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
Less common fixed expenses					225,000
Operating income					$175,000

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:

Question Content Area

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 does the restaurant's operating income change if Proposal 1 is implemented? Provide supporting computations.

Italian House Restaurant

	Keep	Drop
Contribution marginDirect fixed expensesSalesSegment marginVariable expensesSales	$Sales	$Sales
Less operating expensesLess variable expensesLess variable expenses	Less variable expenses	Less variable expenses
Contribution marginDirect fixed expensesSalesSegment marginVariable expensesContribution margin	$Contribution margin	$Contribution margin
Less cost of goods soldLess direct fixed expensesLess direct fixed expenses	Less direct fixed expenses	Less direct fixed expenses
Common fixed expensesContribution marginProduct marginSalesVariable expensesProduct margin	$Product margin	$Product margin
Less direct materialsLess common fixed expensesLess common fixed expenses	Less common fixed expenses	Less common fixed expenses
Operating incomeOperating lossOperating income	$Operating income	$Operating income

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)
Contribution marginDirect fixed expensesSalesSegment marginVariable expensesSales	$Sales	$Sales
Less operating expensesLess variable expensesLess variable expenses	Less variable expenses	Less variable expenses
Contribution marginDirect fixed expensesSalesSegment marginVariable expensesContribution margin	$Contribution margin	$Contribution margin
Less cost of goods soldLess direct fixed expensesLess direct fixed expenses	Less direct fixed expenses	Less direct fixed expenses
Common fixed expensesContribution marginProduct marginSalesVariable expensesProduct margin	$Product margin	$Product margin
Less direct materialsLess common fixed expensesLess common fixed expenses	Less common fixed expenses	Less common fixed expenses
Operating incomeOperating lossOperating income	$Operating income	$Operating income

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)	$fill in the blank 895451fbc02000a_1
Operating income (Proposal 1Drop):	$fill in the blank 895451fbc02000a_2
Operating income (Proposal 2Add to):	$fill in the blank 895451fbc02000a_3