Chapter 15

Segment
Reporting,
and
Decentralizati
on

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 Decentralization in
Organizations
Benefits of
Decentralization Top
Top management
management
freed
freed to
to concentrate
concentrate
on
on strategy.
strategy.
Lower-level
Lower-level managers
managers
gain
gain experience
experience in
in
decision-making.
decision-making. Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
Lower-level decision
Lower-level decision
often
often based
based on
on
better
better information.
information.
Improves
Improves ability
ability to
to
evaluate
evaluate managers.
managers.
©The McGraw-Hill Companies
 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
Lower-level
Decentralization
Lower-level manager’s
manager’s
objectives
objectives may
may not
not
be
be those
those of
of the
the
organization.
organization. May
May bebe difficult
difficult to
to
spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.
©The McGraw-Hill Companies
 Decentralization and
Segment Reporting
An Individual Shop
Marks & Spencers

A segment is any
part or activity of A Sales Territory

an organization
about which a
manager seeks
cost, revenue, or A Service Centre

profit data. A
segment can be . .
.
©The McGraw-Hill Companies
Cost, Profit, and Investments
Centres
Cost centre
Co
A segment s t
whose manager
has control over
costs,
but not over C o st st
Co

revenues or
investment
funds.
©The McGraw-Hill Companies
Cost, Profit, and Investments
Centres
Profit centre Revenues
Sales
A segment whose
Interest
manager has
Other
control over both Costs
costs and Mfg. costs
revenues, Commission
but no control over s
Salaries
investment funds. Other

©The McGraw-Hill Companies

Cost, Profit, and Investments
Centres
Investment
Corporate Headquarters
centre
A segment whose
manager has
control over costs,
revenues, and
investments in
operating assets.

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Cost, Profit, and Investments
Centres

Cost
Cost Profit
Profit Investment
Investment
centre
centre centre
centre centre
centre

Cost, profit,
and investment
centres are all Responsibility
Responsibility
known as centre
centre
responsibility
centres.
©The McGraw-Hill Companies
 Traceable and Common
Costs
Fixed
Costs

Traceable Common

Costs arise because Costs arise because

of the existence of of overall operating
a particular segment activities

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 Traceable and Common
Costs
Fixed
Costs Don’t allocate
common costs

Traceable Common

Costs arise because Costs arise because

of the existence of of overall operating
a particular segment activities

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 Identifying Traceable Fixed
Costs
Traceable costs would disappear over time if the
segment itself disappeared.

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

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 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 We still have a
division but . . . company chairman.

©The McGraw-Hill Companies

 Levels of Segmented
Statements
Webber 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

Let’s
Let’s look
look more
more closely
closely at
at the
the Television
Television
Division’s
Division’s profit
profit statement.
statement.
©The McGraw-Hill Companies
 Levels of Segmented
Statements
Our approach to segment reporting uses
the contribution format.
Profit 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
Total variable costs 150,000
Contribution margin 150,000
Fixed
Fixed and
and
Traceable fixed costs 90,000 variable
variable costs
costs
Segment margin £ 60,000 are
are listed
listed in
in
separate
separate
sections.
sections.
©The McGraw-Hill Companies
 Levels of Segmented
Statements
Our approach to segment reporting uses
the contribution format.
Profit Statement
Contribution Margin Format
Television Division
Sales £ 300,000
Variable COGS 120,000 Segment
Segment margin
margin
Other variable costs 30,000 is
is Television’s
Television’s
Total variable costs 150,000 contribution
contribution
Contribution margin 150,000 to
to overall
overall
Traceable fixed costs 90,000
operations.
operations.
Segment margin £ 60,000

©The McGraw-Hill Companies

Levels of Segmented
Statements

Let’s see how the Television

Division fits into Webber.

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 Levels of Segmented
Statements
Profit Statement
Company Television Computer
Sales £ 300,000
Variable costs (150,000)
CM 150,000
Traceable FC (90,000)
Division margin 60,000
Common costs
Net profit
Segment
Segment margin
margin has
has now
now
become
become division
division margin.
margin.

Let’s add the Computer

Division’s numbers.
©The McGraw-Hill Companies
 Levels of Segmented
Statements
Profit 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 profit

©The McGraw-Hill Companies

 Levels of Segmented
Statements
Profit 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 profit £ 75,000

Common
Common costs
costs arise
arise because
because of
of overall
overall
operating
operating activities.
activities. ABC
ABC may
may be
be helpful
helpful
in
in the
the analysis
analysis ofof common
common costs.
costs.
©The McGraw-Hill Companies
 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.
Let’s see how this works!

©The McGraw-Hill Companies

 Traceable Costs Can
Become Common Costs
Webber’s Television Division
Product
Lines
Television
Television
Division
Division

Regular
Regular Big
BigScreen
Screen

UK
UKSales
Sales Foreign
ForeignSales
Sales UK
UKSales
Sales Foreign
ForeignSales
Sales

Sales
Territories ©The McGraw-Hill Companies
 Traceable Costs Can
Become Common Costs
Profit 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.
©The McGraw-Hill Companies
 Traceable Costs Can Become
Common Costs
Profit 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
©The McGraw-Hill Companies
 Traceable Costs Can Become
Common Costs
Profit 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

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.
©The McGraw-Hill Companies
 Traceable Costs Can Become
Common Costs
Profit 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

The remaining £10,000 cannot be traced to

either the Regular or Big Screen product lines.
©The McGraw-Hill Companies
 Segment Margin
The segment margin is the best gauge of the
long-run profitability of a segment.
Profits

Time
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 Hindrances to Proper Cost
Assignment
The Problems
Assignment of costs
Omission of some
to segments that are
costs in the
really common costs of
assignment process.
the entire organization.

The use of inappropriate

methods for allocating
costs among segments. ©The McGraw-Hill Companies
 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

©The McGraw-Hill Companies

 Inappropriate Methods of
Allocating Costs Among
Segments
Arbitrarily dividing
common costs
among segments
Inappropriate
Failure to trace allocation base
costs directly

Segment Segment Segment Segment

1 2 3 4

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 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, debtors,
debtors, stock,
stock,
plant
plantand
andequipment,
equipment, and
andother
other
productive
productiveassets
assets
©The McGraw-Hill Companies
 Return on Investment (ROI)
Formula

Regal Company reports the following:

Net operating income £ 30,000

Average operating assets £ 200,000
Sales £ 500,000

£30,000
ROI = = 15%
£200,000
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 Controlling the Rate of
Return
Three ways to improve ROI . . .
Reduce
Expenses
 Increase
 Reduce
Sales
Assets

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 Controlling the Rate of
Return

• Regal’s manager was able to increase

sales to £600,000 which increased net
operating income to £42,000.

• There was no change in the average

operating assets of the segment.

Let’s calculate the new ROI.

©The McGraw-Hill Companies

 Return on Investment (ROI)
Formula
We can modify our original formula slightly:

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

ROI = £42,000 £600,000

×
£600,000 £200,000

ROI = 21%

We
We increased
increased ROI
ROI from
from 15%
15% to
to 21%
21%
©The McGraw-Hill Companies
 ROI and the Balanced
Scorecard
The balanced scorecard provides managers
with a roadmap that indicates how the
company intends to increase its ROI.

I’m glad we used the

Reduce balanced scorecard
Expenses to tell which approach
Increase is best.
Reduce
Sales
Assets

©The McGraw-Hill Companies

 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.

©The McGraw-Hill Companies

 Criticisms of ROI
• As division manager at Winston, plc., your
compensation package includes a salary plus bonus
based on your division’s ROI - the higher your ROI,
the bigger your bonus.

• The company requires an ROI of 15% on all new

investments - your division has been producing an
ROI of 30%.

• You have an opportunity to invest in a new project

that will produce an ROI of 25%.

As division manager would you invest in this project?

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Criticisms of ROI
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!

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 Criticisms of ROI
Mmm . . .
I thought we were
supposed to do what
was best for the
company!

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Residual Income - Another
Measure of Performance

Net operating income

above some minimum
return on operating
assets

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 Residual Income
• A division of Zepher has average operating
assets of £100,000 and is required to earn a
return of 20% on these assets.

• In the current period the division earns

£30,000.

Let’s calculate residual income.

©The McGraw-Hill Companies
 Residual Income
Operating assets £ 100,000
Required rate of return × 20%
Required return £ 20,000

Actua l re turn £ 30,000

Re quire d re turn (20,000)
Re sidua l incom e £ 10,000

©The McGraw-Hill Companies

Motivation and Residual
Income

Residual income encourages

managers to make profitable
investments that would
be rejected by managers
using ROI.

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End of Chapter 15

Let’s get to work

on my ROI . . .

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