Carousel Motors is an auto dealership that specializes in selling used cars. Carousel also has a small service station that it uses to (1) make minor repairs on the cars it buys and (2) provide both paid and courtesy repairs and maintenance on customers’ cars. For example, Carousel often runs ads that offer “free maintenance for one year with any auto purchase,” and restricts the maintenance to regularly scheduled items such as oil changes and tire rotations. The following data pertain to Carousel’s most recent year of operations:

You are puzzled by the service department’s zero contribution margin since you know that the service department marks up its variable cost by 100% to arrive at the price charged to an external customer. Digging into the data, you learn that the service department only spent one-half of its time servicing external customers. The remainder of its time was spent repairing cars bought to replenish Carousel’s inventory of used cars and providing courtesy (free) repairs on the used cars sold. For the service department, the above income statement only shows the revenues derived from sales to external customers, while it shows the costs associated with all of its service activities. Moreover, the used car division does not record any costs for the repairs provided by the service department.

Required:
a. Modify Carousel’s contribution margin statement so that the service department’s revenues and the used car’s costs fully reflect the market value of the services provided by the service department to the used car department (i.e., assume that the service department charges used cars what it charges external customers).

b. Jim Carew, the owner of Carousel Motors, believes that closing the service department will increase overall company profit. Based on your calculations in part (a), by how much will Carousel’s overall profit increase or decrease if the service department is closed? (Assume that the used car department will pay an independent service station for the minor repairs on the cars it buys and for the courtesy repairs and maintenance on the used cars sold—all of this will be done at market price, or the amount you calculated in part [a].) What other factors should Jim consider before making the decision to close the service department?
c. Assume that closing the service department will reduce used car sales by 10%. How does this information affect your answer to part (b)? That is, by how much will Carousel’s overall profit increase or decrease if the service department is closed and used car sales decrease by 10%?

Transcribed Image Text:

Used as Service Department Total $2,700,000 1,400,000 $1,300,000 1,000,000 $300,000 200,000 $100,000 RTs Revenue Variable costs Contribution margin $1,300,000 Traceable fixed costs Segment margn Common fixed costs Profit before taxes Common fixed costs equal the salary of the owner plus the salary of the general manager. $200,000 200,000 $0 250,000 ($250,000) $2,500,000 1,200,000 750,000 $550,000