Alberta Gauge Company, Ltd., a small manufacturing company in Calgary, Alberta, manufactures three types of electrical gauges used in a variety of machinery. For many years the company has been profitable and has operated at capacity. However, in the last two years, prices on all gauges were reduced and selling expenses increased to meet competition and keep the plant operating at capacity. Second-quarter results for the current year, which follow, typify recent experience. ALBERTA GAUGE COMPANY, LTD. Income Statement Second Quarter (in thousands) Q-Gauge E-Gauge R-Gauge Total Sales .................................................................................. $1,600 $900 $900 $3,400 Cost of goods sold .............................................................. 1,048 770 950 2,768 Gross margin ...................................................................... $ 552 $130 $ (50) $ 632 Selling and administrative expenses ..................................... 370 185 135 690 Income before taxes ............................................................ $ 182 $ (55) $(185) $ (58) Alice Carlo, the companys president, is concerned about the results of the pricing, selling, and production prices. After reviewing the second-quarter results, she asked her management staff to consider the following three suggestions: Discontinue the R-gauge line immediately. R-gauges would not be returned to the product line unless the problems with the gauge can be identified and resolved. Increase quarterly sales promotion by $100,000 on the Q-gauge product line in order to increase sales volume by 15 percent. Cut production on the E-gauge line by 50 percent, and cut the traceable advertising and promotion for this line to $20,000 each quarter. Jason Sperry, the controller, suggested a more careful study of the financial relationships to determine the possible effects on the companys operating results of the presidents proposed course of action. The president agreed and assigned JoAnn Brower, the assistant controller, to prepare an analysis. Brower has gathered the following information. All three gauges are manufactured with common equipment and facilities. The selling and administrative expense is allocated to the three gauge lines based on average sales volume over the past three years. Special selling expenses (primarily advertising, promotion, and shipping) are incurred for each gauge as follows: Quarterly Advertising and Promotion Shipping Expenses Q-gauge ............................................................................... $210,000 $10 per unit E-gauge ............................................................................... 100,000 4 per unit R-gauge ............................................................................... 40,000 10 per unit Case 1463 Drop a Product Line (LO 4, 5) Unit contribution, E-gauge: $19.00 Chapter 14 Decision Making: Relevant Costs and Benefits 641 The unit manufacturing costs for the three products are as follows: Q-Gauge E-Gauge R-Gauge Direct material ................................................................................. $ 31 $17 $ 50 Direct labor ...................................................................................... 40 20 60 Variable manufacturing overhead ...................................................... 45 30 60 Fixed manufacturing overhead .......................................................... 15 10 20 Total ................................................................................................ $131 $77 $190 The unit sales prices for the three products are as follows: Q-gauge ................................................................................ $200 E-gauge ................................................................................ 90 R-gauge ................................................................................ 180 The company is manufacturing at capacity and is selling all the gauges it produces. Required: 1. JoAnn Brower says that Alberta Gauge Companys product-line income statement for the second quarter is not suitable for analyzing proposals and making decisions such as the ones suggested by Alice Carlo. Write a memo to Alberta Gauges president that addresses the following points. a. Explain why the product-line income statement as presented is not suitable for analysis and decision making. b. Describe an alternative income-statement format that would be more suitable for analysis and decision making, and explain why it is better. 2. Use the operating data presented for Alberta Gauge Company and assume that the presidents proposed course of action had been implemented at the beginning of the second quarter. Then evaluate the presidents proposal by specifically responding to the following points. a. Are each of the three suggestions cost-effective? Support your discussion with an analysis that shows the net impact on income before taxes for each of the three suggestions. b. Was the president correct in proposing that the R-gauge line be eliminated? Explain your answer. c. Was the president correct in promoting the Q-gauge line rather than the E-gauge line? Explain your answer. d. Does the proposed course of action make effective use of the companys capacity? Explain your answer. 3. Are there any qualitative factors that Alberta Gauge Companys management should consider before it drops the R-gauge line? Explain your answer.