Keep-or-Drop-or-Add for Service Firm, Complementary Effects, Traditional Two brothers, Enzo and Pietro, opened the Italian House Restaurant several years ago. The restaurant offers a variety of culinary dishes that are divided into two main product offerings: Primi (pasta first dishes) and Secondi (nonpasta meat and vegetarian second dishes). Although happy that the restaurant generates a positive profit, the brothers would like to increase its profitability and, thus, have developed two separate proposals to accomplish this goal. However, the two brothers differ strongly on which proposal should be pursued. Therefore, they have tasked the restaurant's accountant, Luigi, with analyzing the proposals to determine the most profitable course of action. The restaurant's segmented income statement for the most recent year, as well as details regarding the two proposals, are shown next. Italian House Restaurant Segmented Income Statement Primi Secondi TOTAL Sales revenues $900,000 $1,600,000 $2,500,000 Less variable costs (600,000) (1,000,000) (1,600,000) Contribution margin $300,000 $600,000 $900,000 Less direct fixed costs Advertising (150,000) (25,000) (175,000) Supervision and equipment (250,000) (75,000) (325,000) Product margin ($100,000) $500,000 $400,000 225,000 Less common fixed expenses Segmented Income Statement Primi Secondi TOTAL Sales revenues $900,000 $1,600,000 $2,500,000 Less variable costs (600,000) (1,000,000) (1,600,000) Contribution margin $300,000 $600,000 $900,000 Less direct fixed costs Advertising (150,000) (25,000) (175,000) Supervision and equipment (250,000) (75,000) (325,000) Product margin ($100,000) $500,000 $400,000 Less common fixed expenses Operating income 225,000 $175,000 Proposal 1: Drop the Primi Line Enzo prefers Proposal as he argues that the Primi line is losing money for the restaurant as evidenced by its negative product margin. He notes that he would be quite happy with earning an extra $50,000 in annual profit (ie., his 50 percent share of the avoided product margin loss if Primi is dropped). After careful consideration, Luigi noted the following additional ramifications would result from dropping the Primi product line as part of Proposal 1: Proposal 1: Drop the Primi Line Enzo prefers Proposal 1 as he argues that the Primi line is losing money for the restaurant as evidenced by its negative product margin. He notes that he would be quite happy with earning an extra $50,000 in annual profit (i.e., his 50 percent share of the avoided product margin loss if Primi is dropped). After careful consideration, Luigi noted the following additional ramifications would result from dropping the Primi product line as part of Proposal 1: Twenty percent of Primi's supervision and equipment costs are tied to a regionally renowned kitchen specialist with a unique nontermination employment contract clause. As a result, this specialist would be retrained for other restaurant duties if the Primi line were dropped. Sales of the Secondi line would decrease by 15 percent if the Primi line were dropped because some Secondi customers would no longer patronize the restaurant as other members of their party demand pasta dishes. Proposal 2: Add to the Primi Line (by Investing in It More Heavily) On the other hand, Pietro prefers Proposal 2 as he argues that an Italian restaurant must sell pasta dishes. Furthermore, he believes that Primi's current negative product margin can be converted to a positive margin if Primi's unit sales volume can be increased significantly. After careful consideration, Luigi estimates that Primi's unit sales volume would double if the following steps were taken as part of Proposal 2: Decrease the price of all Primi dishes by 5 percent. Increase annual advertising spending by $55,000 for promotional items that solely feature the Primi line. Increase annual equipment lease cost by $35,000 to obtain additional pasta making and cooking machines (that would not be used by the Secondi line). Increase annual facilities rent cost (included in common fixed expenses) by $25,000 to obtain available space adjacent to the restaurant necessary to accommodate the additional customer volume. Furthermore, the majority of this additional space would be used to expand the size of the restaurant's bathrooms and waiting area, which would be enjoyed by all restaurant customers. The owners have wanted to make these expansions since opening but could not justify the expense without the increase in customer volume that would result from adding to the Primi line. Required: 1. Perform a relevant analysis of Proposal 1. What is the new profit margin for each product line if Proposal 1 is implemented? By what amount d the restaurant's operating income change if Proposal 1 is implemented? Provide supporting computations. Italian House Restaurant Sales Less variable expenses Contribution margin Less direct fixed expenses Product margin Less common fixed expenses Operating Income Feedback Keep Drop Check My Work Calculate operating income by setting up an income statement for both scenarios; keeping and dropping product line. 2. Perform a relevant analysis of Proposal 2. What is the new profit margin for each product line if Proposal 1 is implemented? By what amount does the restaurant's operating income change if Proposal 2 is implemented? Provide supporting computations. Italian House Restaurant Keep Add (Double) Sales Less variable expenses Contribution margin Less direct fixed expenses Product margin Less common fixed expenses Operating income Feedback Check My Work Calculate operating income by setting up an income statement for both scenarios: keeping and adding to product line. 3. Based on the relevant analyses performed in requirements 1 and 2, should Enzo and Pietro choose to implement Proposal 1, Proposal 2, or remain with the status quo? Briefly explain your answer including specific references to your earlier computations. Operating income (Status quo) Operating income (Proposal 1-Drop): Accounting numeric field Operating income (Proposal 2-Add to): implement Proposal 2 because it would The preferred scenario is to generate the greatest operating income. 4. How might an ABC perspective add additional Insight into Luigi's Keep-or-Drop-or-Add relevant analysis and the resulting subsequent product-line decision? An ABC perspective could associated with the two proposals. shed deeper insights into the underlying cost drivers assumed by Luigi in the revenue and cost factors 5. Briefly explain how an accounting analysis from each of the four data analytic types could assist Luigi in his evaluation of Proposals 1 and 2. (See Exhibits 2.5 and 2.6, pp. 37, 40, for a review of data analytic types.) Answers will vary Feedback Check My Work Partially correct Previous Next