CLOSING AN UNPROFITABLE DEPARTMENTPROBLEM 14 - 47

PROBLEM

Tipton One-Stop Decorating sells paint and paint supplies, carpet, and wallpaper at a single-store location. Although the company has been very profitable over the years, management has seen a significant decline in wallpaper sales and earnings. Much of this decline is attributable to the internet and to companies that advertise deeply discounted prices in magazines and offer customers free shipping.

Recent figures follow: PAINT AND SUPPLIES SALES VARIABLE COSTS FIXED COSTS TOTAL COSTS OPERATING INCOME (LOSS) $ 380 000 $ 228 000 56 000 $ 284 000 $ 96 000 CARPETING $ 460 000 $ 322 000 75 000 $ 397 000 $ 63 000 WALLPAPER $ 140 000 $ 112 000 45 000 $ 157 000 $ (17 000)

Tipton is studying whether to drop wallpaper because of the changing market and accompanying loss. If the line is dropped, the following changes are expected to occur: The vacated space will be remodeled at at a cost of $12 400 and will be devoted to an expanded line of high end carpet. Sales of carpet are expected to increase by $120 000, and the line s overall contribution margin ratio will rise by five percentage points.

Tipton can cut wallpaper s fixed costs by 40 percent. Remaining fixed costs will continue to be incurred. Customers who purchased wallpaper often bought paint and paint supplies. Sales of paint and paint supplies are expected to fall by 20 percent. The firm will increase advertising expenditures by $25 000 to promote the expanded carpet line.

Requirement #1 Should Tipton close its wallpaper operation? Show computation to support your answer.

Tipton will be worse off by $12,800 if it discontinues wallpaper sales.

SALES Less: VARIABLE COSTS CONTRIBUTION MARGIN If wallpaper is closed, then:

PAINT AND SUPPLIES $380,000 228,000 $152,000

CARPETING $460,000 322,000 $138,000

WALLPAPER $140,000 112,000 $ 28,000

Loss of wallpaper contribution margin Remodeling Added profitability from carpet sales* Fixed cost savings ($45,000 x 40%) Decreased contribution margin from paint and supplies ($152,000 x 20%) Increased advertising Income (loss) from closure

$(28,000) (12,400) 65,000 18,000 (30,400) (25,000) $(12,800)#2

* The current contribution margin ratio for carpeting is 30% ($138,000 $460,000). This ratio will increase to 35%, producing a new contribution for the line of $203,000 [($460,000 + $120,000) x 35%]. The end result is that carpeting s contribution margin will rise by $65,000 ($203,000 $138,000), boosting firm profitability by the same amount.continuation

Requirement #2 Assume that Tipton s wallpaper inventory at the time of the closure decision amounted to $27 000 . How would you have treated this additional information in making decision?

This cost should be ignored. The inventory cost is sunk. Regardless of whether the department is closed, Tipton will have a wallpaper inventory of $23,700.

Requirement #3 What advantages might Internet- and magazine-based firm have over Tipton that would allow these organization to offer deeply discounted prices prices far below what Tipton can offer? These companies probably carry little or no inventory. When a customer places an order, the firm simply calls its supplier and acquires the goods. The result may be lower expenditures for storage and warehousing. These firms do not need retail space for walk-in customers. Internet- and magazine-based firms can conduct business globally. Tipton, on the other hand, is confined to a single store in Des Moines.

Requirement #4 Build a spreadsheet. Solve requirement #1. Show how the solution will change if the following changes: sales were $400 000 , $450 000 and $130 000 for paint and supplies, carpeting and wallpaper, respectively.