L12 Problem on Profitability Measures for Profit Center.

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Question: - PUMBA Que. Paper [2475]-302 MCS CASE IV

Pike 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 Total
Revenues 2000 1200 1600 4800
Cost of Goods Sold 1050 540 640 2230
Gross Margin 950 660 960 2570
Divisional Overheads 250 125 160 535
Corporate Overheads 400 240 320 960
Divisional 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 800
Cost of Goods Sold 600
Avoidable Divisional Overhead 100
Required –
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 4000
Cost of Goods Sold 450(1050-600) 540 640 1630
Gross Margin 750 660 960 2370
Divisional Overheads 150(250-100) 125 160 435
Corporate Overheads 288[(1200/4000)*960] 288 384 960
Divisional Operating 312 247 416 975
Income

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 2230
Gross Margin 950 660 960 2570
Divisional Overheads 250 125 160 535
Controllable Profit 700 535 800 2035
Corporate Overheads 330 252 377 960
Divisional Operating Income 370 283 423 1075

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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 825000
Controllable Variable Costs 420000
Controllable Fixed Costs 255000
Attributable Segment Costs 75000
Common firm wide cost 95000
allocated to division
Profit/Loss -20000
Solution –
Performance Report
Particulars Amount in Rs.
Sales 825000
Less Controllable Variable Costs 420000
Controllable Contribution margin 405000
Less Controllable Fixed Costs 255000
Controllable Segment Margin 150000
Less Attributable Segment Costs 75000
Segment profit contribution 75000
Less Common firm wide cost 95000
Profit/Loss -20000

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

Sales Revenue 5150000

Less Variable Costs 3565000
Contribution 1585000
Less fixed Costs 800000
Net Income 785000
Following additional information is available about the proportional results of Himalaya - of the
three divisions -
Divisions
X Y Z
205000
Sales Revenue 0 1625000 1475000
146500
Variable Costs 0 1150000 950000
Direct 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
2,050,00 1,625,00 1,475,00
Sales Revenue 0 0 0 5,150,000
1,465,00 1,150,00
Less Controllable Variable Costs 0 0 950,000 3,565,000
Controllable Contribution margin 585,000 475,000 525,000 1,585,000
Less Controllable Fixed Costs 250,000 190,000 175,000 615,000
Segment Profit Contribution 335,000 285,000 350,000 970,000
Less 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
2,050,00 1,625,00 1,475,00
Sales Revenue - Existing 0 0 0 5,150,000
Add Additional Sales 205000 162500 147500 515000
2,255,00 1,787,50 1,622,50
Total sales 0 0 0 5,665,000
1,265,00 1,045,00
Less Controllable Variable Costs 1,611,500 0 0 3,921,500
Controllable Contribution margin 643,500 522,500 577,500 1,743,500
Less Controllable Fixed Costs 250,000 190,000 175,000 615,000
Less Advt. Cost 39,806 31,553 28,641 100,000
Segment Profit Contribution 353,694 300,947 373,859 1,028,500
Less 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 -

Products
2 Color 3 Color Vitrified Total
Budgeted Sales 510000 890000 1475000 2875000
Variable Costs 325000 420000 650000 1395000
Contribution 185000 470000 825000 1480000
Actual 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.

Products
2 Color 3 Color Vitrified Total
Actual Sales 1385000 1190000 575000 3150000
Less Variable Costs
(In proportion of Budgeted sales to Variable
Costs with Actual sales) 882598 561573 253390 1697561
Contribution 502402 628427 321610 1452439
Contribution 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 Company
Sales 1,000 600 400 2,000
Controllable variable Cost 500 360 280 1,140
Controllable Contribution
Margin 500 240 120 860
Common Fixed Cost 660
Profit 200
Actual
Particular Prod1 Prod2 Prod3 Company
Sales 660 660 880 2,200
Less Discount 20 0 0 20
Net Sales 640 660 880 2,180
Controllable Variable Cost 332 400 620 1,352
(Manufacturing and sales) 0
Controllable Contribution
Margin 308 260 260 828
Common Fixed Cost 670
Profit 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 Decrease
I) Effect on Contribution due to Increase in sales
(2200-2000)*(860/2000) 86
II) Effect of Special Discount 20
III) Effect of Sales Mix Variance on Income 88
(Computed as under)
Budegted Contribution 2200* (860/2000) 946
Less Actual Contribution
Prod1 660 * (500/1000) 330
Prod1 660 * (240/600) 264
Prod1 880 * (120/400) 264
858
Sales Mix Variance (Adverse) 88

IV) Effect of Variable Cost Variance 10

1,35
Actual Variable Cost 2
Budgeted Variable Cost
Prod1 660*( 500/1000) 330
Prod2 660*(360/600) 396
Prod3 880*(280/400) 616
1342
Variable Cost Variance (Adverse) 10
86 118
Net Change in Income (Decrease) 32

Decrease in Contribution Net 32

Increase in Advertisement Costs 0
Increase in Common Fixed Costs 10
Decrease 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 –

Sales
Unit Selling Price Quantity(Units)
100 1000
90 2000
80 3000
70 4000
 60 5000
50 6000

The cost of each division is as follows –

South North
Variable Cost p.u. Rs. 11 7
Fixed Cost per annum Rs. 60000 90000
The 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.