Lois Harvak, the controller of California Mining Co., has become increasingly disillusioned with the company’s system of evaluating the performance of profit centers and their managers. The present system focuses on a comparison of budgeted to actual income from operations. Ms. Harvak’s major concern with the current system is the ease with which the measure “income from operations” can be manipulated by profit center managers. Most corporate sales are made on credit and most purchases are made on account. The profit centers are organized according to product line. Below is a typical quarterly income statement for a profit center, Mine #107, that appears in the responsibility report for the profit center:
|
Sales |
$11,000,000 |
|
Cost of goods sold |
9,000,000 |
|
Gross profit |
$2,000,000 |
|
Selling and administrative expenses |
1,500,000 |
|
Income from operations |
$500,000 |
Ms. Harvak has suggested to top management that the company replace the accrual income evaluation measure, “income from operations,” with a measure called “cash flow from operations.” Ms. Harvak suggests that this measure will be less susceptible to manipulation by profit center managers. To defend her position, she compiles a cash flow income statement for the same profit center:
|
Cash receipts from customers |
$8,800,000 |
|
Cash payments for production labor, materials, and overhead |
7,200,000 |
|
Cash payments for selling and administrative activities |
1,400,000 |
|
Cash flow from operations |
$200,000 |
a. If Ms. Harvak is correct about profit center managers manipulating the income measure, where are manipulations likely taking place?
b. Is the proposed cash flow measure less subject to manipulation than the income measure?
c. Could manipulation be reduced if both the cash flow and income measures were utilized? Explain.
d. Do the cash and income measures reveal different information about profit center performance?
e. Could the existing income statement be used more effectively in evaluating performance? Explain.