Course: Cost and Management Accounting School of Business

Code: MBA 609 Chapter 06

Instructor: Nazma Akter
Designation: Assistant Professor
Email: nazma.sob@aust.edu
Cell: 01990480147

Segment Reporting & Decentralization

(Go through the reference books for details)
 Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)
A decentralized organization is one in which decision making is not confined to a few top
executives but rather is spread throughout the organization with managers at various levels
making key operating decisions relating to their sphere of responsibility. Decentralization is a
matter of degree, since all organizations are decentralized to some extent out of necessity.
 Advantages of Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)
A decentralized organization does not confine decision-making authority to a few top executives;
rather, decision-making authority is spread throughout the organization. The advantages of
decentralization are as follows:

1. Top management freed to concentrate on strategy.

2. Decision-making authority leads to job satisfaction.
3. Lower-level managers can respond quickly to customers.
4. Lower-level managers gain experience in decision-making.
5. Lower-level decision often based on better information.

 Disadvantages of Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

1. May be a lack of coordination among autonomous managers.
2. Lower-level managers may make decisions without seeing the “big picture.”
3. Lower-level manager’s objectives may not be those of the organization.
4. May be difficult to spread innovative ideas in the organization.

 Segment (Managerial Accounting, Garrison, 10th edition, p. 527)

A segment is a part or activity of an organization about which managers would like cost,
revenue, or profit data. Examples of segments include divisions of a company, sales territories,
individual stores, service centers, manufacturing plants, marketing departments, individual
customers, and product lines. A company’s operations can be segmented in many ways. For
example, segment the business by geographic region, by individual store, by the nature of the
merchandise, by brand name and so on.

Responsibility Center (Managerial Accounting, Garrison, 10th edition, p. 529)

Responsibility accounting systems link lower-level managers’ decision-making authority with
accountability for the outcomes of those decisions. Responsibility center is broadly defined as
any part of an organization whose manager has control over, and is accountable for cost, profit,
or investment funds. The three primary types of responsibility centers are cost centers, profit
centers, and investment centers. Superior Foods Corporation provides an example of the
various kinds of responsibility centers that exist in an organization.
 Investment S u p e rio r F o o ds C o rp o ra tion
C o rp o rate H e a dq u a rte rs
Centers P re s ide n t a nd C E O

O p e ratio ns F in an ce L e g al P e rs on n el
V ic e P re sid e nt C h ie f F In a nc ia l O ffic er G e n e ra l C ou n s el V ic e P re sid e nt

S a lty S na c ks B e vera g es C o n fe c tio ns

Profit
P ro d u c t M a n g er P ro d u c t M a n a g er P ro d u c t M a n a g er
Centers
B o ttlin g P la nt W a reh o u se D is trib u tio n Cost
M a na g er M a na g er M a na g er
Centers

Cost Center (Managerial Accounting, Garrison, 10th edition, p. 527)

A cost center is a business segment whose manager has control over costs, but not over revenue
or investment funds. Service departments such as accounting, general administration, legal and
personnel are usually considered to be cost centers. In addition, manufacturing facilities are often
considered to be cost center. The manager of the cost center are expected to minimize cost while
providing the level of services or the amount of products demanded by the other parts of the
organization. Standard cost variances and flexible budget variances are often used to evaluate
cost center performance.

 Profit Center (Managerial Accounting, Garrison, 10th edition, p. 528)

In contrast to a cost center, a profit center is any business segment whose manager has control
over both costs and revenue. Like a cost center, however, a profit center generally does not nave
control over investment funds. Profit center managers are often evaluated by comparing actual
profit to targeted or budgeted profit. An example of a profit center is a company’s cafeteria.

 Investment Center (Managerial Accounting, Garrison, 10th edition, p. 528)

An investment center is any segment of an organization whose manager has control over cost,
revenue, and investments in operating assets. Investment center managers are usually evaluated
using return on investment (ROI) or residual income. An example of an investment center would
be the corporate headquarters.

Segment Margin (Managerial Accounting, Garrison, 10th edition, p. 536)

To prepare an income statement for a particular segment, variable expenses are deducted from
sales to yield the contribution margin for the segment. The segment margin, which is computed
by subtracting the traceable fixed costs of a segment from its contribution margin. It
represents the margin available after a segment has covered all of its own costs. The segment
margin is the best gauge of the long-run profitability of a segment. There are two keys to
building segmented income statements:
1. A contribution format should be used because it separates fixed from variable costs and it
enables the calculation of a contribution margin.
 2. Traceable fixed costs should be separated from common fixed costs to enable the
calculation of a segment margin.
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

 Traceable Fixed Cost (Managerial Accounting, Garrison, 10th edition, p. 533)

A Traceable cost or a segment is a fixed cost that is incurred because of the existence of a
particular segment and would disappear over time if the segment itself disappeared. Only the
traceable fixed costs are charged to a segment in the segmented income statements in the report.
It is important to realize that the traceable fixed costs of one segment may be a common fixed
cost of another segment. For example, the landing fee paid to land an airplane at an airport is
traceable to the particular flight, but it is not traceable to first-class, business-class, and
economy-class passengers.

 Common Fixed Cost (Managerial Accounting, Garrison, 10th edition, p. 534)

A common cost is a fixed cost that supports the operations of more than one segment, but is not
traceable in whole or in part to any one segment. Common costs arise because of the overall
operation of the company and would not disappear if any particular segment were eliminated.
Common costs are not allocated to segments.

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Net operating income $ 75,000

Return on Investment (ROI) (Managerial Accounting, Garrison, 10th edition, p. 542)

Rate of return is an approach for measuring managerial performance of a segment. The return on
investment (ROI) is defined as net operating income divided by average operating assets. The
higher the ROI of a business segment, the greater the profit generated in a segment operating
assets. ROI measures net operating income earned relative to the investment in average operating
assets.
 Return on Investment Net Operating Income
(ROI) = Average Operating Assets

Net operating income, rather than net income, is used in the ROI formula. Net operating income
is income before interest and taxes and is sometimes referred to as earning before interest and
taxes (EBIT). Operating assets include cash, account receivable, inventory, plant and
equipment, and all other assets held for productive use in the organization. Most companies use
the net book value of depreciable assets to calculate average operating assets.

We can modify this formula slightly by introducing sales as follows

Net Operating
Sales
Return on Investment Income
= X
(ROI) Average Operating
Sales
Assets
The first term on the right-hand side of the equation is the margin. Margin is a measure of
management’s ability to control operating expenses in relation to sales. The lower the operating
expenses per taka of sales, the higher the margin earned.

Net Operating
Margin = Income
Sales
The second term of the right-hand side of the equation is turnover. Turnover is a measure of the
sales that are generated for each taka invested in operating assets.
Sales
Turnover = Average Operating
Assets
The following alternative form of the ROI formula, which will be used most frequently,
combines margin and turnover:

Return on Investment (ROI) = Margin X Turnover

 Improve or Increase the ROI (Managerial Accounting, Garrison, 10th edition, p. 544)
There are three ways to increase ROI;
1. Increase Sales: With the help of increase in sales we can be able to increase ROI
2. Reduce Expenses: If we can be able to reduce expense, operating income will be
increased. Due to the increase in operating income ROI will be increase
3. Reduce Assets: If we can be able to reduce average operating assets, ROI will be
increased. By using JIT inventory as an operating asset can be reduced.

Criticisms of ROI (Managerial Accounting, Garrison, 10th edition, p. 547)

1. In the absence of the balanced scorecard, management may not know how to increase
ROI. They may increase ROI in a way that is inconsistent with the company’s strategy or
they may take actions that increase ROI in the short run but harm the company in the
long run. Example, cutting back on research and development cost.
2. Managers often inherit many committed costs over which they have no control. These
committed costs may be relevant in assessing the performance of the business segment.
3. A manager who is evaluated based on ROI may reject investment opportunities that are
profitable for the whole company but that would have negative impact on the manager’s
performance evaluation.
 Residual Income (Managerial Accounting, Garrison, 10th edition, p. 548)
Another approach to measuring an investment center’s performance is residual income. Residual
income is the net operating income that an investment center earns above the minimum required
return on its operating assets. That means, Residual income measures net operating income
earned less the minimum required return on average operating assets. Residual income
encourages managers to make profitable investments that would be rejected by managers using
ROI.

Operating assets $ 100,000 Actual income $ 30,000

Required rate of return × 20% Minimum required return (20,000)
Minimum required return $ 20,000 Residual income $ 10,000

 Transfer Pricing (Managerial Accounting, Garrison, 10th edition, p. 554)

A transfer price is the price charged when one segment of a company provides goods or services
to another segment of the company. The fundamental objective in setting transfer prices is to
motivate managers to act in the best interests of the overall company. There are three primary
approaches to setting transfer prices:

1. Negotiated Transfer Prices

2. Transfer at Cost Prices at the selling division

a. Variable Cost
b. Full (Absorption Cost) Cost
3. Transfer at Market Prices

 Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions.
Advantages of negotiated transfer prices:

a) They preserve the autonomy of the divisions, which is consistent with the spirit of
decentralization.
b) The managers negotiating the transfer price are likely to have much better
information about the potential costs and benefits of the transfer than others in the
company.

Transfer at Cost Prices

Many companies set transfer prices at either the variable cost or full (absorption) cost incurred
by the selling division. The drawbacks of this approach include:

1. Using full cost as a transfer price can lead to suboptimization because it does not distinguish
between variable costs, which may be relevant to the transfer pricing decision, and fixed
costs, which may be irrelevant.
2. If cost is used as the transfer price, the selling division will never show a profit on any
internal transfer. The only division that shows a profit is the division that makes the final sale
to an outside party.
3. Cost-based transfer prices do not provide incentives to control costs. If the actual costs of one
division are passed on to the next, there is little incentive for anyone to work on reducing
costs.

 Transfer at Market Prices

A market price (i.e., the price charged for an item on the open market) is often regarded as the
best approach to the transfer pricing problem. It works best when the product or service is sold in
its present form to outside customers and the selling division has no idle capacity. With no idle
capacity the real cost of the transfer from the company’s perspective is the opportunity cost of
the lost revenue on the outside sale.
It does not work well when the selling division has idle capacity. In this case, market-based
transfer prices are likely to be higher than the variable cost per unit of the selling division.
Consequently, the buying division may make pricing and other decisions based on incorrect,
market-based cost information rather than the true variable cost incurred by the company as a
whole.

Problem 1
Caltec, Inc., produces and sells recordable CD and DVD packs. Revenue and cost information
relating to the products follows:

Product
CD DVD
Sales Tk. 8 Tk. 25
Variable expenses per pack 3.20 17.50
Traceable fixed expenses per year 138,000 45,000

Common fixed expenses in the company total Tk. 105000 annually. Last year the company
produced and sold 37500 CD and 18000 DVD packs.

Required
Prepare an income statement for the year segmented by product lines. Show both amount and
percent columns for the company as a whole and for each of the products.

Problem 2
The Magnetic Imaging Division of Medical Diagnostics, Inc., has reported the following results
for last year’s operations

Sales Tk. 25 million

Net operating income Tk. 3 million
Average operating assets Tk. 10 million
Required
1. Compute the margin, turnover, and ROI for the Magnetic Imaging Division
2. Top management of has set a minimum required rate of return on average operating
assets of 25%, what is the residual income for the year?
Problem 3

Regal Company reports the following:

Average operating assets $ 200,000

Sales $ 500,000
Operating expenses $ 470,000
Required
1. What is Regal Company’s ROI?
2. Regal’s manager was able to increase sales to $600,000 while operating expenses increased
to $558,000. What will be the new ROI?
3. Assume that Regal’s manager was able to reduce operating expenses by $10,000 without
affecting sales or operating assets. What will be the new ROI?
4. Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time
techniques without affecting sales or operating expenses. What will be the new ROI?

Problem 4
Collyer Products, Inc., has a Valve Division that manufactures and sells a standard valve as
follows:

Capacity in units 100,000

Selling price to outside customers Tk. 30
Variable cost per unit Tk. 16
Fixed cost per unit based on capacity Tk. 9
The company has a pump division that could use this valve in one of its pumps. The Pump
Division is currently purchasing 10,000 valves per year from an overseas supplier at a cost of Tk.
29 per valve.

Required
1. Assume that the Valve Division has ample idle capacity to handle all of the Pump Division’s
needs. What is the acceptable range, if any, for the transfer price between the two divisions?
2. Assume that the Valve Division is selling all of the valve that it can produce to outside
customers. What is the acceptable range, if any, for the transfer price between the two
divisions?
3. Assume again that the Valve Division is selling all of the valves that it can produce to outside
customers. Also assume that Tk. 3 in variable expenses can be avoided on transfers within
the company, due to reduce selling cost. What is the acceptable range, if any, for the transfer
price between the two divisions?
4. Assume that the Pump Division needs 20,000 special high-pressure valves per year. The
Valve Division variable costs to manufactures and ship the special valve would be Tk. 20 per
unit. To produce this special valve, the Valve Division would give to reduce its production
and sales of regular valves from 100,000 units per year to 70,000 units per year. What is the
lowest acceptable transfer price?

Problem 5
Marple Associates is a consulting firm that specializes in information systems for construction
companies. A segmented income statement for the company’s most recent year is given below:

Company Segment
 Houston Dallas
Sales 750,000 150,000 600,000
Variable expenses 405,000 45,000 360,000
Contribution Margin 345,000 105,000 240,000
Traceable Fixed expenses 168,000 78,000 90,000
Segment Margin 177,000 27,000 150,000
Common Fixed expenses 120,000
Net Operating income 57,000

Required
1. By how much would the company’s net operating income increase if Dallas increased its
sales by Tk. 75,000 per year? Assume no change in cost behavior patterns.
2. Assume that sales in Houston increase by Tk. 50,000 next year and that sales in Dallas
remain unchanged. Prepare a new segmented income statement for the company showing
both amount and percentages.

Problem 6
A company has two segments, A and B. A segmented income statement for the company’s most
recent year is given below:

Segment
Company
A B
Sales 600,000 400,000 200,000
Variable expenses 360,000 260,000 100,000
Contribution Margin 240,000 140,000 100,000
Traceable Fixed expenses 72,000 20,000 52,000
Segment Margin 168,000 120,000 48,000
Common Fixed expenses 18,000
Net Operating income 150,000

The company would like to initiate an intensive advertising campaign in one of the two markets
during the next month. The campaign cost Tk. 8000. Market studies indicate that such a
campaign would increase sales in the A market by Tk. 70,000 or increase sales in the B market
by 60,000

Required
In which of the market would you recommend that the company focus its advertising campaign?
Show computations to support your answer.

Problem 7
Bovine Company, a wholesale distributor of DVDs, has been experiencing losses for some time,
as shown by its most recent monthly income statement below:
Taka
Sales 1,500,000
Variable expenses 588,000
Contribution Margin 912,000
Fixed expenses 945,000
Net Operating income (33,000)
In an effort to isolate the problem, the president has asked for an income statement segmented by
geographic market. Accordingly, the Accounting Department has developed the following data:

Geographic Market
South Central North
Sales Tk. 400,000 Tk. 600,000 Tk. 500,000
Variable expenses as percentage of sales 52% 30% 40%
Traceable Fixed expenses Tk. 240,000 Tk. 330,000 Tk. 200,000

Required
1. Prepare an income statement segmented by geographic market, as desired by the
president.
2. The company’s sales manager believes that sales in the Central geographic market could
be increased by 15% if advertising were increased by Tk. 25000 each month. Would you
recommend the increased advertising? Show computations to support your answer.

Problem 8
Rains Nickless Ltd. has two divisions that operate in Rajshahi and Dhaka. Selected data on the
two divisions follows:
Division
Rajshahi Dhaka
Sales Tk. 9,000,000 Tk.20,000,000
Net operating income 630,000 1,800,000
Average operating assets 3,000,000 10,000,000

Required
1. Compute the ROI for each division
2. Assume that the company evaluates performance by use of residual income and that the
minimum required return for any division is 16%. Compute the residual income for each
division
3. Is the Dhaka Division’s greater residual income an indication that it is better managed?
Explain.

Problem 9
Selected sales and operating data fo9r three divisions of three different companies are given
below:

Division
A B C
Sales 6,000,000 10,000,000 8,000,000
Net operating income 300,000 900,000 180,000
Average operating assets 1,500,000 5,000,000 2,000,000
Minimum required rate of return 15% 18% 12%
Required
1. Compute the ROI for each division, using the formula stated in terms of margin and
turnover.
2. Compute the residual income for each division