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 DesksSales revenue $ 1,150,000 $ 2,105,000 Direct materials 584,000 800,000 Direct labor 160,000 340,000 Required: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?

McNulty, Inc.

                                  Chairs         Desks

a) Profit margin (%)    6.33%        31.36%

b) The estimated margin for desks in year 2 is:

= 17.6%

Explanation:

a) Data and Calculations:

Expected gross profit margin on cost = 20%

Manufacturing overhead for year 1 = $800,000

                                Chairs         Desks         Total

Sales revenue $ 1,150,000 $ 2,105,000   $ 3,255,000

Direct materials    584,000      800,000       1,384,000

Direct labor           160,000      340,000         500,000

Overhead             337,572       462,428         800,000

Total costs        $1,081,572   $1,602,428   $2,684,000

Gross Profit         $68,428      $502,572       $571,000

Profit margin        6.33%            31.36%            21.27%

Margin (%) = Gross profit/Total costs * 100

Allocation of Manufacturing Overhead based on direct labor cost:

Chairs = $337,572 ($584,000/$1,384,000 * $800,000)  

Desks = $462,428 ($800,000/$1,384,000 * $800,000)

Year 2:

                                       Desks        

Sales revenue         $ 2,105,000

Direct materials            800,000

Direct labor                   340,000

Overhead                     650,000

Total costs              $ 1,790,000

Gross Profit                $315,000

Profit margin                17.6%