ISSN 1940-204X

A Partnership with Unlimited Possibilities: A Case of Allocation of Partnership Income and Common Costs

Marc I. Lebow Hampton University

School of Business

Veronique Frucot

Christopher Newport University

Jacob Angima Hampton University

School of Business

INTRODUCTION

You recently graduated magna laude with a degree in accounting, and both your family and alma mater are proud of you. You have been hired at the accounting firm Massey, Hall and Associates CPA, a prestigious accounting firm with a national reputation. After training, you were assigned your first audit. The client is located in a small town in the southern United States. The town was a major river port

established before the Civil War but has now devolved into a sleepy, rural town resembling the TV town of Mayberry.

There are two places open for lunch: the lunch counter at Daviss Drug Store and a hot dog eatery called Rays Quick Lunch. You select the lunch counter at Daviss Drug Store. You watch in awe as the single food service employee behind the counter efficiently prepares each meal and serves each customer quickly. You notice that, without calling ahead, some sandwiches are prepared and placed on the table seconds before a regular customer enters and sits down.

At the beginning of the second week on the audit, you sit down at the lunch counter and prepare to order. As you sit down, the lunch counter employee sits down with you and introduces herself as Nancy Wilson. She also asks you for

your expert accounting advice. She explains, I have been

working here for the past 40 years. I make around $45,000 a year in tips and salary and need to start planning for my future. Mr. Davis is the pharmacist and owner of this drug store, and he operates this business as a sole proprietorship. His son, Junior Davis, is ready to take over. Junior is a good

boy, but he does not know much about business. He also just received his pharmacy degree and license. I trust Mr. Davis will never make a mistake dispensing prescriptions, but I am not so sure about Junior. When he worked here as a boy he would come behind the counter during the day and make himself super ice cream sundaes without paying. He is also not as careful as Mr. Davis.

Mr. Davis has offered to sell the business to the three of his employees before he retires: Junior, Mary Jones, and me. We would run the business as a partnership with the three of us as general partners. Each of us would have an equal say in the running of the business. We would continue to operate the three departments under the new partnership arrangement. I, of course, would keep the lunch counter, Mary would run the sundries, and Junior would run the

pharmacy. Each of us would run our own department without any help from the other partners. By becoming partners, we can share the profits and participate in the management of

the business after Mr. Davis retires.

IMA EDUCATIONAL CASE JOURNAL

1

VOL. 6, NO. 2, ART. 3, JUNE 2013

Table 1

Income Statement ($ in thousands)

ACCOUNT

PHARMACY

SUNDRIES

LUNCH COUNTER

TOTAL

Sales

$ 600,000

$ 620,000

$ 252,000

$1,472,000

Cost of Goods Sold

375,000

400,000

75,000

850,000

Gross Profit

225,000

220,000

177,000

622,000

Direct Operating Expenses

110,000

100,000

60,000

270,000

Salaries

100,000*

40,000

30,000

170,000

Allocated Common Expenses

30,000

30,000

30,000

90,000

Net Income

$ (15,000)

$ 50,000

$ 56,0000

$ 92,000

*Represents owners withdrawals.

Here is the income statement for last year (see Table 1). The salary for the pharmacist is actually Mr. Daviss withdrawals. Under the new arrangement, Junior would be able to withdraw the same amount. The other two salaries are Marys and mine. If we become partners, our salaries would become the compensation allowances shown here in the first part of the proposed formula to allocate the partnership income (see Appendix A). My buy-in price is $50,000. I dont know anything about accounting and need your advice.

I have four concerns. First, what risks and benefits do I get by being a partner? Junior does not know much

about running a business, and Mary and I have only a little management experience: we only run our own departments. We dont know about running the entire business. What are my problems with assuming a managerial role here at the drug store?

Second, as an employee, there is little risk for me as a server; no one is ever unhappy with the foods I prepare, and I have been doing this for 40 years without incident. No one would ever sue the lunch counter or the sundries

department for malpractice. But there is a large risk if Junior fills a prescription wrong and hurts a customer. The store has to pay a large malpractice insurance premium to cover that contingency. What business risks am I assuming by becoming a partner?

Third, the proposed formula for allocating partnership income is complicated (see Appendix A). Is the formula fair to Mary and me? If the income stays the same as last year, how much will I make as a partner as opposed to being an employee?

Finally, the $90,000 in common costs are mostly for the pharmacy. There are basically four areas that make up the common costs: malpractice insurance that costs $60,000

per year; advertising costs $25,000; utilities cost $2,000; and

miscellaneous expenses reserves $3,000. The miscellaneous expenses consist mostly of property and real estate taxes.

Based on my observations of the business, I think that splitting the common costs evenly is unfair to Mary and me. For example, malpractice insurance costs $60,000, of which $58,000 is for the pharmacy. The $2,000 left over

for insurance for the sundries and lunch counter should be evenly split. Advertising costs about $25,000 per year. The pharmacy and lunch counter do not benefit from advertising, so the sundries department should receive the whole amount. Utilities cost about $2,000 per year. (The lunch counter uses $1,000 of that and the other two departments receive $500 each.) The remaining $3,000 in common costs are for taxes and similar expenses. The pharmacy should get $1,500, and the sundries department and the lunch counter should split evenly the remainder ($750 each). That is how

I think the common costs should be allocated, and I would like to suggest it to the others as an alternative proposal. Before I do that, though, I need to know the effects it would have on each partner.

Can you answer my questions?

After going back to work, you tell the story to your boss, the supervising accountant. She explains that Nancys eldest son is a partner with the investment banking firm Silverman & Co.,

a large client of your accounting firm with whom it wishes to maintain good relations. Therefore, performing some pro bono work for Nancy fits into the firms plan for increasing business and building a strong relationship with the investment bank. Your boss advises you to answer Nancys questions, pointing out that this is the type of assignment that the partners recognize, which can facilitate a promotion. Yet she suggests you do the work outside your normal business hours.

The section of the partnership agreement covering allocation of partnership income and losses is shown in Appendix A, and

last years income statement is included in Table 1.

IMA EDUCATIONAL CASE JOURNAL

2

VOL. 6, NO. 2, ART. 3, JUNE 2013

FIRST SET OF REQUIREMENTS:

In a memo to Nancy Wilson, answer the issues she raised. Specifically:

1. Describe the business risks and benefits associated with being a partner. This should include business risks unique to this venture.

2. Calculate each partners share of last years income, assuming that the proposed allocation of partnership income from Appendix A had been in place.

3. Is the proposal worthy of Nancys consideration? Do you think that she should invest in the partnership? Use the calculations from Requirement 2, and support your decision with both the potential income she might earn and the increased risks and benefits from your answer to

Requirement 1.

A

ABOUT IMA

With a worldwide network of more than 65,000 professionals, IMA (Institute of Management Accountants) is the worlds leading organization dedicated to empowering accounting and finance professionals to drive business performance. IMA provides a dynamic forum for professionals to advance their careers through CMA (Certified Management Accountant) certification, research, professional education, networking, and advocacy of the highest ethical and professional standards. For more information about IMA,

please visit www.imanet.org.

ADDITIONAL REQUIREMENTS:

Revise the memo from above, and address the following requirements:

4. Calculate each partners share of last years income, assuming, that Nancys alternative proposal had been in place.

5. If the other parties agree to Nancys alternative, what would be her return on investment? In this calculation, should she use the total income allocated to her, or should she only use the incremental change in her income (the difference between her earnings calculated in Requirement 1 and her current salary of $30,000)?

6. Should Nancy agree to invest in the partnership if the other parties agree with her alternative proposal?

Allocation of Partnership Income

a.

An allowance of $100,000 will be allocated to Junior Davis, $40,000 to Mary Jones, and $30,000 to Nancy Wilson.

b.

Each partner will get 20% of the income or loss for his or her department without consideration of the allocation from part a.

The formula for each department is ((gross profit the sum of direct operating expenses + allocated common expenses) x 20%).

c.

All remaining profits or losses will be allocated to the partners evenly.

IMA EDUCATIONAL CASE JOURNAL

3

VOL. 6, NO. 2, ART. 3, JUNE 2013