DECENTRALIZATION

Except in small organizations, a company’s owners and its top managers must
delegate some decision-making authority to others. When a company’s owners or
stockholders delegate decision-making authority to top managers, they employ
corporate governance systems to direct and control the actions of those managers.
When properly implemented, corporate governance systems provide incentives and
feedback mechanisms to help ensure that the company’s board of directors and top
managers pursue goals that align with the owners’ or stockholders’ interests.
Similarly, when the company’s top managers delegate decision-making authority to
subordinates, they employ management control systems to direct and control actions
of those subordinates. When properly implemented, management control systems
provide incentives and feedback mechanisms to help ensure that all of a company’s
employees pursue goals that align with its interests. 

The process of delegating the decision-making authority throughout an organization is

called decentralization.

SEGMENT REPORTING

A segment is any profit-making entity within an organization in which managers seek

cost, revenue and profit data. 

Direct fixed expenses (or traceable fixed costs) are fixed expenses that are directly
traceable to a segment. These are sometimes called avoidable fixed expenses because
when the segment in which these costs are associated where eliminated, such costs are
avoided. Direct fixed expenses existed only because of the segment, so if the segment
had never existed, such fixed costs would not have been incurred. 

Common fixed expenses are fixed expenses jointly caused by two or more segments
but are not directly traceable in whole or in part to any one segment.  These expenses
will continue even if one or more of the segments is eliminated.

Segment margin is contribution margin less traceable fixed costs. It represents the
margin available after a segment has covered all of its own traceable costs. It is the
best gauge of the long-run profitability of a segment because it includes only those
costs that are caused by the segment. If a segment cannot cover its own costs, then
that segment should probably be dropped. 

Segment margin is useful in major decisions affecting capacity – whether or not to

drop a segment. By contrast, contribution margin is useful in decisions involving
short-run profitability or pricing special orders with the use of temporary existing
capacity. 

Traceable or Common Fixed Costs?

The general guideline is to treat as traceable cost only those costs that would
disappear over time if the segment itself disappeared. That is, if one segment or
division within the company were sold or discontinued, it would no longer be
necessary to have the related traceable fixed costs. However, common fixed costs will
persist even if a segment or division is sold or dropped. It must be emphasized that
common fixed costs should not be allocated to segments when making decisions.
Adding or allocating common fixed costs to the “real costs” of a segment may make
an otherwise profitable segment to be unprofitable. 

Take note that common fixed costs are not manageable by the manager of a segment
to whom they are arbitrarily allocated; they are the responsibility of higher-level
managers. 

Try This!
Which of the following statements is true? (You can select more than one answer.)

A. A segment’s contribution margin minus traceable fixed expenses equals the

segment margin.

B. A company’s common fixed costs should be evenly allocated to business segments

when computing the peso sales for a segment to break-even.

C. A segment’s traceable fixed costs should include only those costs that would
disappear over time if the segment disappeared.

D.  Fixed costs that are traceable to one segment may be a common cost of another
segment.

Answer: A, C & D

Illustrative Problem
Donald Company manufactures one product that is sold for P80 per unit in two areas
– Nueva Ecija and Bataan. The following information pertains to the company’s first
year of operations in which it produced 40,000 units and sold 35,000 units. 

Variable cost per unit:

Manufacturing
Direct materials P24
Direct labor   14
Variable manufacturing overhead     2
Variable selling and administrative     4
Fixed costs per year:
Fixed manufacturing overhead P800,000
Fixed selling and administrative expenses   496,000

The company sold 25,000 units in Nueva Ecija area and 10,000 units in Bataan area.
It determined that P250,000 of its fixed selling and administrative expense is traceable
to Bataan area. P150,000 is traceable to Nueva Ecija area, and the remaining P96,000
is a common fixed expense. The company will continue to incur the total amount of
its fixed manufacturing overhead costs as long as it continues to produce any amount
of its only product. 

Required:
1. What is the unit product cost under variable costing?
2. What is the unit product cost under absorption costing?
3. What is the company’s total contribution margin under variable costing?
 4. What is the company’s net operating income under variable costing?
5. What is the company’s total gross margin under absorption costing?
6. What is the company’s net operating income under absorption costing?
7. What is the amount of the difference between the variable costing and absorption
costing net operating income?
8. What is the company’s break-even point in units?
9. Prepare a segment report showing the result of operations of the Nueva Ecija
Area, the Bataan Area and the company as a whole.
10. Assume that Donald considers dropping the Bataan Area. As a result, sales in
Nueva Ecija will increase by 5% in the second year. All things equal, should Bataan
Area be dropped?
11. Assume instead that an advertising campaign costing P30,000 will be done in
Bataan Area to generate 20% increase in its unit sales. All things equal, should this
campaign be continued?

Answers/Solutions:

1. Direct materials P24

Direct labor   14
Variable manufacturing overhead     2
Total P40

2. Direct materials P24

Direct labor   14
Variable manufacturing overhead     2
Fixed manufacturing overhead   20 (P800,000 / 40,000 units)
Total P60

3. Selling Price P80

Less: Variable costs
Manufacturing P40
Selling & Administrative     4   44
Contribution Margin per unit P36
Multiplied by the Number of Units Sold x 35,000 units
Total Contribution Margin P1,260,000

4. Total Contribution Margin P1,260,000

Less: Fixed Manufacturing Overhead P800,000
Fixed Selling and Administrative Expense   496,000   1,296,000
Net Operating Income (Loss) P(   36,000)

5. Sales (35,000 units x P80) P2,800,000

Less: Cost of Goods Sold (35,000 units x P60)   2,100,000
Total Gross Margin P   700,000

6. Total Gross Margin P700,000

Less: Variable Selling & Administrative Expense 
(35,000 units x P4) P140,000
Fixed Selling & Administrative Expense   496,000   636,000
Net Operating Income (Loss) P  64,000
 7. The difference is the fixed manufacturing overhead cost component in the ending
inventory:
Variable Costing Income P(36,000)
Add: Fixed OH in Ending Inventory
(5,000 units x P20)   100,000
Less: Fixed OH in Beginning Inventory (            0)
Absorption Costing Income P 64,000

8. Break-even point in units = Total Fixed Costs / Contribution Margin per Unit
= P1,296,000 / P36
= 36,000 units

9. The income statement is prepared by segment and in total:

Nueva Ecija Bataan Total

Sales P2,000,000 P800,000 P2,800,000
Less: Variable Product Costs   1,000,000   400,000   1,400,000
Manufacturing Margin P1,000,000 P400,000 P1,400,000
Less: Variable S & A     100,000     40,000     140,000
Contribution Margin P   900,000 P360,000 P1,260,000
Less: Traceable Fixed Costs     150,000   250,000     400,000
Segment Margin P   750,000 P110,000 P   860,000
Less: Common Fixed Costs     896,000
Net Operating Income (Loss) P    (36,000)

10. The income statement is prepared by segment and in total:

Nueva Ecija Bataan Total
Sales (with 5% increase) P2,100,000 0 P2,100,000
Less: Variable Product Costs   1,050,000 0   1,050,000
Manufacturing Margin P1,050,000 0 P1,050,000
Less: Variable S & A     105,000 0    105,000
Contribution Margin P   945,000 0 P   945,000
Less: Traceable Fixed Costs     150,000 0    150,000
Segment Margin P   795,000 0 P   795,000
Less: Common Fixed Costs     896,000
Net Operating Income (Loss) P  (101,000)

Makikita na kapag ang isang segment na may positive segment margin ay nai-dropped, ang
segment margin income nito ay malalagay sa loss. Sa example na ito, dahil may
increase sa sales na 5% sa Nueva Ecija sales, tataas din ang contribution margin nito
ng 5%, kaya P900,000 x 5% = P45,000. Madadagdag ito sa overall income ng
company pero mawawala ang P110,000 mula sa Bataan Area.
Overall Net Operating Income (Loss) P (36,000)
Add: Additional Income from Nueva Ecija Area     45,000
Less: Lost Income if Bataan Area is dropped (110,000)
New Overall Net Operating Income (Loss) P(101,000)
 11. The income statement is prepared by segment and in total:

Nueva Ecija Bataan Total

Sales P2,000,000 P960,000 P2,960,000
Less: Variable Product Costs   1,000,000   480,000   1,480,000
Manufacturing Margin P1,000,000 P480,000 P1,480,000
Less: Variable S & A     100,000     48,000     148,000
Contribution Margin P   900,000 P432,000 P1,332,000
Less: Traceable Fixed Costs     150,000   280,000     430,000
Segment Margin P   750,000 P152,000 P   902,000
Less: Common Fixed Costs     896,000
Net Operating Income (Loss) P       6,000

Or, pwede rin i-compute ng ganito:

Increased in CM of Bataan Area (P360,000 x 20%) P72,000
Less: Increase in Traceable Fixed Cost of Bataan Area   30,000
Increase in Segment Margin of Bataan Area P42,000

Increase in segment margin of Bataan Area (P42,000) will contribute to cover the over-all
loss of P(36,000), thus creating an operating income of P6,000.