Cost Allocations and Measurement of Division Profitability*

Paris Company has three operating divisions. The managers of these divisions are evaluated on their divisional net income before taxes, a figure that includes an allocation of corporate overhead proportional to the sales of each division. The operating statement for the first quarter of 1998 appears below:

The manager of Division A is unhappy that his profitability is about the same as Division B's and much less than Division C's, even though his sales 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 has retained it until now, because the line was still marginally profitable and used facilities that would otherwise be idle. The manager now realizes, however, that the sales from this product line are attracting a fair amount of corporate overhead, which is allocated at the rate of 20% of net sales, and maybe the line is already unprofitable for him. This low-margin line of products had the following characteristics for the quarter:

Thus, the product line accounted for 40% of divisional sales but less than 1 5% of divisional profit.
Required ( 1 ) Prepare the operating statement for the Paris Company for the second quarter of 1998 assuming that sales and operating results are identical to the first quarter except that the manager of Division A drops the low-margin product line entirely from his product group. Is the Division A manager better off from this action? Is the Paris Company better off from this action?
(2) Suggest changes in the Paris Company's divisional reporting and evaluation system that will improve local incentives for decision making that is in the best interests of the firm.

Transcribed Image Text:

DIVISION (IN 000S) A B TOTAL Net sales $2,000 $1,200 $1,600 $4.800 Unit and batch-related costs 1,050 540 640 2,230 Division capacity-related costs 250 125 160 535 Division margin 700 535 800 2,035 Allocated corporate expenses 400 240 320 960 Net income before taxes $300 $295 $480 $1,075