Final answer:
To decide on the elimination of the Eastern Division of Cook Company, we must assess whether the division's lost revenue outweighs the savings in eliminated direct fixed costs. This involves analyzing the company's operating income with and without the division, taking into consideration that corporate fixed costs would still be incurred. A true economic profit calculation would also factor in both explicit and implicit costs.
Step-by-step explanation:
To determine whether Cook Company should eliminate its Eastern Division, we must consider the impact on the company's operating income. Currently, if the division is making less revenue than its variable costs, such as a scenario where revenues are $10,000 and variable costs are $15,000, it might seem intuitive to shut it down. However, one must also account for the fixed costs that would remain even if the division is closed. In this case, corporate costs of $305,000 would still apply.
Using the principles of cost-volume-profit analysis, the decision should be based on whether the elimination of the Eastern Division would increase or decrease the company's net operating income. If the lost revenue from the Eastern Division exceeds the savings from the eliminated direct fixed costs, then the company's operating income would decline, making the elimination unfavorable from a financial perspective.
If we want to calculate the true economic profit, we would subtract both the explicit and implicit costs from the total revenues. For instance, if the total revenues were $200,000 and the explicit and implicit costs were $85,000 and $125,000, respectively, then the economic profit would be -$10,000 per year, suggesting the business is not economically profitable.