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	$ 890,000
Revenues—West	1,046,000
Revenues—Central	1,880,000
Operating Expenses—East	563,900
Operating Expenses—West	625,920
Operating Expenses—Central	1,167,540
Corporate Expenses—Shareholder Relations	159,000
Corporate Expenses—Customer Support	314,500
Corporate Expenses—Legal	271,200
General Corporate Officers’ Salaries	277,750

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	4,500	5,500	8,500
Number of hours billed	1,250	2,100	2,300
	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?

Answer 1

1.

Red Line Railroad Inc.
Divisional Income Statements
For the Quarter Ended December 31
	East	West	Central
Revenues	890000	1046000	1880000
Operating expenses	563900	625920	1167540
Income from operations before service department charges	326100	420080	712460
Less service department charges:
Customer support	76500	93500	144500
Legal	60000	100800	110400
Subtotal	136500	194300	254900
Income from operations	189600	225780	457560

Working:

Customer support:

East: $314500 x 4500/(4500 + 5500 + 8500) = $76500

West: $314500 x 5500/(4500 + 5500 + 8500) = $93500

Central: $314500 x 8500/(4500 + 5500 + 8500) = $144500

Legal:

East: $271200 x 1250/(1250 + 2100 + 2300) = $60000

West: $271200 x 2100/(1250 + 2100 + 2300) = $100800

Central: $271200 x 2300/(1250 + 2100 + 2300) = $110400

2. Profit margin = Income from operations/Revenues

Division	Profit margin
East	21.30%
West	21.59%
Central	24.34%

3. A major weakness of the present method is that the assets invested in each division are not considered.

For better evaluation of divisional performance, the rate of return on investment and residual income should be considered alongwith focusing on controllable revenues and expenses.