Question

Profit Center Responsibility Reporting for a Service Company

Thomas Railroad Company organizes its three divisions, the North (N), South (S), and West (W) regions, 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—N Region	$1,000,300
Revenues—S Region	1,173,700
Revenues—W Region	2,067,000
Operating Expenses—N Region	633,900
Operating Expenses—S Region	698,500
Operating Expenses—W Region	1,250,000
Corporate Expenses—Dispatching	494,000
Corporate Expenses—Equipment Management	234,600
Corporate Expenses—Treasurer’s	152,100
General Corporate Officers’ Salaries	336,000

The company operates three service departments: the Dispatching Department, the Equipment Management Department, and the Treasurer’s Department. The Dispatching Department manages the scheduling and releasing of completed trains. The Equipment Management Department manages the railroad cars inventories. It makes sure the right freight cars are at the right place at the right time. The Treasurer’s Department conducts a variety of services for the company as a whole. The following additional information has been gathered:

	North		South		West
Number of scheduled trains	4,800		5,700		8,500
Number of railroad cars in inventory	1,200		1,800		1,600

Required:

1. Prepare quarterly income statements showing income from operations for the three regions. Use three column headings: North, South, and West. Do not round your interim calculations.

Thomas Railroad Company
Divisional Income Statements
For the Quarter Ended December 31
	North	South	West
Revenues	$	$	$
Operating expenses
Income from operations before service department charges	$	$	$
Service department charges:
Dispatching	$	$	$
Equipment Management
Total service department charges	$	$	$
Income from operations	$	$	$

2. What is the profit margin of each division? Round to one decimal place.

Region	Profit Margin
North Region	%
South Region	%
West Region	%

Identify the most successful region according to the profit margin.

3. What would you include in a recommendation to the CEO for a better method for evaluating the performance of the divisions?

The method used to evaluate the performance of the divisions should be reevaluated.

A better divisional performance measure would be the rate of return on investment (income from operations divided by divisional assets).

A better divisional performance measure would be the residual income (income from operations less a minimal return on divisional assets).

None of these choices would be included.

All of these choices (a, b & c) would be included.

Effect of Proposals on Divisional Performance

A condensed income statement for the Electronics Division of Gihbli Industries Inc. for the year ended December 31, 20Y9, is as follows:

Sales	$2,860,000
Cost of goods sold	1,848,000
Gross profit	$ 1,012,000
Operating expenses	583,000
Income from operations	$ 429,000
Invested assets	$2,200,000

Assume that the Electronics Division received no charges from service departments.

The president of Gihbli Industries Inc. has indicated that the division’s return on a $2,200,000 investment must be increased to at least 22.5% by the end of the next year if operations are to continue. The division manager is considering the following three proposals:

Proposal 1: Transfer equipment with a book value of $440,000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would be less than the amount of depreciation expense on the old equipment by $79,200. This decrease in expense would be included as part of the cost of goods sold. Sales would remain unchanged.

Proposal 2: Reduce invested assets by discontinuing a product line. This action would eliminate sales of $467,500, reduce cost of goods sold by $312,400, and reduce operating expenses by $137,500. Assets of $1,113,900 would be transferred to other divisions at no gain or loss.

Proposal 3: Purchase new and more efficient machinery and thereby reduce the cost of goods sold by $290,400 after considering the effects of depreciation expense on the new equipment. Sales would remain unchanged, and the old machinery, which has no remaining book value, would be scrapped at no gain or loss. The new machinery would increase invested assets by $1,100,000 for the year.

Required:

1. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and rate of return on investment for the Electronics Division for the past year. Round your answers to one decimal place.

	Electronics Division
Profit margin		%
Investment turnover
ROI		%

2. Prepare condensed estimated income statements and compute the invested assets for each proposal.

Gihbli Industries Inc.—Electronics Division
Estimated Income Statements
For the Year Ended December 31, 20Y9
	Proposal 1	Proposal 2	Proposal 3
Sales	$	$	$
Cost of goods sold
Gross profit	$	$	$
Operating expenses
Income from operations	$	$	$
Invested assets	$	$	$

3. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for each proposal. Round your answers to one decimal place.

Proposal	Profit Margin	Investment Turnover	ROI
Proposal 1	%		%
Proposal 2	%		%
Proposal 3	%		%

4. Which of the three proposals would meet the required 22.5% return on investment.

Proposal 1
Proposal 2
Proposal 3

5. If the Electronics Division were in an industry where the profit margin could not be increased, how much would the investment turnover have to increase to meet the president's required 22.5% rate of return on investment? Enter your increase in investment turnover answer as a percentage of current investment turnover. If required, round your answer to one decimal place.
%

Answer 1

I.Thomas Railroad Company :

1.

Thomas Railroad Company
Divisional Income Statements
For the quarter ended December 31
	North	South	West
	$	$	$
Revenues	1,000,300	1,173,700	2,067,000
Operating Expenses	633,900	698,500	1,250,000
Income from operations before service department charges	366,400	475,200	817,000
Service department charges
Dispatching	124,800	148,200	221,000
Equipment management	61,200	91,800	81,600
Total service department charges	186,000	240,000	302,600
Income from Operations	180,400	235,200	514,400

2.

Region	Profit Margin
North	18 %
South	20 %
West	24.9 %

3. The method used to evaluate the performance of the divisions should be reevaluated.

A better divisional performance measure would be the residual income.

II. Gihbli Industries Inc. :

1.

	Electronics Division
Profit Margin	15 %
Investment Turnover	1.3
ROI	19.5 %

2.

Gihbli Industries Inc. : Electronics Division
Estimated Income Statements
For the year ended December 31, 20Y9
	Proposal 1	Proposal 2	Proposal 3
Sales	$ 2,860,000	$ 2,392,500	$ 2,860,000
Cost of Goods Sold	1,768,800	1,535,600	1,557,600
Gross Profit	1,091,200	856,900	1,302,400
Operating Expenses	583,000	445,500	583,000
Income from Operations	508,200	411,400	719,400
Invested Assets	1,760,000	1,086,100	3,300,000

3.

Proposal	Profit Margin	Investment Turnover	ROI
Proposal 1	17.8 %	1.6	28.5 %
Proposal 2	17.2 %	2.2	37.8 %
Proposal 3	25 2 %	0.9	22.7 %

4.

Proposal 1	Yes
Proposal 2	Yes
Proposal 3	No

5. Current profit margin : 15 %

Investment turnover required to achieve ROI of 22.5 % = 22.5 % / 15 % = 1.5

Current investment turnover is 1.3.

Therefore increase in investment turnover required = ( 1.5 - 1.3 ) / 1.3 * 100 = 15.4 %.