (B)                                  800,000

Direct labor (C)                                         340,000

Manufacturing overhead (D)                   650,000

Product cost (E = B+C+D)                     1,790,000

Gross profit (F = A-E)                                315,000  

Profit Margin (G = F/E)                                 18%

Expected margin                                          20%

Therefore, the estimated margin for desks in year 2 is 18%.

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