L12 Problem on Profitability Measures for Profit Center.doc

Question: - PUMBA Que. Paper [2475]-302 MCS CASE IVPike Enterprises has three operating divisions. The managers of these divisions are evaluated on their divisional operating income, a figure that includes an allocation of corporate overhead proportional to the revenues of each division. The operating income statement ($ in thousands) for the quarter of 1998 is as follows –

A Division O Division T Division TotalRevenues 2000 1200 1600 4800Cost of Goods Sold 1050 540 640 2230Gross Margin 950 660 960 2570Divisional Overheads 250 125 160 535Corporate Overheads 400 240 320 960Divisional Operating Income 300 295 480 1075

The manager of A division is unhappy that his profitability is about the same as the O Division’s and is much less than the T Division’s , even though his revenues are much higher than either of these other two divisions. The manager knows that he is carrying one line of products with very low profitability. He was going to replace this line of business as soon as more profitable product

opportunities became available, but he has kept it because the line is marginally profitable and uses facilities that would otherwise be idle. That manager now realizes, however, that the sales from this product line are attracting a fair amount of corporate overheads because of the allocation procedure, and maybe the line is already unprofitable for him. This low-margin line of products had the following characteristics for the most recent quarter ($ in thousand):Revenues 800Cost of Goods Sold 600Avoidable Divisional Overhead 100Required – 1. Prepare the operating income statement for Pike Enterprises for the second quarter of 1998. Assume that revenues and operating results are identical to the first quarter except that the manager of A Division has dropped the low margin product line from his product group.2. Is Pike Enterprises is better off from this action?3. Is the A Division manager better off from this action?4. Suggest changes for Pike’s system of division reporting and evaluation that will motivate division managers to make decisions that are in the best interest of Pike Enterprises as a whole. Discuss any potential disadvantages of your proposal.

Solution – 1.A Division O Division T Division Total

Revenues 1200(2000-800) 1200 1600 4000Cost of Goods Sold 450(1050-600) 540 640 1630Gross Margin 750 660 960 2370Divisional Overheads 150(250-100) 125 160 435Corporate Overheads 288[(1200/4000)*960] 288 384 960Divisional Operating Income

312 247 416 975

2. From the Pike Enterprises’s point of view dropping of a product by A Division is not an appropriate decision. Because this options reduces the company’s profitability from 1075 to 975. Therefore the company should be better off from this decision.

3. Though it is apparent from the financial results of the A Division that the procedure of allocating the corporate overheads is really taxing on its performance. But in view of company’s overall profitability its decision to drop a product line is not a better decision. Therefore A Division should be better off from this action.4. A Division to continue with the unprofitable product some relief should be provided to this division. As regards the reporting and evaluation of divisional performance the present system is quite good however to pave out a way for the exceptional situation it is suggested that the corporate overhead should be charged in proportion to the controllable profits of the divisions, which appears to be a reasonable option of corporate overhead allocation.

A Division O Division T Division Total

Revenues 2000 1200 1600 4800

Cost of Goods Sold 1050 540 640 2230Gross Margin 950 660 960 2570

Divisional Overheads 250 125 160 535Controllable Profit 700 535 800 2035Corporate Overheads 330 252 377 960Divisional Operating Income 370 283 423 1075

=================================== File name - Practical Problems on RC.xls

21.1. XYZ Co. Ltd. Is a multidivisional company. One of its divisions has suffered losses in the first half of the year. The sales and cost data for the said division is given as under. You are required to prepare a performance report for the said division. Also advise the management whether to allow the division to continue

Amount in Rs.Sales 825000Controllable Variable Costs 420000Controllable Fixed Costs 255000Attributable Segment Costs 75000Common firm wide cost 95000allocated to divisionProfit/Loss -20000

Solution –Performance Report

Particulars Amount in Rs.Sales 825000

Less Controllable Variable Costs 420000Controllable Contribution margin 405000

Less Controllable Fixed Costs 255000Controllable Segment Margin 150000

Less Attributable Segment Costs 75000Segment profit contribution 75000

Less Common firm wide cost 95000Profit/Loss -20000

21.2 The Himalaya Chem. Ltd. has the following operating results for the current year -

Sales Revenue 5150000Less Variable Costs 3565000Contribution 1585000Less fixed Costs 800000Net Income 785000

Following additional information is available about the proportional results of Himalaya - of the three divisions -

DivisionsX Y Z

Sales Revenue 2050000 1625000 1475000Variable Costs 1465000 1150000 950000Direct fixed Costs 250000 190000 175000

Find the relative profitability of the three divisions and rank them accordingly. There is a proposal to increase the advertisement expenses by Rs. 100000, which is expected to give additional sales of 10% in all three divisions in that year. Compute the effect of this proposal on individual divisions as also on firm as a whole. The firm's practice as regards expenses is allocation of advertisement is in the proportion of the addition in sale of the divisions and allocated to the divisions as attributable fixed costs.Advice whether the company should go for this advertisement campaign.In case this advertisement campaign gives similar benefits for next three years, what will be your decision?Solution – Performance Evaluation report –   X Y Z Firm  Sales Revenue 2,050,000 1,625,000 1,475,000 5,150,000Less Controllable Variable Costs 1,465,000 1,150,000 950,000 3,565,000  Controllable Contribution margin 585,000 475,000 525,000 1,585,000Less Controllable Fixed Costs 250,000 190,000 175,000 615,000  Segment Profit Contribution 335,000 285,000 350,000 970,000Less Firm Wide Costs       185000  Net Income       785,000  Segment Profit as % of sales 16.3 17.5 23.7  

Performance Evaluation report - After Considering Advertisement proposal - Advertisement expenses Rs. 1,00,000    X Y Z Firm  Sales Revenue - Existing 2,050,000 1,625,000 1,475,000 5,150,000Add Additional Sales 205000 162500 147500 515000  Total sales 2,255,000 1,787,500 1,622,500 5,665,000Less Controllable Variable Costs 1,611,500 1,265,000 1,045,000 3,921,500  Controllable Contribution margin 643,500 522,500 577,500 1,743,500Less Controllable Fixed Costs 250,000 190,000 175,000 615,000Less Advt. Cost 39,806 31,553 28,641 100,000  Segment Profit Contribution 353,694 300,947 373,859 1,028,500Less Firm Wide Costs       185,000  Net Income       843,500  Segment Profit as % of sales 15.7 16.8 23.0  

Rankings 3 2 1  

Though the added advertisement expenditure does not improve the Segments profit performance in comparison with the sales but in total there is growth in the profit of the firm by 58,500 which is more than the advertisement expenses hence not acceptable.In case this campaign is going go give benefits for three years the proposal is acceptable.

21.6 In M/s Bitman Tiles Ltd. The sales manager’s performance is judged by the sales he generates. The Performance is compared with the budgeted sales for evaluation purpose. The sales targeted and actual are given as under for the current year -

Products2 Color 3 Color Vitrified Total

Budgeted Sales 510000 890000 1475000 2875000Variable Costs 325000 420000 650000 1395000Contribution 185000 470000 825000 1480000Actual Sales 1500000 1200000 600000 3300000

There is no change in actual and budgeted prices as well variable costs per unit. Find how do you rate sales manager's performance? Support with computations. Suggest better performance measure for the firm in this regard.

Products2 Color 3 Color Vitrified Total

Actual Sales 1385000 1190000 575000 3150000Less Variable Costs(In proportion of Budgeted sales to Variable Costs with Actual sales) 882598 561573 253390 1697561Contribution 502402 628427 321610 1452439Contribution Margin Ratio 36.27 52.81 55.93 46.11

Though there is increase in the sales volume from rs. 2875000 to 3150000, there is decline in the contribution margin from Rs1480000 to Rs. 1452439; the main reason behind this deviation is unexpected cahnges in the sales mix. Budgeted profitable mix has changed to relatively less profitable actual mix. This has lead to change in weighted average contribution margin from51.48 % to 46.11 %. In real terms the sales manager did not perform well as planned. This obviously spells that mere reliance on sales data may prove misleading. Therefore sales manager may be judged against Sales minus Budgeted Variable Costs and Actual Selling Costs. This will ensure that charging the actual variables against sales may pass on the inefficiency of the production function to sales function, and thereby it may undermine sales manager's performance.

Illustration 1 – MCS Book -Incremental Analysis - Illustration 12 – MCS Book - PUMBA May 2005 Illustration – 9 - MCS Book - Profitability - Diamond Co Ltd.

21.9 Budgeted revenue and costs and actual of Bombay Co. Ltd's three products Prod1, Prod2 & Prod3 for the current year ending March 31, given as under –

Budgeted (Amount Rs. In Lakhs)

Particular Prod1 Prod2 Prod3 CompanySales 1,000 600 400 2,000Controllable variable Cost 500 360 280 1,140Controllable Contribution Margin

500 240 120 860

Common Fixed Cost 660Profit 200ActualParticular Prod1 Prod2 Prod3 CompanySales 660 660 880 2,200Less Discount 20 0 0 20Net Sales 640 660 880 2,180Controllable Variable Cost 332 400 620 1,352(Manufacturing and sales) 0Controllable Contribution Margin

308 260 260 828

Common Fixed Cost 670Profit 158

During the initiatives have been undertaken to enhance the sales of Prod1 by granting special discounts on bulk orders and additional allocation is made for advertisement and sales promotion expenses of Rs. Based on the above data prepare the analytical report on changes in income so as to help the management to cats the responsibility using contribution approach. Note there is no change in selling price.

Solution – Statement Showing Changes in Income - Increase DecreaseI) Effect on Contribution due to Increase in sales(2200-2000)*(860/2000) 86

II) Effect of Special Discount 20III) Effect of Sales Mix Variance on Income 88(Computed as under)Budegted Contribution 2200* (860/2000) 946Less Actual ContributionProd1 660 * (500/1000) 330

Prod1 660 * (240/600) 264Prod1 880 * (120/400) 264

858Sales Mix Variance (Adverse) 88

IV) Effect of Variable Cost Variance 10Actual Variable Cost 1,352Budgeted Variable CostProd1 660*( 500/1000) 330Prod2 660*(360/600) 396Prod3 880*(280/400) 616

1342Variable Cost Variance (Adverse) 10

86 118Net Change in Income (Decrease) 32

Decrease in Contribution Net 32Increase in Advertisement Costs 0Increase in Common Fixed Costs 10Decrease in Net Inome 42 42

PGDBM Paper May 2007

Case 2 – Du Pont & Company has two divisions. South division manufactures an intermediate product for which there is no external market. North division incorporates this intermediate product into a final product which it sells. One unit of intermediate product is used for each unit of final product. The expected units of final product, which north division estimates it can sell at various selling prices are as follows –

Unit Selling Price Sales

Quantity(Units)100 100090 200080 300070 400060 500050 6000

The cost of each division is as follows – South North

Variable Cost p.u. Rs. 11 7

Fixed Cost per annum Rs. 60000 90000The transfer price of the intermediate product determined on cost plus basis is Rs. 35 p.u.You are required to:

a. Prepare profit statement for each division as well as for the total company for the various selling prices.

b. State which selling price maximizes the profit of the North division and the Company as whole.