Wayne Coyle, the controller of PEI Potato Co., is disillusioned with the company’s system of evaluating the performance of divisional profit centers and their managers. The present system focuses on a comparison of budgeted to actual income from operations. Coyle’s major concern with the current system is the ease with which profit center managers can manipulate the measure “Income from operations.” Most corporate sales are made on credit and most purchases are made on account. The profit centers are organized according to product line. Following is the second quarter 2010 income statement for one of the company’s profit centers:
Sales .................. $31,500,000
Cost of goods sold ........... (25,500,000)
Gross profit ................ $ 6,000,000
Selling and administrative expenses ........ (4,500,000)
Income from operations ........... $ 1,500,000
Coyle has suggested that company management replace the accrual-based income from operations evaluation measure with a cash flow from operations measure. He believes this measure will be less susceptible to manipulation by profit center managers. To defend his position, he compiles a cash flow income statement for the same profit center:
Cash receipts from customers ................ $26,400,000
Cash payments for production labor, materials, and overhead .. (21,600,000)
Cash payments for selling and administrative activities .............. (4,200,000)
Cash flow from operations $ 600,000
a. If Coyle is correct that profit center managers are manipulating the income measure, where are manipulations likely taking place?
b. Explain whether the proposed cash flow measure would be less subject to manipulation than the income measure.
c. Explain whether manipulation would be reduced if both the cash flow and income measures were utilized.
d. Do the cash and income measures reveal different information about profit center performance? Explain.
e. How could the existing income statement be used more effectively in evaluating performance?