Discontinuance of a Department:

Direct Operating Expenses: Dept. A, $50,000; Dept. B, $45,000; Dept. C, $40,000

Indirect Operating Expenses: Dept. A, $20,000; Dept. B, $17,500; Dept. C, $20,000

Gross Profit: Dept. A, $85,000; Dept. B, $60,000; Dept,C, $65,000

Based on the above data, on the surface, it appears that you will consider the discontinuance of Department B

We can compute the operating income of each department B as follows: Gross Profit - Direct Operating Expenses - Indirect Operating Expenses = Operating Income

Dept. A: $85,000 - $50,000 - $20,000 = $15,000

Dept. B: $60,000 - $45,000 - $17,500 = ($2500)

Dept. C: $65,000 - $40,000 - $20,000 = $5000

Note that Departments A and C have positive income. Department B has a negative income (parentheses indicate negative income - a loss). It appears that Department B is contributing to our firm in a negative way. For most people, considering the elimination of Department B makes sense. However, the indirect expenses can't be traced to any one department; in other words, the $17,500 in indirect operating expenses for Dept, B will not be eliminated if we discontinue Dept. B - those costs were arbitrarily assigned to the department through an allocation process.

The total gross profit of the three departments is $210,000. If we subtract total direct expenses of $135,000 and total indirect expenses of $57,500, the total operating income of the three departments is $17,500.

If we eliminate Department B, the total gross profit of the firm is reduced to $150,000 ($210,000 - $60,000)

If we eliminate Department B, total direct expenses are reduced to $90,000 ($135,000 - $45,000)

However, total indirect expenses remain the same ($20,000 + $17,500 + $20,000 = $57,500) because indirect expenses can"t be traced to any one department - eliminating a department will not reduce the total cost

If we do eliminate Dept. B, the operating income of the firm would be computed as follows: $150,000 - $90,000 - $57,500 = $2500 of operating income - keep in mind that the operating income before the elimination of Dept. B was $17,500. All in all, it would be a mistake for the firm to eliminate Dept. B