Chapter 14, Problem 24E

Computing Divisional Income: Incomplete Information and Financial Ratios

As a part of an employment interview, you are given the partial income statement and selected financial ratios shown for Sneaky Pete’s, a chain of western stores. Sneaky Pete’s is organized into two divisions: Mountain and Valley. You are told that corporate overhead costs are allocated to divisions based on relative sales.

Required

1. a.      Complete the income statements for both divisions and the corporation as a whole.
2. b.      What recommendation(s) would you make about computing divisional income for divisional performance measurement at Sneaky Pete’s?

To determine

Complete the income statements for both divisions along with the corporation as a whole.

Explanation of Solution

Divisional income statement:

The divisional income statement shows the income of various divisions of the business. It calculates the operating profit of the division by subtracting the expenses of the business from the sales of the division.

Calculate the divisional income statement for mountain division, valley division and corporate:

Company S Divisional Income Statement
Particulars	Mountain division	Valley division	Corporate
Sales	$120.00(6)	$480.00(7)	$600.00(1)
Cost of sales	$60.00(10)	$300.00(10)	$360.00(4)
Gross margin	$60.00(8)	$180.00(8)	$240.00(3)
SG&A	$25.00(9)	$52.00(5)	$77.00(5)
Allocated corporate costs	$8.00	$32.00(11)	$40.00
Operating income(a)	$27.00(8)	$96.00(8)	$123.00(2)
Tax expenses $b=(a\times \text{ 20\%)}$	$5.40	$19.20	$24.60
After tax profit $c\text{ = (a - b)}$	$21.60	$76.80	$98.40

Table: (1)

Working note 1:

Calculate the overall corporate sales:

$\begin{array}{c}\text{Sales = }\frac{\text{After-tax income}}{\text{Profit margin}}\\ =\frac{\$98.4}{0.164}\\ =\text{ \$600}\end{array}$

Working note 2:

Calculate the operating income:

$\begin{array}{c}\text{Operating income = Sales }\times \text{ Operating margin}\\ \text{= \$600 }\times \text{ 20}\text{.5\%}\\ \text{= \$123}\end{array}$

Working note 3:

Calculate the gross margin:

$\begin{array}{c}\text{Gross margin = Sales }\times \text{ gross margin ratio}\\ \text{= \$600 }\times \text{ 40\%}\\ \text{= \$240}\end{array}$

Working note 4:

Calculate the cost of sales:

$\begin{array}{c}\text{Cost of sales = Sales - Gross margin}\\ \text{= \$600 - \$240}\\ \text{= \$360}\end{array}$

Working note 5:

Calculate the SG&A:

$\begin{array}{c}\text{Operating income = Gross margin - (SG\&A + Allocated corporate costs) }\\ \text{\$123 = \$240 - (SG\&A + \$40)}\\ \text{SG\&A = \$77}\end{array}$

Working note 6:

Calculate the sales for mountain division:

The allocated corporate costs are allocated on the basis of sales. The sales level is $600 on the costs of $40, and it will be computed as follows for the costs of $8:

$\begin{array}{c}\text{Allocated corporate costs = }\left(\frac{\text{Corporate sales}}{\text{Total corporrate cost }}\times \text{ Mountain division costs}\right)\\ \text{= }\frac{\$600}{\$40}\times \text{ \$8}\\ \text{= \$120}\end{array}$

Working note 7:

Calculate the sales for valley division:

$\begin{array}{c}\text{Valley division sales = Corporate sales (1) - Mountain division sales (2)}\\ \text{= \$600 - \$120}\\ \text{= \$480}\end{array}$

Working note 8:

Calculate the gross and operating income for both the divisions:

Particulars	Sales (a)	Gross margin (b)	Operating margin (c)	Gross margin $\text{d = (a }\times \text{ b)}$	Operating profit $\text{e = (a }\times \text{ c)}$
Mountain division	$120	50%	23%	$60	$27
Valley division	$480	38%	20%	$180	$96

Table: (2)

Working note 9:

Calculate the SG&A:

$\begin{array}{c}\text{Operating income = Gross margin - (SG\&A + Allocated corporate costs) }\\ \text{\$27 = \$60 - (SG\&A + \$8)}\\ \text{SG\&A = \$25}\end{array}$

Working note 10:

Calculate the cost of sales:

Particulars	Sales	Gross margin	Cost of sales
Mountain division	120	50%	$60
Valley division	480	38%	$298

Table: (3)

Working note 11:

Calculate the allocated corporate costs:

$\begin{array}{c}\text{Allocated coprorate costs = Corporate cost - Mountain division costs}\\ \text{= \$40 - \$8}\\ \text{= \$32}\end{array}$

To determine

Provide recommendations to Company S.

Explanation of Solution

Recommendations to company S:

Company S should not allocate the corporate cost to the divisions. It is not a division specific cost so it should not be allocated on the basis of the revenue of the unit.

Thus, Company S should not allocate the corporate cost to the mountain division and valley division.