Accounting Business Reporting for Decision Making

CHAPTER 14 Performance measurement 573

TABLE  14.3 Fun Hats Company — divisional performance report with common costs allocated

Corporate

Department

stores

Specialty

stores Total

Sales

Variable costs

$ 990 000

470 000

$400 000

420 000

$520 000

370 000

$1 910 000

1 260 000

Contribution margin

Fixed cost

520 000

120 000

(20 000

50 000

) 150 000

80 000

650 000

250 000

Divisional margin

Allocated common costs

400 000

90 000

(70 000

30 000

) 70 000

80 000

400 000

200 000

Profit $ 310 000 ($100 000) ($10 000) $ 200 000

Floor space

Investment level $

900 m^2

2 200 000 $

300 m^2

75 000 $

800 m^2

225 000 $

2 000 m^2

2 500 000

The divisional margin of the department stores division shows a loss of $70 000, indicating that the

division’s revenues are not covering its direct cost, let alone making any contribution to the entity’s

common costs. The fact that sales are not covering variable costs indicates that the products haven’t

been priced correctly. Sadly at times, the focus on sales revenue as a performance measure takes

the spotlight away from what the product or service or division is actually contributing to the entity.

Products or services that are not priced appropriately or are heavily discounted may lead to greater

revenue but  lower  profits.    That    is,  the     more   you  sell,   the     more   you  lose.  It   is  easy   to   sell    items  cheaply.    

However, a performance measurement system should reward good performance.

If   prices cannot  be   increased  and  costs  cannot  be   reduced,   then    closing the  department needs   to  

be   considered.    If   the     department closed, the  variable   costs   would   disappear   in   the     short  term,   but 

some of the fixed divisional costs might remain. However, these costs would disappear in the long

term, and the closure of the department stores division would improve the overall performance of the

organisation by $70 000. The $30 000 in common costs would then need to be allocated to the other

divisions.

The specialty stores division, although showing a positive divisional margin, is now showing a loss

once the common costs are allocated. This may signal a need to either rethink pricing, the common

cost allocation method or whether the division is operating efficiently (i.e. can it reduce costs).

Evaluation of investment level

The third objective of preparing divisional performance reports is to evaluate the performance of the

division in relation to the level of investment. This evaluation may result in an increase or decrease

of investment funds into a division. This could include expanding a division, closing a division or

redistributing investment funds. An evaluation of both the short-term and long-term consequences of

divisional closure is needed. In our example, two divisions are making a loss (see table 14.3). At first

glance, it seems that closing each of these divisions should increase the overall performance of the

organisation by the loss amounts. However, it is necessary to examine what costs will disappear if the

divisions are closed. If the specialty stores division closed, the $80 000 in common costs would need

to be allocated to the remaining departments. The divisional margin for the specialty stores division

shows it is contributing $70 000 towards the common costs, and this would be forgone if the division

were closed. So it is worthwhile investigating whether the performance can be improved to ensure that

the specialty store division can contribute to the bottom line after allowing for common costs. Further,

consideration needs to be given to the level of investment. The entity has $225 000 invested in the

specialty store division. Would the entity be better off investing the funds elsewhere? The next section

will address this more fully.