Question

LCW Inc. produces 4 products in three operating divisions. The Yellow Division produces Stars and Moons, the Green Division produces Clovers, and the Pink Division produces Hearts. The manager of each division is evaluated based on total operating income and receives a bonus equal to 10% of the total operating income.

Each of the products has direct costs of materials and labor. In addition to these costs, each product is allocated a portion of the $1,800,000 in fixed corporate overhead based on direct labor dollars.

The most recent year operating results are presented below:

	stars	moons	clovers	hearts
net sales	1250000	850000	1250000	1650000
direct matrials	-250000	-50000	-125000	-160000
direct labor	-450000	-600000	-540000	-640000
fixed overhead	-363229	-484305	-435874	-516592
operating income	186771	-284305	149126	333408

At the first meeting of the division managers the following year, the Yellow Division manager announces his plan to discontinue the Moons product as it is losing money not only for his division, but for the company as a whole. The labor force will be let go, thus cutting all direct costs. No replacement product is planned.

Is this the best decision for the company? Is it the best decision for the Yellow Division manager? Support your answers with computations – it may be helpful to recalculate the divisional operating income without the Moons product.

Is there a problem with the current evaluation/incentive system? What changes would you suggest?

Invlude any calculations, alalysis or graphs.

Answer 1

Discontinuing the moons product will not be a best decision for the company as the product has positive contribution. Meaningby, the product is contributing an amount of (850,000-(50,000+650,000)) = 200,000 for the fixed cost of the company. By discontinuing the moon product, overall operating income of the comany will go down by 200,000. Below calculations will confirm it:

Yes, this decision would be beneficial for the Yellow Division manager as this department is currently contributing as a negative operating income for his bonus calculation purpose.

Yes, there is aproblem with current incentive system as the system is based on oprating income which is calculated after allocating the fixed costs. Rather, an incentive system based on contribution (Sales - variable cost) would be better as it will not take allocation of fixed costs in account and therefore, will represent to actual performance of the managers.