Bookkeeping – Departmental Accounting (Lesson 71)
One of the goals of accounting is to report to management performance results, specifically financial performance. Since most businesses sell more than one product or render more than one service, management is interested in understanding the performance of the respective products or service. To successfully report this information, the accountant uses departmental accounting to divide the products or services into categories.
Departmental accounting is also known as division, production line or class (1) accounting. To help the reader grasp this concept, here are some examples used in various industries:
* Construction – A typical home contractor may divide his business into additions, remodeling and/or new construction.
* Salons – Many salons have multiple services including mani/pedicures, hair, skin (tanning, makeup and waxing) and therapy (sauna, massage and relaxation).
* Restaurants – Refreshments, entrees and desserts; or sit-down, take out and catering
* Retail – Respective sections such as products and/or services or by location
* Law Firms – Criminal, Real Estate, Business Advice
* Convenience Stores – Retail, Prepaid Foods, Fuel and Sin (Tobacco & Alcohol)
* Manufacturing – By Product Line
* Hotel – Occupancy, Bar/Restaurant, Conference Center (Space and Catering Services)
* Auto Repair – Inspections, Brakes, Tires, Exhaust Systems
* Landscaping – Lawn Maintenance, Design/Fabrication, Arborists
* Flower Shops – General Retail, Funerals, Special Occasions (Weddings, Births, Celebrations)
(1) The term ‘Class’ is used with QuickBooks as the tool to departmentalize a small business. QuickBooks is the most popular small business accounting software.
Departmental accounting is very effective in isolating both beneficial and under performing aspects of any business operation. To appreciate its informative utility the accountant must first understand its scope and limitations. Next I’ll explain its function within the income statement and why overhead is excluded from its use. In addition, I’ll provide a comprehensive illustration and finally how to implement this method of accounting.
Scope and Limitations of Departmental Accounting
Departmental accounting is a tool to break a businesses’ performance down into groups of information based on a product or service to evaluate that group’s overall contribution to the business. It is really an income statement (profit and loss statement) modification with accounting. Basically, it is limited to the revenue generated by that product/service and its direct cost. In effect, departmental accounting stops at the gross profit line for that respective product/service or location’s value.
To illustrate, let’s take a look at a simple lawn and garden center. This retail facility has three distinct centers of sales. First it sells equipment and tools (lawnmowers, yard power tools and yard hand tools). It also has a repair division to service the manufacturer’s products plus other similar products. Finally it sells lawn products including feed, seed, mulch, plants and trees. Here is an example of this store’s departmentalized income statement.
PRESTON LAWN AND GARDEN CENTER
Departmentalized Income Statement
For the Month Ending June 30, 2016
Equipment Retail Repair/Service Total
Sales $107,642 $196,718 $46,407 $350,767
Cost of Sales
Product 73,091 88,951 3,497 165,539
Labor/Commissions 6,414 24,007 13,181 43,602
Transportation 605 2,611 204 3,420
Supplies 76 2,018 3,381 5,475
Other 1,009 744 210 1,963
Sub-Total COS 81,195 118,331 20,473 219,999
Gross Profit $26,447 $78,387 $25,934 $130,768
Taxes and Licenses 7,445
Operational Profit 97,194
Net Profit $87,003
Note that all overhead (expenses and capital costs) are not allocated to the respective departments. Why? The answer lies in the inability to directly associate their costs to one particular product or service. For example management costs reflect all payroll costs in the front office including the owner, general manager, office staff and receptionist. All these individuals perform services for the whole company and not solely to one department. The same is true for facilities and the other expense groups.
However, cost of sales can be directly associated to the respective department of the company. Most employees are single function for a respective product/service. There may be points of time where they step in to help another department but their pay is primarily tied to a particular product or service.
Are you able to notice how much more informative a departmental report is over a traditional report format? If this were presented to management in total, management may understand or have a gut feeling which department earned the bulk of the gross profit, but a departmental report clearly identifies the bread-winner for the business. This report also illustrates a fundamental principle about business; value is about whole dollars earned, not percentage as gross profit (gross profit margin).
The repair service department generates a 55.9% profit margin on sales. It is by far superior in performance over other departments. Retail generates a reasonable 39.8% yet contributes 60% of the $130,768 of gross profit. Retail is the real contributor of value towards the bottom line. When it comes to profit, it is about dollars and not percentages.
As with anything in life and in business there are limitations. Departmental accounting is no exception.
The primary drawback of departmental accounting is misunderstanding its purpose. Many entrepreneurs want to know the overhead costs of the respective department too. They want a financial performance picture of the department as if it stood alone as a single entity. In small business, this is nearly impossible to do. In large to medium size operations (tens of millions in sales per year) the company can use an allocation model based on cost drivers to allocate expenses to each department. In addition, large business operations can hire highly educated managerial accountants to calculate these results. In small business, it isn’t practical. This method is only effective to the gross profit line.
A secondary limitation is evaluating the subjective value a department brings to a business. In Preston Lawn & Garden Center’s departmental report notice the equipment sales department only generates 24.5% gross margin. In the retail business, this is mediocre at best. But the value this department brings is critical for overall success. Without the equipment sales, the long-term success of the service department is questionable. Furthermore, I would be willing to venture that many of the sales are to commercial operations that purchase retail products too.
A third limitation of department accounting is that it doesn’t identify the exact reason a department is successful or underperforming. It merely identifies the financial results of that department. It helps management clarify accomplishments and concerns. The underlying factors are a different subject.
Remember, accounting records economic activity and departmental accounting breaks this information out into distinct groups for evaluation of financial performance. Each industry is different in what needs evaluation and so the accountant must understand how to identify the respective departments.
One of the most critical steps in setting up departmental accounting is identifying the respective departments. Many inexperienced business owners and young accountants have a difficult time structuring the business into departments. Below are some helpful guidelines.
1) Sometimes It Isn’t Needed – Often a small business doesn’t really need to use departmental accounting. Remember its purpose is to break the company down into logical categories or groups. In microbusiness, often only one or two items or services are sold. Breaking out the business into categories is not necessary. This is especially true if selling homogeneous products like a bakery.
2) Location Driven – If a small business does have a homogeneous product line like cosmetics or oriental foods, maybe locations of stores is a more appropriate departmental layout. This is especially effective to evaluate different managers. I will throw in some caution in using this approach though. Often some form of an equalizer is inserted such as profit per square foot or sales volume per customer. Even though there are different locations, it doesn’t mean they are equal for comparison.
3) Teams – In some industries, teams are used as a department. This would exist in engineering (project teams), oil rig crews, advertising firms and in sales (real estate, software etc.).
4) Product Lines – Another successful approach is to divide the company into product lines. The auto dealership industry divides the dealership into five departments driven by different products: New, Used, Parts, Service and the Finance (and Insurance) departments. This is also very common in many large ticket item stores like furniture (by rooms or brands), appliances (kitchen, laundry, heating/cooling), marine (inboard, outboard, jet ski, manual), and equipment (fuel powered, electrical, hydraulic, and manual).
5) Sales Centers – Some businesses have several centers for a multi-array of products/services like a resort. A resort may include lodging, food service, entertainment, beverages and concierge. Walk into a bowling alley and you’ll see four centers of revenue – bowling, retail, food service and the bar. Even a simple putt-putt course will be split into games, putt-putt and/or a driving range. Some even have batting cages.
6) Program Venues – Some educational based operations have long-term relationships with students for a particular subject. They create departments like business, science or liberal arts. Businesses that sell educational materials will have programs or venues to sell to the professional.
The key is to use a logical approach and think of a minimum volume of sales to warrant the bookkeeping work involved. The goal is to divide the business into distinct groups with a set of identifiable characteristics.
A little side note is justifiable at this point. Too many departments take away from the value departmental accounting provides. I’ve seen contractors break the company into departments based on stages of construction instead of by major groups (new home, spec houses, additions and remodeling). Stages of construction is actually called phase costing or phase accounting which is explained in Lesson 73. Do not use more than five departments to any business.
Even at five, the report will be very busy.
I urge three maybe four but never more than five. If more than five departments, figure ways to consolidate two together. Also the location department format is only effective if there is a homogeneous product line like women’s clothing or auto parts. If the stores sell two or more product lines like women’s, men’s and children clothing lines, the departments should be by product line and not location. Location sales and cost tracking are done separately from departmental accounting.
To assist the reader more, look at this comprehensive example.
Flooring world is a contractor membership retail outlet that sells all sorts of flooring products including carpet, wood, tile and laminates. Contractors join as members and send their customers to the retail center to select their respective floors. Flooring world has its own installers and pays a commission to the contractor for sales originating from that customer sent by the contractor.
Each customer transaction is coded with the contractor’s unique three-letter ID so commissions can be calculated. Regular retail customers are assigned a three-letter identifier belonging to the store only. Departmental profit and loss statements are generated each month in the aggregate and for each contractor member.
JR Construction is a member and gets both reports from Flooring World. During July, he sent in two customers that purchased not only carpet but one purchased a tile floor too. The following are the reports JR Construction received.
Departmental Income Statement (Summary Format)
For the Month Ending July 31, 2016
Carpet Wood Laminates Tile Total
Product $97,118 $36,204 $142,710 $26,781 $302,813
Install 52,409 29,490 62,487 18,665 163,051
Other 8,919 6,649 12,019 3,004 30,591
Total Sales 158,446 72,343 217,216 48,450 $496,455
Cost of Sales
Materials 61,672 17,202 77,519 7,404 163,797
Labor 12,778 9,410 12,941 8,823 43,952
Subcontractors 21,200 7,657 32,757 6,512 68,126
Transportation 3,642 2,808 3,809 3,219 13,478
Insurance 1,916 742 2,040 655 5,353
Commissions 3,486 2,016 5,061 814 11,377
Other 1,505 965 8,212 2,271 12,953
Sub-Total 106,199 40,800 142,339 29,698 319,036
Gross Profit $52,247 $31,543 $74,877 $18,752 177,419
Operational Profit 70,807
Capital Expenses 21,403
Net Profit $49,404
FLOORING WORLD (A MEMBERSHIP COMPANY)
Member’s Departmental Income Statement
Member ID: JRC
For the Month Ending July 31, 2016
Carpet Tile Total
Sales Units (2) (1) (3)
Product $9,241 $4,019 $13,260
Installations 3,700 3,750 7,450
Other 307 761 1,068
Total Sales $13,248 $8,530 $21,778
Cost of Sales
Materials 6,749 1,809 8,558
Labor 1,640 -o- 1,640
Subcontractors 1,200 3,310 4,510
Transportation 217 -0- 217
Insurance 110 76 186
Commissions 314 179 493
Other 216 405 621
Sub-Total COS 10,446 5,779 16,225
Gross Profit $2,802 $2,751 $5,553
In the membership only report expenses are not included because that is a company only item and there is no allocation to each member. The member’s report stops at gross profit. The units line is merely information telling the member that there were two customers for carpet and a customer also purchased a tile floor.
Implementing Departmental Accounting
Departmental accounting is easier to implement than what it appears. Most accounting software programs add an additional data field called departments or classes*. In the field’s table add the respective departments. I encourage accountants to keep the number of classes to less than five.
* ‘Class’ is the term used with QuickBooks.
When entering data into the respective journals, an additional column is displayed for data entry called department or class. With each respective line of information, select the corresponding class to assign revenues or cost of sales.
Now comes the tricky part. In Lessons Four through Ten I explained the six different types of accounts. The class or departmental assignment is only necessary with sales and cost of sales. Do not assign a department to any other type of account. Here are the reasons:
* Expenses – If you assign a department or class to a general expense the reports will have an expense line with a value in it under that department’s column. Expenses are generic and are pretty much equal to all departments. If this does exist, simply click on that entry (value) in the report and unassigned the value. If you adamantly feel the expense is for that department, reassigned the value to the ‘Other’ account in cost of sales.
* Balance Sheet Accounts – Over the years I’ve seen accountants attempt to departmentalize balance sheet assets and liabilities. This is OK if you know what you are doing. Often accountants can’t figure out why the departmental balance sheet doesn’t balance. This is basic accounting, since expenses affect the income statement and expenses are excluded in departmental accounting, current earnings are non assignable to departments thus the equity section will always be off in departmental balance sheets. In effect a departmental balance sheet will never balance. Only truly knowledgeable accountants understand how to reconcile departmental balance sheets to the overall balance sheet.
* Other Revenues – Sales is a subset of revenues. Other revenues include items such as interest earned, penalties and fees charged on accounts and even the money earned from the soda vending machine in the lobby. Generally, none of these revenue sources are charged to a particular department. Some organizations use a catch-all department called administration. It is here that other revenues, expenses and other costs are coded for a departmental category. The header section for Flooring World will like this:
Carpet Wood Laminates Tile Admin Total
Sales $ZZ,ZZZ $ZZ,ZZZ $ZZZ,ZZZ $ZZ,ZZZ -0- $ZZZ,ZZZ
Other Rev -0- -0- -0- Z,ZZZ ZZZ Z,ZZZ
Total Rev $ZZ,ZZZ $ZZ,ZZZ $ZZZ,ZZZ $ZZ,ZZZ $ZZZ $ZZZ,ZZZ
If you are using the very popular QuickBooks software, if any line entry for a journal entry is designated to an income statement account (revenue, cost of sales, expenses) and not categorized to a particular class (department). Then the report will create and additional column called ‘Other’, any values in this column should be clicked on to open to the source entry and each item needs to be categorized to a class (department). Again create an administration department to act as the default catch-all for expenses and other forms of revenue.
Summary – Departmental Accounting
Departmental accounting is an accounting method breaking out sales and direct cost of sales into well-defined categories or groups. It allows management to break the business operation down into separate work centers to determine respective profitability. General expenses are not assigned to a department (or assigned to the ‘Admin’ department) as these costs are company wide and have no bearing on how profitable a particular product line, location, team or sales center is performing.
Departmental accounting is used to isolate well performing or poorly operated sections of the business. It is strictly an income statement tool for sales and direct costs only. It is a highly complicated task to apply to the balance sheet and therefore not recommended for balance sheet accounts. If used properly, management can significantly improve business performance. Act on Knowledge.
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