Accounting for Decision Making and Control 8th Edition by Jerold Zimmerman

Exercise 2

Sanchez Gadgets
Sanchez Gadgets purchases innovative home kitchen gadgets from around the world (such as a kitchen torch, a pasta maker, and an automatic salad spinner) and sells them to specialty cooking retail stores. Sanchez has a marketing department that locates and purchases the innovative gadgets and prepares price lists and catalogs for Sanchez's direct selling force. Sanchez's salespeople are assigned geographic sales territories and are responsible for all the specialty kitchen stores in their geographic territories.
Management at Sanchez is concerned that with over 450 different items it is currently carrying too many different SKUs (SKUs are "stock keeping units"). Management is currently looking for a methodology to eliminate unprofitable SKUs. To focus on developing that methodology, assume that Sanchez has just four SKUs: SKU1, SKU2, SKU3, and SKU4. The following data summarize the current sales, selling prices, and cost (purchase price plus freight) for each SKU:
Sanchez purchases items for sale and inventories them. The cost of inventorying each item (including the opportunity cost of financing the item) is 20 percent of the annual cost of the item. So if 100 units of a gadget are sold each year, and the cost of the item is $4, Sanchez's inventory holding cost is $80 (20% × 100 × $4).
The annual cost of the marketing department is $135,000. This amount consists of the salaries and fringe benefits of the employees who purchase the products and prepare the catalogs and price lists. Management determines that marketing department costs vary with the number of SKUs.
The annual cost of the direct sales force is $350,000. This amount consists of the salaries, fringe benefits, and travel expenses of the salespeople who call on the retail specialty kitchen stores to sell Sanchez gadgets. After extensive conversations with the salespeople, management believes that the salespeople spend their time in proportion to the sales volume of the gadgets. In other words, if a particular gadget accounts for 10 percent of Sanchez's total revenue, then the sales force spends about 10 percent of its time selling that item.
Required:
a. Design a reporting methodology that identifies possible SKUs that Sanchez should consider dropping from its product mix. Using your methodology, compute the profitability of each of the four SKUs.
b. Based on your analysis in part ( a ), which SKUs should Sanchez drop? Which ones should Sanchez retain?
c. Discuss the critical assumptions underlying your analysis in part ( a ).