College Accounting, by Heintz and Parry Chapter 26: Departmental Accounting

Eddie was sure that Nick would be tired after he spent the weekend at the state capital with one of the bands he managed, but Nick came in on Monday with a real bounce in his step. “I was in a record store just to see how other stores do things, and this place had a separate section with videos for sale. I think we could do the same thing and use our same inventory strategy, stocking just the films that are hottest with the college crowd. Tons of Jim Carrey, no Jim Cagney, if you know what I mean.” “It could work, Nick. It’s certainly worth researching.” “I guess the one question I have from an accounting perspective is: with everything happening in the same store, how would we know whether the new department was profitable or not?” “Good question. To get accurate answers, we would need to start doing departmental accounting.” nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“Departmental accounting provides separate data about the revenues and expenses of each department. It can serve three purposes: 1) planning is improved when we set goals for each part of the company 2) control is improved because we can pinpoint the source of unusual variations 3) performance evaluation is improved because we can see which department managers are doing their job well. Overall, we can make better decisions about which department needs attention (or more floor space). Generally, it’s easy to track sales and cost of goods sold by department. Many companies even use multiple sales and cost of goods sold accounts. The difficult issue is allocating the operating expenses.” nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“Operating expenses can be categorized as either direct expenses or indirect expenses. Direct expenses are spent for the specific benefit of one department and are easily allocated to that department. Examples might be a department manager’s salary or a delivery of one department’s goods to a customer. Indirect expenses benefit the whole business and aren’t easily broken down to the specific department benefited. Examples would include radio ads of a general nature or the accountant’s salary. One expense category (like wage expense or advertising expense) can include both direct and indirect spending. nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“Let’s look at some of our expenses the ones that are red) and see how they might be allocated on a reasonable basis if we added a video department.” The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and increase percent (decrease) Revenues: Sales $365, ,925 75,049 21% Rent Revenue 500 3,000 2, % Interest Revenue 368 1,436 1, % Total Revenues 366, ,361 78,617 21% Expenses: Cost of Goods Sold $213, ,984 50,309 24% Wage Expense 74,160 85,922 11,762 16% Depn. Exp.-Bldg. 6,490 8,653 2,163 33% Supply Exp (43) (5%) Advertising Expense 7,230 7, % Insurance Exp , % Bank Credit Card Exp. 4,369 6,223 1,854 42% Utilities Expense 1,853 2, % Miscellaneous Exp. 1,238 1, % Interest Expense 2,386 2, % Total Expenses 313, ,773 67,617 22% Net Income $53,588 $64,588 $11,000 21%

“Wage expense would be hard because we wouldn’t have a separate manager or sales clerk for the video department. The point-of-sale terminal could track how many transactions occur in each department and allocate the wages for the sales clerks and me, the accountant, on that basis. With regard to your time, we might have you track your time for a few weeks and develop a ratio on that basis. The calculation could look like this: Wages X Percent of Transactions or Time = Departmental Wages CD’s: Sales/ Accounting.: $45,922 X 70% = $32, Manager: 40,000 X 60% = 24, Total $56, Videos: Sales/ Accounting.: $45,922 X 30% = $13, Manager: 40,000 X 40% = 16, Total $29, nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“Depreciation Expense-Building would probably be allocated on the basis of square feet used by each department. The sales floor is 25’ X 28’ or 700 square feet, and videos might take up 14’ X 16’ or 224 square feet. Office space would be left out of the calculation. The calculation could look like this: Depreciation X sq. ft./ sq. ft. used by all depts. = Dept. Depreciation CD’s: $8,653 X 476/700 = $5, Videos: 8,653 X 224/700 = 2, Total $8, nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“Advertising Expense of $7,843 would include some newspaper ads that could be allocated on the basis of square inches devoted to each department or radio ads that could be allocated on the basis of seconds talking about each department. The remaining costs might be allocated on the basis of relative sales. The calculation could look like this: Expense X Dept. Sales. / Total Sales = Dept. Advertising CD’s: Direct Exp.: $3, Indirect: $3,209 X 360,500 / 440,925 = 2, Total: $6, Videos: Direct Exp.: $1, Indirect: $3,209 X 80,425 / 440,925 = Total $1, nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“Bank Credit Card Expense of $6,223 could be a direct expense if we are able to track bank credit card sales by department. If not, it would be done on the basis of relative sales, like this: Expense X Dept. Sales. / Total Sales = Dept. Advertising CD’s: $6,223 X 360,500 / 440,925 = $5, Videos: $6,223 X 80,425 / 440,925 = 1, Total $6, Now you try one, Nick.” Question: What is a reasonable way to allocate utilities expense of $2,242? nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

Answer: ”Although there can be more than one reasonable method, it would certainly be reasonable to allocate this expense on the basis of square footage, since neither department has equipment that would use disproportionate amounts of energy. The calculation would look like this:” Total Utility Expense X sq. ft./ sq. ft. used by all depts. = Dept. Utility Expense CD’s: $2,242 X 476/700 = $1, Videos: 2,242 X 224/700 = Total $2, “So if I understand this, Eddie, what you’re showing me will allow me to calculate operating income for each department.” “Yes, as well as useful statistics like operating income as a percent of sales and operating expenses as a percent of sales. Let’s see what this might look like.” nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“This is a departmental income statement with all revenues and expenses allocated.” “Shoot, the video department is a money loser. We’d better not do it.” The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 CD’s Videos Total Revenues: Sales $360,500 80, ,925 Rent Revenue 2, ,000 Interest Revenue 1, ,436 Total Revenues 364,127 81, ,361 Expenses: Cost of Goods Sold $212,932 51, ,984 Wage Expense 56,145 29,777 85,922 Depn. Exp.-Bldg. 5,884 2,769 8,653 Supply Exp Advertising Expense 6,045 1,798 7,843 Insurance Exp ,100 Bank Credit Card Exp. 5,088 1,135 6,223 Utilities Expense 1, ,242 Miscellaneous Exp. 1, ,385 Interest Expense 2, ,629 Total Expenses 292,296 88, ,773 Operating Income(Loss) $71,831 (7,243) $64,588

“Nick, what you just said is a very common misconception among readers of departmental income statements. The thing you need to remember is that, as long as a department has revenue greater than its direct expenses, that department is improving the net income of the whole company. To make that clearer, some companies only allocate direct expenses to departments, and subtract indirect expenses separately. We should do that type of a statement for The CD Side of Town using our projections for 2001.” nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience

“The left two columns show only the direct revenues and expenses. The bottom line for each department shows that they each have a positive direct operating margin.” The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 CD’s Videos Indirect Total (direct exp.) (direct exp.) rev. & exp. Revenues: Sales $360,500 80, ,925 Rent Revenue 0 0 3,000 3,000 Interest Revenue 0 0 1,436 1,436 Total Revenues 360,500 80,425 4, ,361 Expenses: Cost of Goods Sold $212,932 51, ,984 Wage Exp. (sales clerks=direct) 25,000 10,000 50,922 85,922 Depn. Exp.-Bldg. 5,148 2,423 1,082 8,653 Supply Exp Advertising Expense 3,421 1,213 3,209 7,843 Insurance Exp ,100 1,100 Bank Credit Card Exp. 5,088 1, ,223 Utilities Expense 1, ,242 Miscellaneous Exp ,385 Interest Expense 0 0 2,629 2,629 Total Expenses 253,832 66,742 60, ,773 Operating Income(Loss) $106,668 $13,683 ($55,763) $64,588

Question: ”To analyze the two departments, can you calculate direct operating margin as a percent of sales and operating expenses as a percent of sales for both departments?” The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 CD’s Videos Indirect Total (direct exp.) (direct exp.) rev. & exp. Revenues: Sales $360,500 80, ,925 Rent Revenue 0 0 3,000 3,000 Interest Revenue 0 0 1,436 1,436 Total Revenues 360,500 80,425 4, ,361 Expenses: Cost of Goods Sold $212,932 51, ,984 Wage Exp. (sales clerks=direct) 25,000 10,000 50,922 85,922 Depn. Exp.-Bldg. 5,148 2,423 1,082 8,653 Supply Exp Advertising Expense 3,421 1,213 3,209 7,843 Insurance Exp ,100 1,100 Bank Credit Card Exp. 5,088 1, ,223 Utilities Expense 1, ,242 Miscellaneous Exp ,385 Interest Expense 0 0 2,629 2,629 Total Expenses 253,832 66,742 60, ,773 Operating Income(Loss) $106,668 $13,683 ($55,763) $64,588

Answer: ”Direct operating margin as a percent of sales would be calculated as follows: CD’s: Direct operating margin $106,668 Sales = 360,500 = 29.6% Videos: $13,683 80,425 = 17.0% For operating expenses as a percent of sales, don’t forget to exclude cost of goods sold: CD’s: Operating expenses $40,900 Sales = 360,500 = 11.3% Videos: $15,690 80,425 = 19.5% Clearly, videos are not as profitable as CD’s (in our projections). However, two relevant questions are: 1) ‘Will videos make more profit in their floor space than the CD’s that we would no longer have room for?’ and 2) ‘Will our new video customers also buy CD’s?’ Nick, I think we have more research to do.” nDetails about this topicnSupporting information and examplesnHow it relates to your audiencenDetails about this topicnSupporting information and examplesnHow it relates to your audience