Cost-Hierarchy-Based Operating Income Statement

Learning Objective 3 Understand the cost-hierarchy-based operating income statement

• allocate only those costs that will be affected by actions at a particular hierarchical level

Our analysis so far has focused on customer-level costs—costs of activities that managers can work with customers to influence such as sales orders, customer visits, and shipments. We now consider other costs of the Provalue Division (such as research and development [R&D] and design costs, costs to manage different distribution channels, and costs of division administration) and corporate costs incurred by Astel Computers (such as corporate brand advertising and general administration costs). Customer actions do not influence these costs, which raises two important questions: (1) Should these costs be allocated to customers when calculating customer profitability, and (2) if they are allocated, on what basis should they be allocated given the weak cause-and-effect relationship between these costs and customer actions? We start by considering the first question and introduce the cost-hierarchy-based operating income statement, which does not allocate noncustomer-level costs.

Exhibit 15-6 shows an operating income statement for the Provalue Division for 2019. The customer-level operating incomes of Customers A and B in Exhibit 15-3 are shown in columns 3 and 4 in Exhibit 15-6. The format of Exhibit 15-6 is based on the Provalue Division’s cost hierarchy. As described in Exhibit 15-2, some costs of serving customers, such as the salary of the wholesale distribution-channel manager, are not customer-level costs and are therefore not allocated to customers in Exhibit 15-6. Managers identify these costs as distribution-­channel costs because changes in customer behavior will have no effect on these costs. Only decisions pertaining to the channel, such as a decision to discontinue wholesale distribution, will influence these costs. Many managers also believe that salespeople responsible for managing individual customer accounts would lose motivation if sales bonuses were adversely affected as a result of allocating to customers distribution-channel costs over which they have minimal influence. As Exhibit 15-6 shows, Astel subtracts wholesale distribution-channel costs from the total customer-level operating income of the wholesale channel without allocating these costs to individual wholesale customers.

Next, consider division-sustaining costs such as R&D, design, and administration costs of the Provalue Division. Managers believe there is no direct cause-and-effect relationship between these costs and customer or sales manager’s actions. Under this view, allocating ­division-sustaining costs serves no useful purpose in decision making, performance evaluation, or motivation. Suppose, for example, that the Provalue Division allocates the $7,300,000 of division-sustaining costs to its distribution channels and that in some subsequent period this allocation results in a business-sales channel showing a loss. Should the Provalue Division shut down that business-sales distribution channel? Not if (as we discussed in Chapter 12) division-sustaining costs are unaffected by shutting down the business-sales distribution channel. Allocating division-sustaining costs to distribution channels gives the misleading impression that potential cost savings from discontinuing a distribution channel are greater than they are. The cost-hierarchy-based income statement in Exhibit 15-6 therefore subtracts division-sustaining costs of the Provalue Division from the total operating income at the distribution-channel level without allocating division-sustaining costs either to the distribution channel or to individual customers.

In a cost-hierarchy-based income statement, how should we treat the corporate costs for brand advertising, $1,050,000, and administration, $4,400,000, incurred by Astel Computers to support the Provalue and Deskpoint divisions? The Deskpoint Division has revenues of $200,000,000 and operating costs of $170,000,000. Exhibit 15-7 presents the cost-hierarchy-based income statement for Astel Computers as a whole. Corporate-sustaining costs are not allocated either to divisions or to channels or to customers. That’s because, as discussed earlier in the context of division-sustaining costs, there is no direct cause-and-­effect relationship between these costs and the profitability of different customers or divisions. These costs are unaffected by the actions of division managers or customers, so corporate-sustaining costs are subtracted as a lump-sum amount after aggregating operating incomes of the divisions.

Some managers and management accountants advocate fully allocating all costs to distribution channels and to customers because all costs are incurred to support the sales of products to customers. Allocating all corporate costs motivates division managers to examine how corporate costs are planned and controlled. Similarly, allocating division costs to distribution channels motivates the managers of the distribution channels to monitor costs incurred in the division. Managers who want to calculate the full costs of serving customers must allocate all corporate, division, and distribution-channel costs to customers. These managers and management accountants argue that, in the long run, customers and products must eventually be profitable on a full-cost basis. As we discussed in Chapter 14, for some decisions such as pricing, allocating all costs ensures that long-run prices are set at a level to cover the cost of all resources used to produce and sell products. In this case, the sum of operating incomes of all customers equals companywide operating income.

Still other companies allocate only those corporate costs, division costs, or channel costs to customers that are widely perceived as causally influencing customer actions or that provide explicit benefits to customer profitability. Corporate advertising is an example of such a cost. These companies exclude other costs such as corporate administration or donations to charitable foundations because the benefits to the customers are less evident or too remote. If a company decides not to allocate some or all corporate, division, or channel costs, it results in total company profitability being less than the sum of individual customer profitabilities.

For some decision purposes, allocating some but not all indirect costs may be the preferred alternative. Consider the performance evaluation of the wholesale-channel manager of the Provalue Division. The controllability notion (see Chapter 6, Responsibility and Controllability) is frequently used to justify excluding corporate costs such as salaries of the top management at corporate headquarters from responsibility accounting reports of the wholesale-channel manager. Although the wholesale-channel manager tends to benefit from these corporate costs, he or she has no say in (“is not responsible for”) how much of these corporate resources to use or how much they cost.

The value of the hierarchical format in Exhibits 15-6 and 15-7 is to distinguish among various degrees of objectivity when allocating costs so that it dovetails with the different levels at which managers make decisions and evaluate performance. The issue of when and what costs to allocate is another example of the “different costs for different purposes” theme emphasized throughout this text.

In the next section, we calculate customer profitability if Astel’s managers decide to allocate distribution-channel costs (such as costs of the wholesale channel), division-sustaining costs (such as costs of R&D and design), and corporate-sustaining costs (such as corporate administration costs of Astel Computers) to individual customers.