Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 39

Evaluate Performance Evaluation System: Behavioral Issues

Several years ago, Seville Company acquired Salvador Components. Prior to the acquisition, Salvador manufactured and sold automotive components products to third-party customers. Since becoming a division of Seville, Salvador has manufactured components only for products made by Seville’s Luxo Division.

Seville’s corporate management gives the Salvador Division management considerable latitude in running the division’s operations. However, corporate management retains authority for decisions regarding capital investments, product pricing, and production quantities.

Seville has a formal performance evaluation program for all division managements. The evaluation program relies substantially on each division’s ROI. Salvador Division’s income statement provides the basis for the evaluation of Salvador’s management. (See the following income statement.)

The corporate accounting staff prepares the divisional financial statements. Corporate general services costs are allocated on the basis of sales dollars, and the computer department’s actual costs are apportioned among the divisions on the basis of use. The net divisional investment includes divisional fixed assets at net book value (cost less depreciation), divisional inventory, and corporate working capital apportioned to the divisions on the basis of sales dollars.

SEVILLE COMPANY Salvador Division Income Statement For the Year Ended October 31 ($000)
Sales revenue		$32,000
Costs and expenses
Product costs
Direct materials	$ 4,000
Direct labor	8,800
Factory overhead	10,400
Total	$23,200
Less increase in inventory	2,800	$20,400
Engineering and research		960
Shipping and receiving		1,920
Division administration
Manager’s office	$1,680
Cost accounting	320
Personnel	656	2,656
Corporate cost
General services	$1,840
Computer	384	2,224
Total costs and expenses		$28,160
Divisional operating profit		$ 3,840
Net plant investment		$12,800
Return on investment		30%

Required

a. Discuss Seville Company’s financial reporting and performance evaluation program as it relates to the responsibilities of Salvador Division.

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b. Based on your response to requirement (a), recommend appropriate revisions of the financial information and reports used to evaluate the performance of Salvador’s divisional management. If revisions are not necessary, explain why.

Step 1 of 2

a.?An answer that assumed that managers should only be held responsible for what they control would make the following arguments:

?The financial reporting and performance evaluation program of Seville Products is inappropriate as a measure of the responsibilities of the Salvador Division. Salvador is being evaluated as a profit or investment center when it has no control over pricing, production and investment decisions. Salvador is a cost center and the performance report should only consider costs under the control of Salvador management.

?Additionally, the corporate general service costs should not be included on the performance report because these costs are not under the control of the division management. Moreover, the allocation basis is artificial in that corporate management determines Salvador Division sales volume.

?Salvador’s managers currently share some of the organization-wide risk because they are held responsible for things they do not control. Presumably, they must be compensated for sharing this risk if they are risk-averse. On the other hand, they might attain nonpecuniary rewards from being an “investment center” instead of a cost center. Despite the fact that Salvador’s managers are held responsible for things outside of their control, it is not clear that Salvador’s managers or the company would be better off by making Salvador a cost center, although it is a cost center, de facto.