If a department can’t cover all of its costs, which include its fair share of overhead, we should get rid of it. It’s that simple!

The speaker was Ricardo Delgado, controller of Mercancía, S.A., a large distributor of appliances in Santa Tecla, a small industrial town just outside San Salvador, the capital of El Salvador. He was discussing the poor financial performance of the company’s video department at a monthly meeting of the company’s department managers.

BACKGROUND

Mercancía imported large appliances and distributed them to retailers throughout Central America. It carried three broad lines of merchandise: audio equipment (such as stereo tuners, CD players, and radios), video equipment (including televisions and VCRs), and portable communication devices (such as cell phones and electronic pagers). Each line accounted for about one-third of the company’s total sales revenue. Financial statements for the most recent year are contained in Exhibit 1.

Recently, Sr. Delgado had begun to prepare product line (or “department,” as each product line was called) income statements. The video department’s income statement for the first quarter of 2005 is contained in Exhibit 2. Of the three departments, only the video department lost money during the quarter. The other two had profit margins of about 8 percent.

REACTIONS

Ernesto Gallardo, the video department’s manager was not happy with Sr. Delgado’s conclusions:

This so called income statement may show a loss, but it misses a lot of important factors. First, it’s just for three months, and a slow three months at that, coming just after the holidays. Second, the video department helps out the other departments a lot. Buyers come here to buy TVs for their stores, and they wander into the audio department or the communication department, and they sometimes buy something there too. How do you measure that on our department’s income statement.

Juana Fuentes, the company’s managing director, had another set of concerns:

Let’s forget the loss-leader argument, Ernesto. Video sales are helped by audio and communications sales, too. Also, since we don’t have any other data to go on, let’s assume the first quarter is representative of the year, even though it may not be. I’m still not convinced that we’d be better off as a company by getting rid of the video department. . . .

Assignment

1. Assume that the video department’s sales in the first quarter of 2005 were one-third of the company’s sales, and that each of the other two department’s had profit margins (income before taxes as a percent of net sales revenues) of 8 percent. What was Mercancía’s income or loss before taxes for the quarter?
2. Analyze what the company’s income or loss before taxes would have been without the video department? Be specific in explaining the differences, addressing each of the notes to Exhibit 2.
3. Is Mercancía, S.A. a financially viable company? What additional information would you like to have to assist you in your assessment?