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Closing a department

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Hambley's Toy store is on Regent Street in London. It has a magic department near the main door. Suppose that management is considering dropping the magic department, which has consistently shown an operating loss. The predicted income statements follow (for ease of analysis, only three product lines are shown):

The $310,000 of magic department fixed expenses include the compensation of employees of $100,000. These employees will be released if the magic department is abandoned. All of the magic department's equipment is fully depreciated, so none of the $310,000 pertains to such items. Furthermore, disposal values of equipment will be exactly offset by the costs of removal and remodeling.

If the magic department is dropped, the manager will use the vacated space for either more general merchandise or more electronic products. The expansion of general merchandise would not entail hiring any additional salaried help, but more electronic products would require an additional person at an annual cost of $25,000. The manager thinks that sales of general merchandise would increase by $300,000; electronic products, by $200,000. The manager's modest predictions are partially based on the fact that she thinks the magic department has helped lure customers to the store and thus improved overall sales. If the magic department is closed, that lure would be gone.
1) Should the magic department be closed? Explain, showing computations.

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Solution Summary

The solution explains the use of relevant costs in making a decision regarding closing of a department within a store

Solution Preview

We have to first analyze the financial situation of the Magic department. This is currently showing a loss of $100,000. The contribution margin is positive at $210,000. The variable costs are being met. Of the fixed costs, only the employee compensation will be reduced, ...

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