Segment Reporting

and Decentralization
ACC 2203 Review Workshop
Professor Huang
Responsibility Accounting, Performance Measurement
Segment Reporting, and Transfer Pricing

Large companies are comprised of many business units or

segments. A segment may be a division, department, product
line, sales territory, or a service center. Effective management of
large companies requires delegating much of the decision
making authority from corporate top management to segment
managers. Segment managers are, in turn, held responsible for
improving the segment performance as it relates to the overall
corporate performance.
Responsibility Accounting, Performance Measurement
Segment Reposting, and Transfer Pricing
Responsibility Accounting is a management system that aims to develop
performance measures by which segment managers are evaluated. Under
responsibility accounting segments are broadly categorized as:

 Cost centers – segments whose managers are held responsible only for costs
but not for revenue or investments

 Profit centers – segments whose managers are held responsible for both
costs and revenues but not for investments

 Investment centers – segments whose managers are held responsible for the
capital invested as well as the profits made in the segment
 Segment Reporting
Obviously, in each segment category managerial responsibilities are
different. The performance measures for evaluating managers
should also be different so as to be consistent with the
responsibilities. For example, assigning revenue or sales targets to
a cost center manager would not be sensible.
What are the advantages and disadvantages of decentralization – that
is dividing the company into cost, profit, and investment centers
and hiring managers to run each center rather than requiring the
corporate top management to run all of them?
 Segment Reporting
Segment reports provide information about each segment’s financial
performance and are important for assessing a segment’s success in attaining
its goals as set mainly by upper level management.
Segmented income statements reveal the profits earned by individual segments
and hence the contribution of each segment to the overall corporate
profitability. Income statements of segments are usually prepared in the
contribution format which requires identifying the fixed costs attributable to
segments.
Traceable fixed costs – are caused by a particular segment and would go away
if the segment is discontinued
Common fixed costs – costs that are incurred to support more than one segment
and hence are not directly identified with a particular segment. Common fixed
costs would not go away if any particular segment is discontinued.
Only traceable fixed costs are included in the income statements of segments;
common fixed costs are excluded.
 Traceable and Common Costs
Classify the following fixed costs as traceable or common (Note: NBC is a subsidiary
of GE):
 The salary of GE’s CEO

 The salary of the president of GE’s Appliances business unit which comprises
multiple divisions such as Refrigerators & Freezers; Washers & Dryers;
Dishwashers & Disposers

 The maintenance cost for the broadcasting studios of NBC

 The depreciation cost on the GE headquarters building

 The maintenance and depreciation cost on the cameras used by NBC’s sports
division

 The salaries paid to the news anchors at NBC

 The cost of heating, lighting, and air conditioning the NBC offices in Burbank,
California and in New York
 Concept check
1. Managers in which of the following responsibility centers are held
responsible for profits? (You may select more than one answer.)
a. Revenue centers
b. Cost centers
c. Profit centers
d. Investment centers

2. Which of the following statements is false? (You may select more than
one answer.)
a. The same cost can be traceable or common depending on how the
segment is defined.
b. In general, common fixed costs should be assigned to segments.
c. If a company eliminates a segment of its business, the costs that were
traceable to that segment should disappear.
d. If four segments share $1 million in common fixed costs and one
segment is eliminated, the common fixed costs will decrease by
$250,000.
 Segment Reporting - Example
 The Coldex Company has two divisions: Refrigerators
Division and Deep-Freezers Division. The following
financial information pertains to the operations of the
divisions:
(in thousands) Refrigerators Deep-Freezers
Sales revenue $600,000 $330,000
Var. Man. $180,000 $120,000
Variable S&A $100,000 $80,000
Traceable FC $140,000 $100,000
 The common fixed costs in the company totaled $93,000
Segment Reporting - Example
Prepare an income statement for the
Coldex company segmented by the
divisions.
(in thousands)Company Refrigerators Deep-Freezers
Sales revenue $
Variable costs$
Cont. margin $
Traceable FC $
Division margin $
Common FC $
Net Op income $
 Measuring Segment Performance
A major purpose of segment reporting is to determine how well segments have performed
and how well they are being run by the segment managers. In many companies, segment
performance directly affects managerial compensation, managerial promotion, and
amount of investment funds allocated to each segment by the headquarters. We will
study two popular metrics that are primarily used in profit and investment centers for
judging segment performance: Return on investment (ROI) and Residual income.
Return on investment (ROI) measures the net operating income generated per dollar of
investment in operating assets

Net operating income

Return on investment 
Average operating assets
Net operating income – income before interest and taxes (or earnings before
interest and taxes – EBIT)
Operating assets – include accounts receivable, inventory, plant and equipment
and other productive assets; excludes land held for future use, investments in other
companies
Average operating assets – average value of the operating assets between the
beginning and end of a period
 ROI - Definition
The ROI formula can also be expressed as follows:
Net operating income Sales
ROI = x
Sales Average operating assets

Sales Margin Capital Turnover

Sales margin – measures a segment’s ability to control its operating

costs and to make money on its sales
Capital turnover – measures a segment’s ability to generate revenue
for each dollar invested in operating assets
Sales margin and capital turnover constitute the components of ROI and
point attention to areas that present improvement opportunities such as
increasing sales without increasing operating assets (increases capital
turnover) and reducing costs without impairing sales (increases sales
margin).
 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

ROI = Margin  Turnover

Net operating income Sales
ROI = ×
Sales Average operating assets
 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 = Margin  Turnover
Net operating income Sales
ROI = ×
Sales Average operating assets
 Increasing ROI – An Example
ROI = Margin  Turnover
Net operating income Sales
ROI = ×
Sales Average operating assets
 Increasing Sales Without an
Increase in Operating Assets
 Regal’s manager was able to increase sales to $600,000
while operating expenses increased to $558,000.
 Regal’s net operating income increased to $42,000.
 There was no change in the average operating assets of the
segment.

What is the new ROI?

 Increasing Sales Without an
Increase in Operating Assets
ROI = Margin  Turnover
Net operating income Sales
ROI = ×
Sales Average operating assets

ROI = ??
 Decreasing Operating Expenses with no
Change in Sales or Operating Assets
Assume that Regal’s manager was able to reduce
operating expenses by $10,000 without
affecting sales or operating assets. This would
increase net operating income to $40,000.
Regal Company reports the following:
Net operating income $ 40,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 460,000
 Decreasing Operating Assets with no
Change in Sales or Operating Expenses
Assume that Regal’s manager was able to reduce
inventories by $20,000 using just-in-time
techniques without affecting sales or operating
expenses.
Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 180,000
Sales $ 500,000
Operating expenses $ 470,000
Let’s calculate the new ROI.
 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.
 Residual Income - Definition
Residual Income (RI) measures the net operating income earned in
excess of a required return on operating assets.

RI = Net operating income – Required return on

operating assets

Decision rule: Accept a project if its residual income >0

Residual income recognizes that funds invested in operating assets

impose a cost on the firm. For example, if a firm borrowed bank
loans to acquire the operating assets, it has to pay interest. To
improve the value of the firm, those assets must generate an
income greater than the interest payments. Otherwise, value will
be destroyed.
 Residual Income - Example
A division of Epsilon Corp. has average operating assets of
$200,000. The required rate of return for the division is
20%. The division recently reported a net operating
income of $50,000. Calculate the division’s residual
income and indicate whether Epsilon should keep or
discontinue the division.

 Required return on assets =

 RI =
 ROI Vs. Residual Income
The residual income approach emphasizes maximizing the overall firm value by
encouraging managers to invest in projects that earn more than the firm’s
cost of capital. The ROI approach, on the other hand, emphasizes
maximizing the segment ROI, leading managers to sometimes forego
projects that would otherwise improve overall firm value but reduce
segment ROI.
Problem: Sussex Magnet, a division of Sussex International Corp., has a net
operating income of $150,000 and average operating assets of $500,000.
The required annual rate of return for the company is 20%. Sussex Magnet
identified a new project that would require an investment of $180,000 and
earn an additional net operating income of $40,000 per year.
1. What is the division’s current ROI?

2. If the manager of Sussex Magnet is compensated based on the division’s

ROI, would the manager undertake the new project? Why or why not?
 ROI Vs. Residual Income
3. Would the Sussex International Corp. want the
Sussex Magnet division to undertake the new
project? Why or why not?
4. What is Sussex Magnet’s current residual
income?
5. If the manager of Sussex Magnet is
compensated based on the division’s residual
income, would the manager undertake the new
project? Why or why not?
Quick Check 
Redmond Awnings, a division of Wrapup 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%
Quick Check 
Redmond Awnings, a division of Wrapup 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
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
Quick Check 
Redmond Awnings, a division of Wrapup 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
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