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Relevant costing: Incremental analysis

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Maggie Sharrer, a recent graduate of Rolling's accounting program, evaluated the operating performance of Poway Company's six divisions. Maggie made the following presentation to Poway's Board of Directors and suggested the Erie Division be eliminated. "If the Erie Division is eliminated," she said, "our total profits would increase by $24,500."

The Other Erie
Five Divisions Division Total
Sales $1,664,200 $100,000 $1,764,200
COGS 978,520 76,500 1,055,020
Gross profit 685,680 23,500 709,180
Oper.expenses 527,940 48,000 575,940
Net income $ 157,740 $ (24,500) $ 133,240

In the Erie Division, cost of goods sold is $60,000 variable and $16,500 fixed, and operating expenses are $25,000 variable and $23,000 fixed.

None of the Erie Division's fixed costs will be eliminated if the division is discontinued.

Is Maggie right about eliminating the Erie Division? Prepare a schedule to support your answer.

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Incremental Analysis

Mayfield Software Case
Mark Pelton works for Mayfield Software. As a vendor account manager (VAM), he is responsible for Mayfield's relationship with Nelson Electronics.
Nelson Electronics manufactures an ergonomic keyboard. Mayfield Software designed the keyboard and markets it, but then outsourced the manufacturing to Nelson. In the past year, Mayfield purchased 83,400 keyboards at $55 per unit. Mayfield sells the keyboards for $64 wholesale and $79 retail.
Mark is negotiating a new contract with Nelson. Mark is concerned about the low profit margin on the keyboards. He would like Nelson to lower its price. Nelson insists that it is only making a 10% profit and has provided cost information to support its assertion.
Nelson Costs for Keyboards:
Components $3,500,000
Direct labor 300,000
Depreciation of equipment 80,000
Depreciation of building 60,000
Supervisor salaries 80,000
Advertising 50,000
General and administrative 100,000
Total costs $4,170,000
Number of units 83,400
Unit cost $50
Markup at 10% is $55
Mark has some additional information to help him in his negotiations. He knows that Nelson has some excess capacity. Production of the Mayfield keyboards does not mean that Nelson has to turn down business from other customers.
Also, Mark knows that all costs other than components, direct labor, and supervisor salaries were allocated to the keyboard by Nelson on the basis of relative sales. Sales to Mayfield were $4,587,000, which is 12% of Nelson's total sales of $38,225,000. So, for example, Nelson allocated 12% of total advertising costs to the Mayfield keyboards, which means that the $50,000 in advertising cost is 12% of the total advertising cost of $416,667.
In the coming year, Mayfield estimates that demand for its keyboard will be 100,000 units if the company maintains its current wholesale and retail prices.
Mark would like Nelson to lower its price to $52 per keyboard. Analyze the information for Mark and prepare a briefing to assist his negotiations with Nelson.
The Mayfield Software Deliverable - Fixed and Variable Costs
First, separate the costs into fixed and variable.
Then, use incremental analysis to look at the information from Nelson's perspective. How much money would Nelson make at $52 per keyboard if Mayfield orders 100,000 of them? Or, to put it another way, how much money will Nelson lose if it loses the Mayfield account?
Mark is very busy. Create a cover memo that reminds him of the issues for his upcoming negotiations with Nelson. Then, present the current Nelson costs and profits. Finish with updated Nelson costs and profits assuming that the target price of $52 per keyboard is achieved.
The deliverable is a Word document with a cover memo and then information on fixed costs, variable costs, and potential lost profit.

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