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Continue or Eliminate Analysis

Introductions:
Think of the divisions of a company like leaves on an Aspen tree. Like the leaves on an Aspen tree, divisions in a company have a life cycle. It is up to the accountant to help management to determine when to eliminate an old unprofitable division in order to keep the company healthy and productive. If divisions are eliminated at the wrong time, it can result in harm to the entire company just as removing leaves from an Aspen tree could harm the tree.
Prezi Presentation

A profitable division is one that produces income, which covers variable cost, fixed cost, and produces a profit. The problem with eliminating unprofitable divisions is that sometimes those divisions are producing income that covers allocated fixed cost. Without those divisions fixed cost would have to be transferred to other profitable divisions, which would reduce profits from those divisions. The end result would be a decrease in income, which would result in an overall drop in net income. It is very important to determine the overall effect of eliminating a division before any action is taken by the company. You must always remember to look at the effects of elimination on the whole. The only exception to this rule is if the company has a replacement division that will be profitable to replace the old unprofitable division. Limited resources often require the replacement of old unprofitable division to make ways for new divisions that can produce a profit. Also note that if a unprofitable division is not covering variable cost, not producing a positive contribution margin, then it should without question be eliminated to prevent future losses. For a full presentation on the “Continue or Eliminate Analysis” go to this Web link: http://prezi.com/7usjx2zailku/continue-or-eliminate-analysis-for-divisions-within-a-company/

12/2013 MJC

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Continue or Eliminate Analysis
Example problem:
Jeni Maynard, a new executive for Francisco Corporation has been evaluating the operating performance of her corporation. She has developed a proposal to eliminate the Gates Division in order to increase profitability. The management of Francisco Corporation has asked your input on this proposal. Prepare a “Continue or Eliminate Analysis” to determine if the management of the corporation should accept Jeni’s proposal or not.

Information provided:

The other three Divisions Sales Cost of goods sold Gross Profit Operating expenses Net Income 1,324,000 850,000 474,000 260,000 214,000

Gates Division 120,000 80,000 40,000 45,000 (5,000)

Total 1,444,000 930,000 514,000 305,000 209,000

In the Gate’s Division, cost of goods sole is 42,000 variable and 38,000 fixed, and operating expenses are 25,000 variable and 20,000 fixed. None of the Gates Division’s fixed costs will be eliminated if the division is eliminated. Instructions: 1. Prepare a “Continue or Eliminate Analysis.” 2. Should Francisco Corporation implement Ms. Maynard’s proposal? Why or Why not?

12/2013 MJC

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Continue or Eliminate Analysis
Answer:
The “Continue or Eliminate Analysis
Continue Sales Variable Costs: Cost of Goods Sold Operating Expenses Total Variable Costs Contribution Margin Fixed Costs: Cost of Goods Sold Operating Expenses Total Fixed Cost Net Loss 120,000 42,000 25,000 67,000 53,000 38,000 20,000 58,000 (5,000) Eliminate 0 0 0 0 0 38,000 20,000 58,000 (58,000) Net Income Increase or Decrease (120,000) 42,000 25,000 67,000 (53,000) 0 0 0 (53,000)

Calculations:
Variable costs are added to get total variable cost: 42,000 + 25,000 = 67,000 Total variable costs are subtracted from sales to get contribution margin: 120,000 – 67,000 = 53,000 Fixed costs are added to get total fixed cost: 38,000 + 20,000 = 58,000 Contribution Margin minus total fixed cost equals Net Loss: For Continue: 53,000 – 58,000 = 5,000 For Eliminate: 0 – 58,000 = 58,000 Increase or Decrease is determined by subtracting the net loss to arrive with the amount for increase or decrease in net income: 58,000 – 5,000 = 53,000

Under the continue section the corporation would continue to have net losses of $5,000 but under the eliminate section the corporation would need to allocate net losses of $53,000 to the other divisions. All income along with variable costs would be eliminated if the division was eliminated.

Results:
Should Francisco Corporation implement Ms. Maynard’s proposal? Why or Why not? The answer is no. If Ms. Maynard’s proposal was implemented, the corporation would loss income that covers $53,000 in fixed cost each year. This course of action would result in an overall reduction of net income by $53,000. Only if this division can be replaced with a profitable division should Francisco Corporation eliminate the Gate Division.

12/2013 MJC

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