Segment Reporting and Decentralization

UAA ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

The Work of Management

Planning

Evaluating

Decision Making

Organizing & Directing

Controlling

Controlling Operations
Management by exception
Responsibility Accounting

Delegation of authority
Management by walking around

Responsibility Accounting
. . . is a reporting system in which a

cost is charged to the lowest level of management that has responsibility for it.
President and CEO Vice President Marketing Vice President Production Vice President Controller

Installing Responsibility Accounting

Create a set of financial

performance goals (budgets). performance.

Measure and report actual Evaluate based on comparison of

actual with budget.

Responsibility Accounting
Evaluation of responsibility centers

depends on . . .

The extent of delegation of authority; and

A managers preference

Decentralization . . .
. . . the delegation of authority to the

lowest level of management responsibility that can make decisions.

Centralization . . .
. . . A centralized organization is one in

which little authority is delegated to lower level managers.

Decentralization
The more decentralized the firm, the

greater the need for control.

Monitor employees

Motivate employees

Advantages of Decentralization
Top level managers are relieved of

making routine decisions.

Higher employee morale Training Decisions are made where the action is

taking place.

Disadvantages of Decentralization
Upper level management loses some

control.

Lack of goal congruence. Duplication of effort.

Decentralization and Segment Reporting

An Individual Store
Quick Mart

A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be

A Sales Territory

A Service Center

Cost, Profit, and Investments Centers

Responsibility Centers

Cost Center

Profit Center

Investment Center

Responsibility Centers: A Systems Perspective

Data (Inputs)

Processing Steps Within Information Systems Capital . . . Working Capital Equipment Etc.

Information (Outputs)

Resources used . . .

Output . . .

DM DL MOH

Goods, Services, Ideas

Cost, Profit, and Investments Centers

Cost Center A segment whose manager has control over costs, but not over revenues or investment funds.

Responsibility Centers: A Systems Perspective

Input

Process

Output

Cost Center
Control only this

Evaluation . . .
A cost center is evaluated by means of

performance reports (i.e., comparison of actual with standard).

Segments Classified as Cost, Profit and Investment Centers

Responsibility Centers: A Systems Perspective

Input

Process

Output

Profit Center
Control these

Cost, Profit, and Investments Centers

Profit Center A segment whose manager has control over both costs and revenues, but no control over investment funds.
Revenues
Sales Interest Other

Costs
Mfg. costs Commissions Salaries Other

A Profit Center . . .
A profit center is evaluated by

means of contribution margin income statements.

Segments Classified as Cost, Profit and Investment Centers

Cost, Profit, and Investments Centers

Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets.

Corporate Headquarters

Responsibility Centers: A Systems Perspective

Input

Process

Output

Investment Center
Control these

Investment Center
An investment center is evaluated by

means of the Return on Investment (ROI) or the Residual Income (RI) it is able to generate.

Segments Classified as Cost, Profit and Investment Centers

Responsibility Centers

Profit Center Vs. Investment Center

A profit center is focused on profits as

measured by the difference between revenues and expenses. the assets employed in earning revenues.

An investment center is compared with

Levels of Segmented Statements

Levels of Segmented Statements

Levels of Segmented Statements

Webber, Inc. has two divisions.

Webber, Inc.

Computer Division

Television Division

Lets look more closely at the Television Divisions income statement.

Our approach to segment reporting uses the contribution format.

Income Statement Contribution Margin Format Television Division Sales $ 300,000 Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate sections.

Our approach to segment reporting uses the contribution format.

Income Statement Contribution Margin Format Television Division Sales $ 300,000 Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Segment margin is Televisions contribution to profits.

Division Segment Margin

Traceable and Common Costs

Fixed Costs Dont allocate common costs. Common
A cost that supports more than one segment but that would not go away if any particular segment were eliminated.

Traceable
Costs arise because of the existence of a particular segment

Identifying Traceable Fixed Costs

Traceable costs would disappear over time if the segment itself disappeared.
No computer division means . . . No computer division manager.

Identifying Common Fixed Costs

Common costs arise because of overall operation of the company and are not due to the existence of a particular segment.
No computer division but . . . We still have a company president.

Levels of Segmented Statements

Sales Variable costs CM Traceable FC Division margin Common costs Net operating income Income Statement Company Television $ 500,000 $ 300,000 230,000 150,000 270,000 150,000 170,000 90,000 100,000 $ 60,000 25,000 $ Computer $ 200,000 80,000 120,000 80,000 $ 40,000

Common costs should not be allocated to the 75,000 divisions. These costs would remain even if one of the divisions were eliminated.

Traceable Costs Can Become Common Costs

Fixed costs that are traceable on one segmented statement can become common if the company is divided into smaller segments.

Lets see how this works!

Traceable Costs Can Become Common Costs

Webbers Television Division
Television Division

Product Lines
Big Screen

Regular

U.S. Sales

Foreign Sales

U.S. Sales

Foreign Sales

Sales Territories

Traceable Costs Can Become Common Costs

Income Statement Television Division Regular Sales $ 300,000 $ 200,000 Variable costs 150,000 95,000 CM 150,000 105,000 Traceable FC 80,000 45,000 Product line margin 70,000 $ 60,000 Common costs 10,000 Divisional margin $ 60,000 Big Screen $ 100,000 55,000 45,000 35,000 $ 10,000

Fixed costs directly traced to the Television Division

$80,000 + $10,000 = $90,000

Traceable Costs Can Become Common Costs

Income Statement Television Division Regular Sales $ 300,000 $ 200,000 Variable costs 150,000 95,000 CM 150,000 105,000 Traceable FC 80,000 45,000 Product line margin 70,000 $ 60,000 Common costs 10,000 Divisional margin $ 60,000 Big Screen $ 100,000 55,000 45,000 35,000 $ 10,000

Of the $90,000 cost directly traced to the Television Division, $45,000 is traceable to Regular and $35,000 traceable to Big Screen product lines.

Traceable Costs Can Become Common Costs

Income Statement Television Division Regular Sales $ 300,000 $ 200,000 Variable costs 150,000 95,000 CM 150,000 105,000 Traceable FC 80,000 45,000 Product line margin 70,000 $ 60,000 Common costs 10,000 Divisional margin $ 60,000 Big Screen $ 100,000 55,000 45,000 35,000 $ 10,000

The remaining $10,000 cannot be traced to either the Regular or Big Screen product lines.

Segment Margin
The segment margin is the best gauge of the long-run profitability of a segment.

Profits

Time

Responsibility and Controllability

Controllability is . . .
The degree of influence that a specific

manager has over costs, revenues, or other items in question.

Controllability
Few costs are

clearly under the sole influence of one manager.

Controllability
With a long

enough time span, all costs will come under someones control.

The Controllability Principle

Management Actions

Costs Uncontrollable Environmental Effects

Managers only partially control costs.

The Controllability Principle

Management Actions

. . . lead to more predictable rewards for managers.

Costs Uncontrollable Environmental Effects

Performance Measures

Rewards

Performance measurement systems that are based on controllable costs . . .

The Controllability Principle

The performance measures and rewards will influence management to focus on the controllable costs.
Management Actions

Costs

Performance Measures

Rewards

The Controllability Principle

Management Actions

Costs Uncontrollable Environmental Effects

Performance Measures

Rewards

When performance measures are affected by uncontrollable environmental effects . . .

The Controllability Principle

Management Actions

Costs

Performance Measures

Rewards

Uncontrollable Environmental Effects

. . . management may try to control the performance measure rather than the underlying cost.

Hindrances to Proper Cost Assignment The Problems

Omission of some costs in the assignment process. Assignment of costs to segments that are really common costs of the entire organization.

The use of inappropriate methods for allocating costs among segments.

Omission of Costs
Costs assigned to a segment should include all costs attributable to that segment from the companys entire value chain.
Business Functions Making Up The Value Chain
R&D Product Design Customer Manufacturing Marketing Distribution Service

Inappropriate Methods of Allocating Costs Among Segments

Arbitrarily dividing common costs among segments

Failure to trace costs directly

Inappropriate allocation base

Segment 1

Segment 2

Segment 3

Segment 4

Return on Investment
The ROI formula is expressed as:

Return on Investment
Where . . .

Income Margin = -------------------Sales

Return on Investment
Where . . .

Sales Turnover = -----------------------------Invested Capital

Return on Investment
Income
------------------------------

Sales The ratio of operating income to sales

Sales
------------------------------

Invested Capital

The efficiency of asset utilization.

Return on Investment

Income -----------------------------Sales

Sales -----------------------------Invested Capital

The ratio of operating income to sales

The efficiency of asset utilization.

Return on Investment

Income -----------------------------Invested Capital

ROI

Cost of Goods Sold Selling Expense Admin. Expense

Sales

Sales - OE
Operating Expenses

Net Oper. Income

NOI / Sales
Sales

Margin

Margin is a measure of managements ability to control operating expenses in relation to sales.

Turnover is a measure of the amount of sales that can be generated in an investment center for each dollar invested in operating assets.
Cash Accounts Receivable Inventory Current Assets Sales

Sales / AOA
Ave Oper Assets

Turnover

CA + NCA
PP&E
Other Assets Noncurr. Assets

Cost of Goods Sold

Selling Expense Admin. Expense

Sales

Sales - OE
Operating Expenses

Net Oper. Income

NOI / Sales
Sales

Margin

MxT
Cash Sales

ROI

Accounts Receivable
Inventory

Current Assets

Sales / AOA
Ave Oper Assets

Turnover

CA + NCA
PP&E Other Assets Noncurr. Assets

Measuring Income and Invested Capital

Income -----------------------------Sales

Sales -----------------------------Invested Capital

Measuring Income
Variety of possibilities
Text uses EBIT (Net Operating Income)
Earnings Before Interest and Taxes

Measuring Invested Capital

Variety of possibilities
Text uses Net Book Value
Consistent with how PP&E is listed on the Balance Sheet. Consistent with the computation of operating income.

Return on Investment (ROI) Formula

Income before interest and taxes (EBIT)

Net operating income ROI = Average operating assets

Cash, accounts receivable, inventory, plant and equipment, and other productive assets.

Improving the ROI

Increase Sales
Reduce Expenses

Reduce Assets

XYZ Company

Income (EBIT)

$30,000

Sales

$500,000

Invested Capital

$200,000

Return on Investment
$30,000 -------------$500,000 $500,000 -------------$200,000

6%

x
15%

2.5

Approach #1: Increase Sales

Increase Sales . . .
Assume that XYZ is able to increase

sales to $600,000.

Net Operating Income increases to

$42,000.

Average Operating Assets remain

unchanged.

What is the impact on ROI?

Return on Investment
$42,000 -------------$600,000 $600,000 -------------$200,000

x x
21%

7%

3.0

Reduce Expenses . . .
Assume that XYZ is able to reduce

expenses by $10,000

Net Operating Income increases to

$40,000.

Average Operating Assets and sales

remain unchanged.

What is the impact on ROI?

Return on Investment
$40,000 -------------$500,000 $500,000 -------------$200,000

x x
20%

8%

2.5

Reduce Assets . . .
Assume that XYZ is able to reduce

its operating assets from $200,000 to $125,000. remain unchanged.

Sales and Net Operating Income What is the impact on ROI?

Return on Investment
$30,000 -------------$500,000 $500,000 -------------$125,000

x x
24%

6%

2.4

Advantages of ROI . . .
It encourages managers to focus on the

relationship among sales, expenses, and investment. cost efficiency.

It encourages managers to focus on

It encourages managers to focus on

operating asset efficiency.

Disadvantages of ROI
It can produce a narrow focus on

divisional profitability at the expense of profitability for the overall firm. short run at the expense of the long run.

It encourages managers to focus on the

Overinvestment
Evaluation in terms of profit can lead

to overinvestment.

Overinvestment
Increases in

Assets

Company Manager

Increases in

Profits

Underinvestment
Evaluation in terms of ROI can lead to

underinvestment.

Overinvestment
Decreases in

Assets

Company Manager

Increases in

ROI

Criticisms of ROI . . .
ROI tends to emphasize short-run

performance over long-run profitability. by the division manager due to committed costs.

ROI may not be completely controllable

Multiple Criteria . . .
Growth in market share Increases in productivity Dollar profits Receivables turnover Inventory turnover Product innovation

Residual Income . . .
. . . is the net operating income

that an investment center is able to earn above some minimum rate of return on its operating assets.
Residual Income = EBIT Required Profit = EBIT Cost of Capital x Investment

Residual Income Example

Division A Division B

Invested Capital EBIT Last Year

$1,000,000 200,000

$3,000,000 450,000

*Min. Required R of R
Residual Income

120,000
$80,000

360,000
$90,000

*Minimum Required Rate of Return = 12%

Problem with RI . . .
RI cannot be used to compare

performance of divisions of different sizes.

Advantage of RI . . .
RI encourages managers to make

profitable investments that would be rejected under the ROI approach.

Example . . .
Assume that ABC Companys Division A

has an opportunity to make an investment of $250,000 that would generate a 16% return. Should the investment be made?

The Divisions current ROI is 20%.

Marsh Company Return on Investment

Present New Overall

Invested Capital (1) NOPAT (2) ROI (1)/(2) *$250,000 x 16% = $40,000

$1,000,000 200,000 20%

$250,000 *40,000 16%

$1,250,000 240,000 19.2%

Reject - Reduces overall ROI!!!

Present New Overall

Marsh Company Return on Investment

Invested Capital (1) NOPAT (2) ROI (1)/(2) *$250,000 x 16% = $40,000

$1,000,000 200,000 20%

$250,000 *40,000 16%

$1,250,000 240,000 19.2%

Accept - Positive Residual Income!!!

Present New Overall

Marsh Company Residual Income

Invested Capital (1) NOPAT (2) Minimum RofR*

$1,000,000 200,000 $120,000

$250,000 40,000 $30,000

$1,250,000 240,000 $150,000

Residual Income

$80,000

$10,000

$90,000

*Minimum Required Rate of Return = 12% x Invested Capital

Economic Value Added

Economic Value Added (EVA) is after-

tax operating profit minus the total annual cost of capital

If EVA is positive, the company is creating wealth.

If EVA is negative, the company is destroying capital.

Calculating EVA . . .
EVA = After-tax operating income

minus (the weighted-average cost of capital times total capital employed)

Determine weighted average cost of capital
Determine total dollar amount of capital employed