Question

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 $912,100

Revenues—S Region 1,105,800

Revenues—W Region 1,975,400

Operating Expenses—N Region 578,000

Operating Expenses—S Region 658,100

Operating Expenses—W Region 1,194,600

Corporate Expenses—Dispatching 470,400

Corporate Expenses—Equipment Management 214,500

Corporate Expenses—Treasurer’s 138,700

General Corporate Officers’ Salaries 306,300

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 4,900 5,900 8,800

Number of railroad cars in inventory 800 1,300 1,200

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?

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

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

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

d. None of these choices would be included.

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

Answer 1

Solution 1:

Thomas Railroad company
Divisional Income statement
For the Quarter ended 31 Dec
Particulars	N Region	S Region	W Region
Revenue	912,100	1,105,800	1,975,400
Less: Operating Expenses	578,000	658,100	1,194,600
Income From Operations before charges	334,100	447,700	780,800
Less: Service department Charges
Dispatching	117,600	141,600	211,200
Equipment Management	52,000	84,500	78,000
Total Service department Charges	169,600	226,100	289,200
Income from Operations	164,500	221,600	491,600
Profit margin (%)	18.04%	20.04%	24.89%

Working Note:

1. Treasurer’s Expenses of $138,700 are not required to be allocated in Income statement on Divisional level since Treasurer’s department is working for company as a whole.
2. Corporate Officer’s salary will also be assumed as unallocable and will be charged on Income statement at corporate level.
3. Divisional allocation of Service department charges can be worked out as below:

Thomas Railroad company
Service Department Charges Allocation
For the Quarter ended 31 Dec
Particulars	Total Expense	Basis of Allocation	Total Allocation units	Ratio of Allocation	N Region	S Region	W Region
Dispatching	470,400	No. of Scheduled Trains	19600	4900:5900:8800	117,600	141,600	211,200
Equipment Management	214,500	No. of railroad cars	3300	800:1300:1200	52,000	84,500	78,000
Total	684,900				169,600	226,100	289,200

Solution 2:

From Solution 1, we can state that

Profit Margin (%) = N Region 18.04%, S Region 20.04%, W Region 24.89%

Most successful region is W region since it is having highest profit margin (%).

Solution 3:

E. Since a CEO is responsible to Investors and Chairman he has to significantly look over the income being generated on the money put in by the Investors.

Option E will provide the best measure to CEO on divisional level. Since revenue is higher in Region W but it may have significantly higher or lower assets than other divisions. Adding the KPI as Income above the minimum desired income OR Rate of return on Income is the best measure to evaluate the divisional performance for CEO.