Day Street Delis Owner Is Disturbed By Poor Profit Performan

Day Street Delis Owner Is Disturbed By The Poor Profit Performance Of

Day Street Deli’s owner is disturbed by the poor profit performance of his ice cream counter. He has prepared a profit analysis for the year just ended, which shows sales of $45,000, cost of food totaling $20,000, resulting in a gross profit of $25,000. Operating expenses include wages of counter personnel ($12,000), paper products ($4,000), utilities ($2,900), depreciation of counter equipment and furnishings ($2,500), allocated depreciation of the building ($4,000), and the deli manager’s salary ($3,000). The total expenses add up to $28,400, leading to a reported loss of $3,400 on the ice cream counter. The owner is concerned about this loss and wishes to understand the analysis better, including any inaccuracies or areas for correction.

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The profit analysis provided by the owner of Day Street Deli regarding the ice cream counter exhibits several critical flaws, primarily stemming from inappropriate allocation of costs and the failure to distinguish between variable and fixed expenses, which distorts the true profitability of the counter.

Firstly, the owner combines both direct and indirect costs in a way that doesn't accurately reflect the incremental profitability of the ice cream counter. For example, the wages of counter personnel, amounting to $12,000, are most likely variable costs directly associated with the counter's operations and should be considered in analyzing the counter’s contribution margin. This expense directly fluctuates with sales volume and should be treated as a relevant cost in decision-making about the counter's profitability.

In contrast, many of the other expenses, such as depreciation of counter equipment ($2,500), depreciation of the building ($4,000), and the deli manager’s salary ($3,000), are fixed costs that are generally allocated over the entire operation and are not variable with the ice cream counter's sales. These should not be included in the calculation of the counter’s contribution margin but should be accounted for in the overall store’s fixed costs.

Secondly, the owner's analysis presents a total operating expense of $28,400 and a profit/loss figure solely by subtracting this from gross profit, which includes all costs, regardless of their relevance to the ice cream counter. This approach results in an inaccurate assessment of the counter's profitability because it blends fixed costs (which would exist regardless of the counter’s performance) with variable costs. To properly evaluate the counter’s performance, one must segregate variable costs from fixed costs and compute the contribution margin.

Thirdly, fixing the problem involves reclassification of costs to determine the true contribution margin of the ice cream counter. For example, if the wages of counter personnel are variable, then the contribution margin would be calculated as sales ($45,000) minus variable costs (food costs plus wages), giving a clearer picture of how much revenue is available to cover fixed costs and contribute to profit.

Applying this correction, we recognize that food costs of $20,000 are variable and directly related to sales. When combined with wages of $12,000, assuming these wages fluctuate with sales (e.g., based on hours worked related to sales volume), the total variable costs become $32,000. Deducting these from sales results in a negative contribution margin, indicating the counter is not covering its variable costs, which inherently means it is loss-making at the variable level.

Furthermore, fixed costs such as depreciation ($2,500 + $4,000) and the manager’s salary ($3,000) should be allocated appropriately to assess whether the counter is contributing sufficiently to fixed expenses. If the contribution margin is negative or insufficient to cover fixed costs, the counter should be evaluated for discontinuation or operational improvements.

In conclusion, the owner’s analysis overstates the expenses by including fixed costs directly attributable to the entire store as relevant expenses for the counter, thus misrepresenting its profitability. A more appropriate approach involves calculating the contribution margin by subtracting variable costs from sales, then comparing this margin with the fixed costs allocated to the counter to determine true profitability. Based on the data, the ice cream counter is likely unprofitable at the variable cost level, suggesting that the owner should consider either cost reductions, pricing adjustments, or operational changes to improve performance.

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