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Segment Reporting,

Decentralization, and the Balanced


Scorecard
Chapter 12

© 2010 The McGraw-Hill Companies, Inc.


Decentralization in Organizations

Benefits of Top
Top management
management
Decentralization freed
freed to
to concentrate
concentrate
on
on strategy.
strategy.
Lower-level
Lower-level managers
managers
gain
gain experience
experience inin
decision-making.
decision-making. Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
Lower-level
Lower-level decisions
decisions
often
often based
based on
on
better
better information.
information.
Lower
Lower level
level managers
managers
can
can respond
respond quickly
quickly
to
to customers.
customers.

McGraw-Hill/Irwin Slide 2
Decentralization in Organizations
May
May be
be aa lack
lack of
of
coordination
coordination among
among
autonomous
autonomous
Lower-level
Lower-level managers
managers managers.
managers.
may
may make
make decisions
decisions
without
without seeing
seeing the
the
“big
“big picture.”
picture.” Disadvantages of
Decentralization
Lower-level
Lower-level manager’s
manager’s
objectives
objectives may
may not
not
be
be those
those of
of the
the May
May bebe difficult
difficult to
to
organization.
organization. spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.

McGraw-Hill/Irwin Slide 3
Cost, Profit, and Investments Centers

Cost
Cost Profit
Profit Investment
Investment
Center
Center Center
Center Center
Center

Cost, profit,
and investment
centers are all
known as Responsibility
Responsibility
Center
Center
responsibility
centers.
McGraw-Hill/Irwin Slide 4
Cost Center

A segment whose manager has control over costs,


but not over revenues or investment funds.

McGraw-Hill/Irwin Slide 5
Profit Center

Revenues
A segment whose
Sales
manager has control
Interest
over both costs and
Other
revenues,
Costs
but no control over
investment funds. Mfg. costs
Commissions
Salaries
Other

McGraw-Hill/Irwin Slide 6
Investment Center
Corporate Headquarters

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

McGraw-Hill/Irwin Slide 7
Responsibility Centers
Investment
Centers S u pe r i o r F o o d s
C o r p o r a t e
C o r p o r a t i o n
H e a d q u a r t e r s
P r e s i d e n t a n d C E O

O p e r a t i o n s F i n a n c e L e g a l P e r s o n n
V i c e P r e s i Cd eh ni e t f F I n a n c i Ga l e On fe f ri ca el rC o u Vn is c e e l P r e s

S a l t y S n a c B k es v e r a g e Cs o n f e c t i o n s
P r o d u c t M P a r on dg ue rc t M P a r no ad gu ec r t M a n a g e r

B o t t l i n g WP l aa r n e t h o Du si s e t r i b u t i o n
Cost
Centers
M a n a g e Mr a n a g e Mr a n a g e r

Superior Foods Corporation provides an example of the


various kinds of responsibility centers that exist in an
organization.
McGraw-Hill/Irwin Slide 8
Responsibility Centers

S u pe r i o r F o o d s C o r p o r a t i o n
C o r p o r a t e H e a d q u a r t e r s
P r e s i d e n t a n d C E O

O p e r a t i o n s F i n a n c e L e g a l P e r s o n n
V i c e P r e s i Cd eh ni e t f F I n a n c i Ga l e On fe f ri ca el rC o u Vn is c e e l P r e s

S a l t y S n a c B k es v e r a g e Cs o n f e c t i o n s
P r o d u c t M P a r on dg ue rc t M P a r no ad gu ec r t M a n a g e r

B o t t l i n g WP l aa r n e t h o Du si s e t r i b u t i o n
Profit
M a n a g e Mr a n a g e Mr a n a g e r
Centers
Superior Foods Corporation provides an example of the
various kinds of responsibility centers that exist in an
organization.
McGraw-Hill/Irwin Slide 9
Responsibility Centers

S u pe r i o r F o o d s C o r p o r a t i o n
C o r p o r a t e H e a d q u a r t e r s
P r e s i d e n t a n d C E O

O p e r a t i o n s F i n a n c e L e g a l P e r s o n n
V i c e P r e s i Cd eh ni e t f F I n a n c i Ga l e On fe f ri ca el rC o u Vn is c e e l P r e s

S a l t y S n a c B k es v e r a g e Cs o n f e c t i o n s
P r o d u c t M P a r on dg ue rc t M P a r no ad gu ec r t M a n a g e r

B o t t l i n g WP l aa r n e t h o Du si s e t r i b u t i o n
Cost
Centers
M a n a g e Mr a n a g e Mr a n a g e r

Superior Foods Corporation provides an example of the


various kinds of responsibility centers that exist in an
organization.
McGraw-Hill/Irwin Slide 10
Learning Objective 1
Prepare a segmented income
statement using the
contribution format, and
explain the difference between
traceable fixed costs and
common fixed costs.

McGraw-Hill/Irwin Slide 11
Decentralization and Segment Reporting
An Individual Store
Quick Mart

A segment is any part


A Sales Territory
or activity of an
organization about
which a manager
seeks cost, revenue,
or profit data. A Service Center

McGraw-Hill/Irwin Slide 12
Superior Foods: Geographic Regions

S u p e r i o r F o o d s C o r p o r a t i o n
$ 5 0 0 , 0 0 0 , 0 0 0

E a s t W e s t M i d w e s t S o u t h
$ 7 5 , 0 0 0 , 0 $ 0 3 0 0 0 , 0 0 0 , 0$ 05 05 , 0 0 0 , 0 $0 70 0 , 0 0 0 ,

O r e g o n W a s h i n g t oC n a l i f o r n Mi a o u n t a i n S t a t
$ 4 5 , 0 0 0 , 0 $0 50 0 , 0 0 0 , 0 $ 0 1 0 2 0 , 0 0 0 , 0$ 08 05 , 0 0 0 , 0 0 0

Superior Foods Corporation could segment its business


by geographic region.

McGraw-Hill/Irwin Slide 13
Superior Foods: Customer Channel

S u p e r i o r F o o d s C o r p o r a t i o n
$ 5 0 0 , 0 0 0 , 0 0 0

C o n v e n i e n c eS uS p t oe rr em s a r k e W t Ch oh l a e i sn as l e D i s t D r i rb u u g t so tr os r e
$ 8 0 , 0 0 0 , 0 0 0 $ 2 8 0 , 0 0 0 , 0 0 0$ 1 0 0 , 0 0 0 , 0 0 0 $ 4 0 , 0 0 0 , 0 0

S u p e r m a r k eS t u C p h e a r mi n a A r k eS t u C p h e ar mi n a B r k eS t u C p h e ar mi n a C r k e t C h a i n
$ 8 5 , 0 0 0 , 0 0 0 $ 6 5 , 0 0 0 , 0 0 0 $ 9 0 , 0 0 0 , 0 0 0 $ 4 0 , 0 0 0 , 0 0 0

Superior Foods Corporation could segment its business


by customer channel.

McGraw-Hill/Irwin Slide 14
Keys to Segmented Income Statements

There are two keys to building


segmented income statements:
A contribution format should be used
because it separates fixed from variable costs
and it enables the calculation of a
contribution margin.

Traceable fixed costs should be separated


from common fixed costs to enable the
calculation of a segment margin.

McGraw-Hill/Irwin Slide 15
Identifying Traceable Fixed Costs

Traceable costs arise because of the existence of a


particular segment and would disappear over time if the
segment itself disappeared.

No computer No computer
division means . . . division manager.

McGraw-Hill/Irwin Slide 16
Identifying Common Fixed Costs

Common costs arise because of the overall


operation of the company and would not
disappear if any particular segment were
eliminated.

No computer We still have a


division but . . . company president.

McGraw-Hill/Irwin Slide 17
Traceable Costs Can Become
Common Costs

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.
McGraw-Hill/Irwin Slide 18
Segment Margin
The segment margin, which is computed by
subtracting the traceable fixed costs of a segment
from its contribution margin, is the best gauge of the
long-run profitability of a segment.
Profits

Time
McGraw-Hill/Irwin Slide 19
Traceable and Common Costs

Fixed Don’t allocate


Costs common costs to
segments.

Traceable Common

McGraw-Hill/Irwin Slide 20
Activity-Based Costing
Activity-based costing can help identify how costs
shared by more than one segment are traceable to
individual segments.
Assume that three products, 9-inch, 12-inch, and 18-inch pipe, share 10,000
square feet of warehousing space, which is leased at a price of $4 per square
foot.
If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square
feet, respectively, then ABC can be used to trace the warehousing costs to the
three products as shown.
P ipe P roducts
9-inch 12-inch 18-inch Tota l
W a re house sq. ft. 1,000 4,000 5,000 10,000
Le a se price pe r sq. ft.
$ 4 $ 4 $ 4 $ 4
Tota l le a se cost $ 4,000 $ 16,000 $ 20,000 $ 40,000

McGraw-Hill/Irwin Slide 21
Levels of Segmented Statements

Webber, Inc. has two divisions.

W e b b e r , I n c .

C o m p u t e r DT ie v l ie s v i oi s n i o n

McGraw-Hill/Irwin Slide 22
Levels of Segmented Statements
Our approach to segment reporting uses the
contribution format.
Income Statement Cost
Cost of
of goods
goods
Contribution Margin Format sold
sold consists
consists of
of
Television Division variable
variable
Sales $ 300,000 manufacturing
manufacturing
Variable COGS 120,000 costs.
costs.
Other variable costs 30,000
Fixed
Fixed and
and
Total variable costs 150,000
variable
variable costs
costs
Contribution margin 150,000
are
are listed
listed in
in
Traceable fixed costs 90,000
separate
separate
Division margin $ 60,000
sections.
sections.

McGraw-Hill/Irwin Slide 23
Levels of Segmented Statements
Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution Margin Format Contribution
Contribution margin
margin
Television Division is
is computed
computed byby
Sales $ 300,000 taking
taking sales
sales minus
minus
Variable COGS 120,000 variable
variable costs.
costs.
Other variable costs 30,000
Total variable costs 150,000
Segment
Segment margin
margin
Contribution margin 150,000
is
is Television’s
Television’s
Traceable fixed costs 90,000
contribution
contribution
Division margin $ 60,000
to
to profits.
profits.

McGraw-Hill/Irwin Slide 24
Levels of Segmented Statements

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
Net operating
income

McGraw-Hill/Irwin Slide 25
Levels of Segmented Statements

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
Common
Common costs
costs should
should notnot
Net operating
be
be allocated
allocated to
to the
the
income $ 75,000 divisions.
divisions. These
These costs
costs
would
would remain
remain even
even ifif one
one
of
of the
the divisions
divisions were
were
eliminated.
eliminated.
McGraw-Hill/Irwin Slide 26
Traceable Costs Can Become
Common Costs

As previously mentioned, fixed costs that


are traceable to one segment can become
common if the company is divided into
smaller segments.

Let’s see how this works


using the Webber, Inc.
example!

McGraw-Hill/Irwin Slide 27
Traceable Costs Can Become
Common Costs

Webber’s Television Division


Television
Division

Regular Big Screen

Product
Lines
McGraw-Hill/Irwin Slide 28
Traceable Costs Can Become
Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 200,000 $ 100,000
Variable costs 95,000 55,000
CM 105,000 45,000
Traceable FC 45,000 35,000
Product line margin $ 60,000 $ 10,000
Common costs
Divisional margin

We obtained the following information from


the Regular and Big Screen segments.
McGraw-Hill/Irwin Slide 29
Traceable Costs Can Become
Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 300,000 $ 200,000 $ 100,000
Variable costs 150,000 95,000 55,000
CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000
Product line margin 70,000 $ 60,000 $ 10,000
Common costs 10,000
Divisional margin $ 60,000

Fixed
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000

McGraw-Hill/Irwin Slide 30
External Reports
The Financial Accounting Standards Board now requires
that companies in the United States include segmented
financial data in their annual reports.

1. Companies must report segmented


results to shareholders using the same
methods that are used for internal
segmented reports.
2. Since the contribution approach to
segment reporting does not comply
with GAAP, it is likely that some
managers will choose to construct
their segmented financial statements
using the absorption approach to
comply with GAAP.

McGraw-Hill/Irwin Slide 31
Omission of Costs

Costs assigned to a segment should include all


costs attributable to that segment from the
company’s entire value chain.
chain
Business Functions
Making Up The
Value Chain

Product Customer
R&D Design Manufacturing Marketing Distribution Service

McGraw-Hill/Irwin Slide 32
Inappropriate Methods of Allocating Costs
Among Segments

Failure to trace
costs directly Inappropriate
allocation base

Segment Segment Segment Segment


1 2 3 4

McGraw-Hill/Irwin Slide 33
Common Costs and Segments
Common costs should not be arbitrarily allocated to segments
based on the rationale that “someone has to cover the
common costs” for two reasons:
1. This practice may make a profitable business segment appear
to be unprofitable.

2. Allocating common fixed costs forces managers to be held


accountable for costs they cannot control.

Segment Segment Segment Segment


1 2 3 4

McGraw-Hill/Irwin Slide 34
Quick Check 
Income Statement

Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 $ 14,000 $ 230,000
Common costs 200,000
Profit $ 44,000

Assume that Hoagland's Lakeshore prepared its


segmented income statement as shown.
McGraw-Hill/Irwin Slide 35
Quick Check 

How much of the common fixed cost of $200,000


can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.

McGraw-Hill/Irwin Slide 36
Quick Check 

How much of the common fixed cost of $200,000


can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.

A common fixed cost


cannot be eliminated by
dropping one of the
segments.

McGraw-Hill/Irwin Slide 37
Quick Check 

Suppose square feet is used as the basis for


allocating the common fixed cost of $200,000. How
much would be allocated to the bar if the bar
occupies 1,000 square feet and the restaurant 9,000
square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000

McGraw-Hill/Irwin Slide 38
Quick Check 

Suppose square feet is used as the basis for


allocating the common fixed cost of $200,000. How
much would be allocated to the bar if the bar
occupies 1,000 square feet and the restaurant 9,000
square feet?
a. $20,000
b. $30,000 The bar would be
c. $40,000 allocated 1/10 of the cost
d. $50,000 or $20,000.

McGraw-Hill/Irwin Slide 39
Quick Check 

If Hoagland's allocates its common


costs to the bar and the restaurant,
what would be the reported profit of
each segment?

McGraw-Hill/Irwin Slide 40
Allocations of Common Costs
Income Statement

Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 14,000 230,000
Common costs 200,000 20,000 180,000
Profit $ 44,000 $ (6,000) $ 50,000

Hurray, now everything adds up!!!


McGraw-Hill/Irwin Slide 41
Quick Check 
Should the bar be eliminated?
a. Yes
b. No

McGraw-Hill/Irwin Slide 42
Quick Check 
Should the bar be eliminated?
a. Yes
b. No The profit was $44,000 before
eliminating the bar. If we eliminate
the bar,
Income profit drops to $30,000!
Statement

Hoagland's
Lakeshore Bar Restaurant
Sales $ 700,000 $ 700,000
Variable costs 250,000 250,000
CM 450,000 450,000
Traceable FC 220,000 220,000
Segment margin 230,000 230,000
Common costs 200,000 200,000
Profit $ 30,000 $ 30,000
McGraw-Hill/Irwin Slide 43
Learning Objective 2

Compute return on investment


(ROI) and show how changes in
sales, expenses, and assets
affect ROI.

McGraw-Hill/Irwin Slide 44
Return on Investment (ROI) Formula

Income
Incomebefore
before interest
interest
and
and taxes
taxes(EBIT)
(EBIT)

Net operating income


ROI =
Average operating assets

Cash,
Cash, accounts
accountsreceivable,
receivable, inventory,
inventory,
plant
plantand
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.

McGraw-Hill/Irwin Slide 45
Net Book Value vs. Gross Cost

Most companies use the net book value of


depreciable assets to calculate average
operating assets.

Acquisition cost
Less: Accumulated depreciation
Net book value

McGraw-Hill/Irwin Slide 46
Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating
assets
Margin × Turnover
ROI =
McGraw-Hill/Irwin Slide 47
Increasing ROI

There are three ways to increase ROI . . .


Reduce
Increase Expenses Reduce
Sales Assets

McGraw-Hill/Irwin Slide 48
Increasing ROI – An Example
Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000

What is Regal Company’s ROI?


Margin × Turnover
ROI =
ROI = Net operating income × Sales
Sales Average operating assets

McGraw-Hill/Irwin Slide 49
Increasing ROI – An Example

Margin × Turnover
ROI =
ROI = Net operating income × Sales
Sales Average operating assets

ROI = $30,000 × $500,000


$500,000 $200,000

ROI =6% × 2.5 = 15%

McGraw-Hill/Irwin Slide 50
Investing in Operating Assets to Increase
Sales
Assume that Regal's manager invests in a $30,000
piece of equipment that increases sales by
$35,000, while increasing operating expenses
by $15,000.
Regal Company reports the following:
Net operating income $ 50,000
Average operating assets $ 230,000
Sales $ 535,000
Operating expenses $ 485,000

Let’s calculate the new ROI.


McGraw-Hill/Irwin Slide 51
Investing in Operating Assets to Increase
Sales

Margin × Turnover
ROI =
ROI = Net operating income × Sales
Sales Average operating assets

ROI = $50,000 × $535,000


$535,000 $230,000

9.35% × 2.33 = 21.8%


ROI =

ROI
ROI increased
increased from
from 15%
15% to
to 21.8%.
21.8%.

McGraw-Hill/Irwin Slide 52
Criticisms of ROI

In the absence of the balanced


scorecard, management may
not know how to increase ROI.

Managers often inherit many


committed costs over which
they have no control.

Managers evaluated on ROI


may reject profitable
investment opportunities.

McGraw-Hill/Irwin Slide 53
Learning Objective 3

Compute residual income and


understand its strengths and
weaknesses.

McGraw-Hill/Irwin Slide 54
Residual Income - Another Measure of
Performance

Net operating income


above some minimum
return on operating
assets

McGraw-Hill/Irwin Slide 55
Calculating Residual Income

Net Average Minimum


Residual
income
= operating -
income (
operating
assets
× required rate of
return )
This computation differs from ROI.
ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
McGraw-Hill/Irwin Slide 56
Residual Income – An Example


The
The Retail
Retail Division
Division of
of Zephyr,
Zephyr, Inc.
Inc. has
has
average
average operating
operating assets
assets of
of $100,000
$100,000 and
and is
is
required
required toto earn
earn aa return
return of
of 20%
20% on
on these
these
assets.
assets.

InIn the
the current
current period,
period, the
the division
division earns
earns
$30,000.
$30,000.

Let’s calculate residual income.

McGraw-Hill/Irwin Slide 57
Residual Income – An Example

Operating assets $ 100,000


Required rate of return × 20%
Minimum required return $ 20,000

Actua l incom e $ 30,000


M inim um re quire d re turn (20,000)
Re sidua l incom e $ 10,000

McGraw-Hill/Irwin Slide 58
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

McGraw-Hill/Irwin Slide 59
Quick Check 

Redmond Awnings, a division of Wrap-up Corp., has


a net operating income of $60,000 and average
operating assets of $300,000. The required rate of
return for the company is 15%. What is the division’s
ROI?
a. 25%
b. 5%
c. 15%
d. 20%

McGraw-Hill/Irwin Slide 60
Quick Check 

Redmond Awnings, a division of Wrap-up Corp., has


a net operating income of $60,000 and average
operating assets of $300,000. The required rate of
return for the company is 15%. What is the division’s
ROI?
a. 25%
b. 5%
c. 15% ROI = NOI/Average operating assets
d. 20% = $60,000/$300,000 = 20%

McGraw-Hill/Irwin Slide 61
Quick Check 

Redmond Awnings, a division of Wrap-up Corp.,


has a net operating income of $60,000 and
average operating assets of $300,000. If the
manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No

McGraw-Hill/Irwin Slide 62
Quick Check 

Redmond Awnings, a division of Wrap-up Corp.,


has a net operating income of $60,000 and
average operating assets of $300,000. If the
manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes ROI = $78,000/$400,000 = 19.5%
b. No
This lowers the division’s ROI from
20.0% down to 19.5%.

McGraw-Hill/Irwin Slide 63
Quick Check 

The company’s required rate of return is 15%.


Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000 per
year?
a. Yes
b. No

McGraw-Hill/Irwin Slide 64
Quick Check 

The company’s required rate of return is 15%.


Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000 per
year?
a. Yes ROI = $18,000/$100,000 = 18%
b. No The return on the investment
exceeds the minimum required rate
of return.

McGraw-Hill/Irwin Slide 65
Quick Check 

Redmond Awnings, a division of Wrap-up Corp., has


a net operating income of $60,000 and average
operating assets of $300,000. The required rate of
return for the company is 15%. What is the division’s
residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000

McGraw-Hill/Irwin Slide 66
Quick Check 

Redmond Awnings, a division of Wrap-up Corp., has


a net operating income of $60,000 and average
operating assets of $300,000. The required rate of
return for the company is 15%. What is the division’s
residual income?
a. $240,000
b. $ 45,000
c. $ 15,000 Net operating income $60,000
Required return (15% of $300,000) (45,000)
d. $ 51,000 Residual income $15,000

McGraw-Hill/Irwin Slide 67
Quick Check 

If the manager of the Redmond Awnings division


is evaluated based on residual income, will she
want to make an investment of $100,000 that
would generate additional net operating income
of $18,000 per year?
a. Yes
b. No

McGraw-Hill/Irwin Slide 68
Quick Check 

If the manager of the Redmond Awnings division


is evaluated based on residual income, will she
want to make an investment of $100,000 that
would generate additional net operating income
of $18,000 per year?
a. Yes
b. No Net operating income $78,000
Required return (15% of $400,000) (60,000)
Residual income $18,000

Yields an increase of $3,000 in the residual income.

McGraw-Hill/Irwin Slide 69
Divisional Comparisons and Residual
Income

The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of
different sizes.

McGraw-Hill/Irwin Slide 70
Zephyr, Inc. - Continued
Recall the following Assume the following
information for the Retail information for the Wholesale
Division of Zephyr, Inc. Division of Zephyr, Inc.

Retail W holesale
Operating assets $ 100,000 $ 1,000,000
Required rate of return× 20% 20%
Minimum required return $ 20,000 $ 200,000

Retail W holesale
Actual income $ 30,000 $ 220,000
Minimum required return (20,000) (200,000)
Residual income $ 10,000 $ 20,000

McGraw-Hill/Irwin Slide 71
Zephyr, Inc. - Continued
The residual income numbers suggest that the Wholesale Division outperformed
the Retail Division because its residual income is $10,000 higher. However, the
Retail Division earned an ROI of 30% compared to an ROI of 22% for the
Wholesale Division. The Wholesale Division’s residual income is larger than the
Retail Division simply because it is a bigger division.
Retail W holesale
Operating assets $ 100,000 $ 1,000,000
Required rate of return× 20% 20%
Minimum required return $ 20,000 $ 200,000

Retail W holesale
Actual income $ 30,000 $ 220,000
Minimum required return (20,000) (200,000)
Residual income $ 10,000 $ 20,000

McGraw-Hill/Irwin Slide 72
Learning Objective 4

Understand how to construct


and use a balanced scorecard.

McGraw-Hill/Irwin Slide 73
The Balanced Scorecard

Management
Management translates
translates its
its strategy
strategy into
into
performance
performance measures
measures that
that employees
employees
understand
understand and
and influence.
influence.

Financial Customers

Performance
measures
Internal Learning
business and growth
processes

McGraw-Hill/Irwin Slide 74
The Balanced Scorecard: From
Strategy to Performance Measures
Performance Measures
Financial What are our
Has our financial financial
performance improved? goals?

What customers do Vision


Customer we want to serve
Do customers recognize that and and
we are delivering more value? how are we going to Strategy
win and retain
them?
Internal Business Processes What internal busi-
Have we improved key business ness processes
processes so that we can deliver are
more value to customers? critical to providing
value to
customers?
Learning and Growth
Are we maintaining our ability
to change and improve?
McGraw-Hill/Irwin Slide 75
The Balanced Scorecard:
Non-financial Measures

The balanced scorecard relies on non-financial measures


in addition to financial measures for two reasons:

 Financial
 Financial measures
measures are are lag
lag indicators
indicators that
that summarize
summarize
the
the results
results of
of past
past actions.
actions. Non-financial
Non-financial measures
measures are
are
leading
leading indicators
indicators of
of future
future financial
financial performance.
performance.

 Top
 Top managers
managers are
are ordinarily
ordinarily responsible
responsible forfor financial
financial
performance
performance measures
measures –– not
not lower
lower level
level managers.
managers.
Non-financial
Non-financial measures
measures are
are more
more likely
likely to
to be
be
understood
understood and
and controlled
controlled by
by lower
lower level
level managers.
managers.
McGraw-Hill/Irwin Slide 76
The Balanced Scorecard for Individuals

The entire organization Each individual should


should have an overall have a personal
balanced scorecard. balanced scorecard.

AA personal
personal scorecard
scorecard should
should contain
contain measures
measures that
that can
can be
be
influenced
influenced by
by the
the individual
individual being
being evaluated
evaluated and
and that
that
support
support the
the measures
measures in in the
the overall
overall balanced
balanced scorecard.
scorecard.
McGraw-Hill/Irwin Slide 77
The Balanced Scorecard

A balanced scorecard should have measures


that are linked together on a cause-and-effect
basis.

If we improve Another desired


Then
one performance performance measure
measure . . . will improve.

The balanced scorecard lays out concrete


actions to attain desired outcomes.

McGraw-Hill/Irwin Slide 78
The Balanced Scorecard and Compensation
Incentive compensation should be linked to
balanced scorecard performance
measures.

McGraw-Hill/Irwin Slide 79
The Balanced Scorecard ─ Jaguar Example
Profit
Financial
Contribution per car

Number of cars sold


Customer
Customer satisfaction
with options

Internal
Business Number of Time to
options available install option
Processes

Learning Employee skills in


and Growth installing options
McGraw-Hill/Irwin Slide 80
The Balanced Scorecard ─ Jaguar Example
Profit

Contribution per car

Number of cars sold

Customer satisfaction Results


with options Satisfaction
Increases
Strategies
Increase Number of Time to
Options options available install option Time
Decreases

Increase Employee skills in


Skills installing options
McGraw-Hill/Irwin Slide 81
The Balanced Scorecard ─ Jaguar Example
Profit

Contribution per car


Results
Cars sold
Number of cars sold Increase

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option

Employee skills in
installing options
McGraw-Hill/Irwin Slide 82
The Balanced Scorecard ─ Jaguar Example
Profit
Results
Contribution per car Contribution
Increases

Number of cars sold

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option Time
Decreases

Employee skills in
installing options
McGraw-Hill/Irwin Slide 83
The Balanced Scorecard ─ Jaguar Example
Results
Profit Profits
Increase
If number
Contribution per car Contribution
of cars sold Increases
and contribution
Cars Sold
per car increase, Number of cars sold
Increases
profits
increase. Customer satisfaction
with options

Number of Time to
options available install option

Employee skills in
installing options
McGraw-Hill/Irwin Slide 84
Transfer Pricing

Appendix 12A

© 2010 The McGraw-Hill Companies, Inc.


Key Concepts/Definitions
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.

McGraw-Hill/Irwin Slide 86
Three Primary Approaches

There are three primary


approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.

McGraw-Hill/Irwin Slide 87
Learning Objective 5

Determine the range, if any,


within which a negotiated
transfer price should fall.

McGraw-Hill/Irwin Slide 88
Negotiated Transfer Prices

A negotiated transfer price results from discussions


between the selling and buying divisions.
Range of Acceptable
Transfer Prices
Advantages of negotiated transfer prices:
Upper limit is
1. They preserve the autonomy of the determined by the
buying division.
divisions, which is consistent with
the spirit of decentralization.
2. 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. Lower limit is
determined by the
selling division.

McGraw-Hill/Irwin Slide 89
Grocery Storehouse – An Example

Assume the information as shown with respect


to West Coast Plantations and Grocery Mart
(both companies are owned by Grocery
Storehouse).
West Coast Plantations:
Naval orange harvest capactiy per month 10,000 crates
Variable cost per crate of naval oranges $ 10 per crate
Fixed costs per month $ 100,000
Selling price of navel oranges on the outside
market $ 25 per crate
Grocery Mart:
Purchase price of current naval oranges $ 20 per crate
Monthly sales of naval oranges 1,000 crates

McGraw-Hill/Irwin Slide 90
Grocery Storehouse – An Example
The selling division’s (West Coast Plantations) lowest acceptable transfer
price is calculated as:
Variable cost Total contribution margin on lost sales
Transfer Price ≥ +
per unit Number of units transferred

Let’s calculate the lowest and highest acceptable


transfer prices under three scenarios.
The buying division’s (Grocery Mart) highest acceptable transfer price is
calculated as:
Transfer Price ≤ Cost of buying from outside supplier

If an outside supplier does not exist, the highest acceptable transfer price
is calculated as:
Transfer Price ≤ Profit to be earned per unit sold (not including the transfer price)

McGraw-Hill/Irwin Slide 91
Grocery Storehouse – An Example
If West Coast Plantations has sufficient idle capacity (3,000 crates) to
satisfy Grocery Mart’s demands (1,000 crates), without sacrificing
sales to other customers, then the lowest and highest possible
transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
$ -
Transfer Price ≥ $10 + = $ 10
1,000

Buying division’s highest possible transfer price:


Transfer Price ≤ Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable


transfer prices is $10 – $20.
McGraw-Hill/Irwin Slide 92
Grocery Storehouse – An Example
If West Coast Plantations has no idle capacity (0 crates) and must
sacrifice other customer orders (1,000 crates) to meet Grocery Mart’s
demands (1,000 crates), then the lowest and highest possible transfer
prices are computed as follows:
Selling division’s lowest possible transfer price:
( $25 - $10) × 1,000
Transfer Price ≥ $ 10 + = $ 25
1,000

Buying division’s highest possible transfer price:


Transfer Price ≤ Cost of buying from outside supplier = $ 20

Therefore, there is no range of


acceptable transfer prices.
McGraw-Hill/Irwin Slide 93
Grocery Storehouse – An Example
If West Coast Plantations has some idle capacity (500 crates) and
must sacrifice other customer orders (500 crates) to meet Grocery
Mart’s demands (1,000 crates), then the lowest and highest possible
transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
( $25 - $10) × 500
Transfer Price ≥ $ 10 + = $ 17.50
1,000

Buying division’s highest possible transfer price:


Transfer Price ≤ Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable


transfer prices is $17.50 – $20.00.
McGraw-Hill/Irwin Slide 94
Evaluation of Negotiated Transfer Prices
If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices within which
both the selling and buying divisions would have
higher profits if they agree to the transfer.

If managers are pitted against each other rather


than against their past performance or
reasonable benchmarks, a noncooperative
atmosphere is almost guaranteed.

Given the disputes that often accompany the


negotiation process, most companies rely on
some other means of setting transfer prices.

McGraw-Hill/Irwin Slide 95
Transfers at the Cost to the Selling Division

Many companies set transfer prices at either


the variable cost or full (absorption) cost
incurred by the selling division.
Drawbacks of this approach include:
1. Using full cost as a transfer price
can lead to suboptimization.
2. The selling division will never
show a profit on any internal
transfer.
3. Cost-based transfer prices do not
provide incentives to control
costs.

McGraw-Hill/Irwin Slide 96
Transfers at Market Price

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.
1. A market price approach works
best when the product or service
is sold in its present form to
outside customers and the
selling division has no idle
capacity.
2. A market price approach does
not work well when the selling
division has idle capacity.

McGraw-Hill/Irwin Slide 97
Divisional Autonomy and Suboptimization
The principles of
decentralization suggest
that companies should
grant managers autonomy
to set transfer prices and
to decide whether to sell
internally or externally,
even if this may
occasionally result in
suboptimal decisions.
This way top management
allows subordinates to
control their own destiny.
McGraw-Hill/Irwin Slide 98
Service Department Charges

Appendix 12B

© 2010 The McGraw-Hill Companies, Inc.


Learning Objective 6

Charge operating departments


for services provided by service
departments.

McGraw-Hill/Irwin Slide 100


Service Department Charges

Operating Service
Departments Departments

Do not directly
Carry out central
engage in
purposes of
operating
organization.
activities.

McGraw-Hill/Irwin Slide 101


Reasons for Charging Service Department
Costs
Service department costs are charged to operating
departments for a variety of reasons including:

To
To provide
provide operating
operating
To
To encourage
encourage departments
departments with
with
operating
operating departments
departments more
more complete
complete cost
cost
to
to wisely
wisely use
use service
service data
data for
for making
making
department
department resources.
resources. decisions.
decisions.

To
To help
help measure
measure the the To
To create
create an
an incentive
incentive
profitability
profitability of
of for
for service
service
operating
operating departments
departments to to
departments.
departments. operate
operate efficiently.
efficiently.

McGraw-Hill/Irwin Slide 102


Transfer Prices

The
The service
service department
department charges
charges
considered
considered inin this
this appendix
appendix can
can bebe
viewed
viewed as
as aa transfer
transfer price
price that
that is
is
charged
charged for
for services
services provided
provided byby
service
service departments
departments to to operating
operating
departments.
departments.
Service
Departments
$ Operating
Departments

McGraw-Hill/Irwin Slide 103


Charging Costs by Behavior

Whenever possible,
variable and fixed
service department costs
should be charged
separately.

McGraw-Hill/Irwin Slide 104


Charging Costs by Behavior

Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.

McGraw-Hill/Irwin Slide 105


Charging Costs by Behavior

Charge
Charge fixed
fixed service
service department
department costs
costs to
to
consuming
consuming departments
departments inin predetermined
predetermined
lump-sum
lump-sum amounts
amounts that
that are
are based
based on
on the
the
consuming
consuming department’s
department’s peak-period
peak-period or
or
long-run
long-run average
average servicing
servicing needs.
needs.

Are based on amounts of


Should not vary from
capacity each consuming
period to period.
department requires.

McGraw-Hill/Irwin Slide 106


Should Actual or Budgeted Costs Be
Charged?

Budgeted variable
and fixed service department
costs should be charged to
operating departments.

McGraw-Hill/Irwin Slide 107


Sipco: An Example
Sipco has a maintenance department and two operating
departments: Cutting and Assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixed
maintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:
Percent of
Peak-Period
Operating Capacity Hours Hours
Departments Required Planned Used
Cutting 60% 75,000 80,000
Assembly 40% 50,000 40,000
Total hours 100% 125,000 120,000

Allocate maintenance costs to the two operating departments.


McGraw-Hill/Irwin Slide 108
Sipco: End of the Year

Actual hours
Cutting Assembly
Department Department
Variable cost allocation:
$0.60 × 80,000 hours $ 48,000
$0.60 × 40,000 hours $ 24,000
Fixed cost allocation:

Total allocated cost

McGraw-Hill/Irwin Slide 109


Sipco: End of the Year

Actual hours
Cutting Assembly
Department Department
Variable cost allocation:
$0.60 × 80,000 hours $ 48,000
$0.60 × 40,000 hours $ 24,000
Fixed cost allocation:
60% × $200,000 120,000
40% × $200,000 80,000
Total allocated cost $ 168,000 $ 104,000

Percent of peak-period capacity.


McGraw-Hill/Irwin Slide 110
Quick Check 
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:

Percent of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500

McGraw-Hill/Irwin Slide 111


Quick Check 

How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the end
end of of the
the
year?
year?
a.
a. $121,200
$121,200
b.
b. $254,400
$254,400
c.
c. $139,500
$139,500
d.
d. $117,000
$117,000

McGraw-Hill/Irwin Slide 112


Quick Check 

How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to to Mercy
Mercy Hospital
Hospital at
at the
the end
end ofof the
the
year?
year?
a.
a. $121,200
$121,200
b.
b. $254,400
$254,400
c. $139,500
c.Variable
$139,500cost allocation:
Mercy Northside

d.
d. $117,000
$117,000
$4.20 × 16,000 miles $ 67,200
$4.20 × 17,500 miles $ 73,500
Fixed cost allocation
45% × $120,000 54,000
55% × $120,000 66,000
Total allocated cost $ 121,200 $ 139,500

McGraw-Hill/Irwin Slide 113


Pitfalls in Allocating Fixed Costs

Allocating fixed
costs using a variable
allocation base.

McGraw-Hill/Irwin Slide 114


Pitfalls in Allocating Fixed Costs

Using sales
dollars as an
allocation base. Result
Sales of one department
influence the service
department costs
allocated to other
departments.

McGraw-Hill/Irwin Slide 115


Autos R Us – An Example
Autos
Autos RR Us
Us has
has one
one service
service department
department andand three
three
sales
sales departments,
departments, New New Cars,
Cars, Used
Used Cars,
Cars, and
and Car
Car
Parts.
Parts. The
The service
service department
department costs
costs total
total $80,000
$80,000
for
for both
both years
years in
in the
the example.
example.
Contrary
Contrary to
to good
good practice,
practice, Autos
Autos R R Us
Us allocates
allocates the
the
service
service department
department costs
costs based
based on
on sales.
sales.

McGraw-Hill/Irwin Slide 116


Autos R Us – First-year Allocation

Departments
New Used Parts Total
Sales by department $ 1,500,000 $ 900,000 $ 600,000 $ 3,000,000
Percentage of total sales 50% 30% 20% 100%
Allocation of service
department costs $ 40,000 $ 24,000 $ 16,000 $ 80,000

$1,500,000 ÷ $3,000,000 50% of $80,000

In
In the
the next
next year,
year, the
the manager
manager of of the
the New
New Cars
Cars department
department
increases
increases sales
sales byby $500,000.
$500,000. Sales
Sales inin the
the other
other departments
departments
are
are unchanged.
unchanged. Let’s Let’s allocate
allocate the
the $80,000
$80,000 service
service department
department
cost
cost for
for the
the second
second year
year given
given the
the sales
sales increase.
increase.
McGraw-Hill/Irwin Slide 117
Autos R Us – Second-year Allocation

Departments
New Used Parts Total
Sales by department $ 2,000,000 $ 900,000 $ 600,000 $ 3,500,000
Percentage of total sales 57% 26% 17% 100%
Allocation of service
department costs $ 45,714 $ 20,571 $ 13,714 $ 80,000

$2,000,000 ÷ $3,500,000 57% of $80,000


IfIf you
you were
were the
the manager
manager of of the
the New
New Cars
Cars department,
department, would
would
you
you be
be happy
happy with
with the
the increased
increased service
service department
department
costs
costs allocated
allocated to to your
your department?
department?

McGraw-Hill/Irwin Slide 118


End of Chapter 12

McGraw-Hill/Irwin Slide 119