Question

Red Line Railroad Inc. has three regional divisions organized as profit centers. The chief executive officer (CEO) evaluates divisional performance, using income from operations as a percent of revenues. The following quarterly income and expense accounts were provided from the trial balance as of December 31:

Revenues—East	$ 862,000
Revenues—West	1,036,000
Revenues—Central	1,890,000
Operating Expenses—East	563,600
Operating Expenses—West	621,840
Operating Expenses—Central	1,167,900
Corporate Expenses—Shareholder Relations	150,000
Corporate Expenses—Customer Support	360,000
Corporate Expenses—Legal	252,000
General Corporate Officers’ Salaries	274,500

The company operates three service departments: Shareholder Relations, Customer Support, and Legal. The Shareholder Relations Department conducts a variety of services for shareholders of the company. The Customer Support Department is the company’s point of contact for new service, complaints, and requests for repair. The department believes that the number of customer contacts is an activity base for this work. The Legal Department provides legal services for division management. The department believes that the number of hours billed is an activity base for this work. The following additional information has been gathered:

	East	West	Central
Number of customer contacts	5,000	6,000	9,000
Number of hours billed	1,400	2,000	2,200

	Required:
1.	Prepare quarterly income statements showing income from operations for the three divisions. Use three column headings: East, West, and Central.
2.	Identify the most successful division according to the profit margin. Enter percentage rounded two decimal places (e.g. 0.22547 is 22.55%).
3.	What would you include in a recommendation to the CEO for a better method for evaluating the performance of the divisions? What is a major weakness of the present method?

Quarterly Income Statements

1. Prepare quarterly income statements showing income from operations for the three divisions. Use three column headings: East, West, and Central.

Red Line Railroad Inc.

Divisional Income Statements

For the Quarter Ended December 31

1		East	West	Central
2	Revenues
3	Operating expenses
4	Income from operations before service department charges
5	Service department charges:
6	Customer Support
7	Legal
8	Total service department charges
9	Income from operations

2. Compute the profit margin for each division. Enter percentage rounded two decimal places (e.g. .22547 is 22.55%).

Division	Profit Margin
East Division	%
West Division	%
Central Division	%

Answer 1

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Part 1
		East	West	Central
Revenues		$                     862,000	$        1,036,000	$     1,890,000
Operating expenses		$                    -563,600	$          -621,840	$   -1,167,900
Income from operations before service department charges		$                     298,400	$            414,160	$        722,100
Service department charges:
Customer Support		$                        90,000	$            108,000	$        162,000
Legal		$                        63,000	$              90,000	$           99,000
Total service department charges		$                     153,000	$            198,000	$        261,000
Income from operations		$                     145,400	$            216,160	$        461,100
Working:
	East	West	Central	Total
Number of customer contacts	5,000	6,000	9,000	20,000
Weight	25.00%	30.00%	45.00%
Allocation of $360,000	$         90,000	$                     108,000	$            162,000
Number of hours billed	1,400	2,000	2,200	5,600
weight	25.00%	35.71%	39.29%
Allocation of $252,000	$         63,000	$                        90,000	$              99,000
Part 2	a	b	b/a
	Revenue	Operating Income	Profit Margin
East	$       862,000	$                     145,400	16.87%
West	$   1,036,000	$                     216,160	20.86%
Central	$   1,890,000	$                     461,100	24.40%
Part 3
Major weakness is that this method does not consider amount of investment being done by company which
have impact on earning.
Hence, better divisional performance measure would be:
1. Return on Investment (ROI)
2. Residual Income (RI)