The Benmac Corporation has three operating divisions. The managers of these divisions are evaluated on their divisional Net Income Before Taxes, a figure which includes an allocation of corporate overhead proportional to the sales of each division. The operating statement for the first quarter of 1994 appears below:
A B C Total
Net sales (000) £2,000 £1,200 £1,600 £4,800
Cost of sales 1,050 540 640 2,230
Division Overhead 250 125 160 535
Division Contribution 700 535 800 2,035
Corporate Overhead 400 240 320 960
Net Income Before Taxes £300 £295 £480 £1,075
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The manager of Division A is unhappy that his profitability is about the same as Division B and much less than Division C's, even though his sales are much higher than either of these other two divisions. The manager knows that he is carrying one line of products with very low profitability. He was going to replace this line of business as soon as more profitable product opportunities became available, but has retained it until now since the line was still marginally profitable and used facilities that would otherwise be idle. The manager now realises, however, that the sales from this product line are attracting a fair amount of corporate overhead because of the allocation procedure and maybe the line is already unprofitable for him.
This low margin line of products had the following characteristics for the quarter:
Net Sales (000) £800
Cost of Sales 600
Allocated Divisional Overhead 100
Thus the product line accounted for 40 percent of divisional sales but less than 15 percent of divisional profit.
1. Prepare the operating statement for the Benmac Corporation for the second quarter of 1994 assuming that sales and operating results are identical to the first quarter except that the manager of Division A drops the low margin product line entirely from his product group. Is the Division A manager better off from this action? Is the Benmac Corporation better off from this action?
2. Suggest improvements to the Benmac Corporation's divisional reporting and evaluation system that will improve local incentives for decision-making that is in the best interests of the firm.
1. Without the £800,000 in sales from the low margin product line in Division A, the second quarter operating statements will be:
A B C Total
Net sales (000) £1,200 £1,200 £1,600 £4,000
Cost of sales 450 540 640 1,630
Division Overhead 150 125 160 435
Division Contribution 600 535 688 1,935
Corporate Overhead 288 288 384 960
Net Income Before Taxes £312 £247 £416 £975
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The Division A manager is able to show a £12,000 higher profit because the £100,000 in lost contribution margin from the dropped product line is more than offset by the £112,000 reduction in corporate overhead. Divisional sales are now only 30 percent of corporate sales rather than the previous 41.7 percent of sales. The Benmac Corporation is worse off because it has lost the £100,000 contribution margin from the dropped product line with no reduction in corporate overhead.
2. The easiest solution is to not allocate fixed corporate overhead to divisions. Then, the problem of dysfunctional behaviour will not arise. But central management may want the division managers to "see" the cost of corporate operations so that they will understand that the corporation as a whole is not profitable unless the combined divisions' contribution margins exceed corporate overhead. In this case, an allocation basis should be chosen that is not manipulatable or under the control of division managers, and has the property that the actions of one division do not affect the allocations to other divisions (as occurred in the second quarter for the Benmac Corporation). In general, a lump sum allocation based on, say, budgeted net income, or budgeted assets, rather than an allocation that varies proportionately with an actual measure of activity (such as sales or actual net income) will minimise dysfunctional behaviour. The allocation should be such that managers treat it as a fixed, unavoidable charge, rather than a charge that will vary with decisions they take