Reporting for Control

Chapter 11
Note
• You can ignore the following sections of the
textbook:
 Balanced Scorecard
 Quality Cost in Appendix 11A of the e-book
 Service Department Cost Allocations in
Appendix 11A of the e-book

2
Decentralization in Organizations
Benefits of
Top management
Decentralization freed to concentrate
on strategy.
Lower-level managers
gain experience in
decision-making. Decision-making
authority leads to
Lower-level decisions job satisfaction.
often based on
better information. Lower level managers can
respond quickly to
customers.

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

Revenue Cost Profit Investment

center center center center

Revenue, cost, profit,

and investment centres
are all known as
Responsibility
responsibility centers.
center

5
Responsibility Centers
• Revenue Center:
 A segment whose manager has control over
revenues, but no control over costs or investment
funds.
• Cost Center:
 A segment whose manager has control over costs,
but not over revenues or investment funds.
• Profit Center:
 A segment whose manager has control over both
costs and revenues, but no control over investment
funds.
• Investment Center:
 A segment whose manager has control over costs,
revenues, and investments in operating assets.

6
 Responsibility Centers – Example
Fictional Corporate Chart - Pepsico

President & CEO

Information Finance Personnel

Operations Technology
Chief Financial
Vice President Chief Information Vice President
Officer Officer

Frito Lay Canada Pepsi-Cola Brands Tropicana

Product Manager Cost Centers
Product Manager Product Manager

Bottling Plant Warehouse Distribution Profit Centers

Manager Manager Manager

7
Segmented Reporting
• Financial performance reporting for organizational
units.
• In particular, measuring the contribution of each
unit towards the firm’s profit
• For example: product or geographic divisions,
departments, plants, offices, sales territories,
product lines.
• Performance evaluation of units and of their
managers
 Controllable costs vs. non-controllable costs

8
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.

9
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.
• These are direct costs for the segment and
controllable costs in evaluating the segment
managers’ performance.
• E.g., no computer division means no computer
division manager

10
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.
• These are indirect costs for the segment and non-
controllable costs in evaluating the segment
managers’ performance.
• E.g., no computer division but we still have a
company president

11
Segmented Reporting – Format
Division 1 Division2 Total
Sales $XXX $XXX $XXX
Variable costs $XXX $XXX $XXX
Contribution margin $XXX $XXX $XXX
Traceable fixed costs $XXX $XXX $XXX
Segment margin $XXX $XXX $XXX
Common fixed costs $XXX
Net operating income $XXX

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Cost-Allocation Death Spiral - Example
• EMMMs Inc. operates a single production facility
at which it produces 4 products: Eeny, Meany,
Miney, and Moe.
• The firm’s finance department has prepared the
following report on the projected profitability of
the 4 products for the next 12-month period.
• The firm’s fixed costs, which consist of factory
rent, selling costs, and general administrative
costs, are assigned to products based on the
number of units produced and sold.
 The firm has no inventories.

13
 EMMMs Profitability Report

Initial Report
(all figures are in thousands) Eeny Meany Miney Moe Total
Number of Units 35 30 25 10 100
Sales Revenue 200.00 450.00 675.00 900.00 2,225.00
Less: Variable Costs 100.00 270.00 400.00 600.00 1,370.00
Fixed Costs* 201.25 172.50 143.75 57.50 575.00
Operating Profit/(Loss) -101.25 7.50 131.25 242.50 280.00

* Fixed costs are assigned to products based on number of units.

• Management thinks that Eeny is a loss maker, and

thus drops this product.

14
 EMMMs: 3 products

Drop Eeny
(all figures are in thousands) Meany Miney Moe Total
Number of Units 30 25 10 65
Sales Revenue 450.00 675.00 900.00 2,025.00
Less: Variable Costs 270.00 400.00 600.00 1,270.00
Fixed Costs* 265.38 221.15 88.46 575.00
Operating Profit/(Loss) (85.38) 53.85 211.54 180.00

• However, Meany turns from a profitable product to a

loss maker after Eeny is dropped. Management thus
drops Meany.
15
 EMMMs: 2 products

Drop Meany
(all figures are in thousands) Miney Moe Total
Number of Units 25 10 35
Sales Revenue 675.00 900.00 1,575.00
Less: Variable Costs 400.00 600.00 1,000.00
Fixed Costs* 410.71 164.29 575.00
Operating Profit/(Loss) (135.71) 135.71 -

• Now Miney turns from a profitable product to a loss

maker after Meany is dropped. Management thus
further drops Miney.
16
 EMMMs: 1 product

Drop Miney
(all figures are in thousands) Moe Total
Number of Units 10 10
Sales Revenue $ 900 $ 900
Less: Variable Costs 600 600
Fixed Costs* 575 575
Operating Profit/(Loss) $ (275) $ (275)

• Only Moe is left, but it again turns from a profitable

product to a loss maker… What’s wrong here?

17
 EMMMs Profitability Report - Segmented
Eeny Meany Miney Moe Total
Number of units 35 30 25 10 100
Sales $200 $450 $675 $900 $2,225
Variable costs 100 270 400 600 1,370
Contribution margin 100 180 275 300 855
Traceable fixed costs 0 0 0 0 0
Segment margin $100 $180 $275 $300 855
Common fixed costs 575
Net operating income $280

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Quick Check
Income Statement for LP Limited

LP Bar LP Restaurant LP Total

Sales $ 100,000 $ 700,000 $ 800,000
Variable costs 60,000 250,000 310,000
CM 40,000 450,000 490,000
Traceable FC 26,000 220,000 246,000
Segment margin $ 14,000 $ 230,000 244,000
Common FC 200,000
Operating income $ 44,000

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

avoided by eliminating the LP Bar?
a. None of it.
b. Some of it.
c. All of it.
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Quick Check
Income Statement for LP Limited

LP Bar LP Restaurant LP Total

Sales $ 100,000 $ 700,000 $ 800,000
Variable costs 60,000 250,000 310,000
CM 40,000 450,000 490,000
Traceable FC 26,000 220,000 246,000
Segment margin $ 14,000 $ 230,000 244,000
Common FC 200,000
Operating income $ 44,000

Management allocates the common fixed cost to the two

segments based on sales dollars (i.e., $25,000 to LP Bar
and $175,000 to LP Restaurant. After this, they think LP Bar
makes a loss of $11,000. Should the LP Bar be dropped?
a. Yes.
b. No. 20
Transfer Pricing –
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.

21
Transfer Pricing –
Three Primary Approaches
• There are three primary approaches to setting
transfer prices:
 Negotiated transfer prices;
 Transfers at the cost incurred by the selling
division; and
 Transfers at market price

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Negotiated Transfer Prices
• A negotiated transfer price results
from discussions between the selling
and buying divisions.
• Advantages of negotiated transfer
prices:
 They preserve the autonomy of the
divisions, which is consistent with
the spirit of decentralization.
 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.

23
Negotiated Transfer Prices
• When transfers are optional (at either the
supplying or purchasing division’s discretion),
transfers should take place if they create a
differential profit for the company as a whole

24
 Negotiated Transfer Prices
• Maximum transfer price is the maximum price the
purchasing division is willing to pay
 maximum transfer price = current purchase
price from external supplier
OR, in most cases,
 maximum transfer price = selling division’s
selling price to external customer
• Also, any additional costs to transfer or cost
savings on transfer need to be considered.
Transfer Price  Cost of buying from outside supplier

25
 Negotiated Transfer Prices
• Minimum transfer price is the minimum
acceptable price the selling division is willing to
accept and is equal to the price that will make the
division as well off before and after the transfer
minimum transfer price
= variable cost per unit (cost incurred by
selling division)
+ Contribution Margin on lost sales
+ any incremental costs of transferring
Variable cost Total contribution margin on lost sales
Transfer Price  +
per unit Number of units transferred

26
Negotiated Transfer Prices
• If maximum > minimum, then a range of transfer
prices exist and it can be shown that transfers will
result in a differential profit to the company
• The question to be resolved is where to set the
transfer price:
 if set at the minimum, all differential profits are
allocated to the purchasing division
 if set at the maximum, all differential profits are
allocated to the selling division
 any transfer price within the range will result in
splitting the differential profit between the two
division
 where the transfer price settles is a matter of
negotiation between the divisions

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Example 1 – Scenario 1
Information on Division A:
Capacity in units 50,000
Selling price to external customers $15 per unit
Variable cost per unit $8
Fixed costs per unit (based on capacity) $5
• Division B is currently purchasing 5,000 units per
year from outside source at a cost of $14.
• Division A is currently producing 40,000 units.
• What is the minimum and maximum transfer
price?
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Example 1 –Scenario 2
Information on Division A:
Capacity in units 50,000
Selling price to external customers $15 per unit
Variable cost per unit $8
Fixed costs per unit (based on capacity) $5
• Division B is currently purchasing 5,000 units per
year from outside source at a cost of $14.
• Division A is working at full capacity.
• What is the minimum and maximum transfer
price?
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Example 1 –Scenario 3
Information on Division A:
Capacity in units 50,000
Selling price to external customers $15 per unit
Variable cost per unit $8
Fixed costs per unit (based on capacity) $5
• Division B is currently purchasing 5,000 units per
year from outside source at a cost of $14.
• Division A has idle capacity of 2,500 units.
• What is the minimum and maximum transfer
price?
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 Example 1 – Scenario 4
Information on Division A:
Capacity in units 50,000
Selling price to external customers $15 per unit
Variable cost per unit $8
Fixed costs per unit (based on capacity) $5
• Division B is currently purchasing 5,000 units per year
from outside source at a cost of $14.
• Division A is working at full capacity, but a negotiated
$2 in variable costs can be avoided on any
intracompany sales.
• What is the minimum and maximum transfer price?
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Example 2
A company has a number of divisions, two of which are the
engine and the car division. Data for these two divisions are as
follows:
Engine Division Car Division

Capacity 55,000 Production 20,000

Production 40,000 Selling Price $27,000
Selling Price $500 Variable costs* $17,000
Variable Costs $300 * Includes engine purchased
externally at a cost of $480
Fixed Costs $5M

Calculate the minimum and maximum transfer price.

What is the benefit to the company if a transfer takes place?
32
Transfers at the Cost
Incurred by 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:
 Using full cost as a transfer price and can lead
to suboptimization.
 The selling division will never show a profit on
any internal transfer.
 Cost-based transfer prices do not provide
incentives to control costs.

33
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.
 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.
 A market price approach does not work well
when the selling division has idle capacity.

34
Divisional Autonomy
and Suboptimal Decisions
• 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.

35
Return on Investment (ROI)
Operating Income
ROI =
Investment Base
• Profit?
 Operating Income = Earnings before interest
and income taxes
• Investment Base = Average Operating Assets
 Assets used to earn operating income: cash,
receivables, inventories, plant, property, &
equipment
 Average of beginning and ending balances
Understanding ROI

37
Increasing ROI
• There are three ways to increase ROI . . .
Reduce
Operating
Increase Reduce
Expenses
Sales Operating
Assets

38
ROI – An Example
Operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000

Regal Company reports the following:

What is the Company’s ROI?

Operating income $30,000
ROI = = = 15%
Average operating assets $200,000
Increasing Sales Without
an Increase in Operating Assets
• The company’s investment manager was able to
increase sales to $600,000, while operating
expenses increased to $558,000. Therefore the
operating income increased to $42,000.
• There was no change in the average operating
assets of the segment.

What is the new ROI?

Operating income $42,000
ROI = = = 21%
Average operating assets $200,000

ROI increased from 15% to 21%. 40

Advantages of ROI
• As a ratio, it is comparable across divisions of different
sizes.
• As a percentage, it is readily comparable against a
cost of capital.
• For publicly traded companies, it can be calculated by
“outsiders” (eg, investors, financial analysts);
therefore, top mgmt. may want division managers to
focus on improving ROI.
• Encourages managers to focus on:
 The relationship among sales, expenses, and
investment
 Cost efficiency
 Operational asset efficiency

41
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 at the expense of
overall company profitability.
• Focuses on the short term at the expense of the
long term

42
 Residual Income (RI)
• The amount of operating income in excess of a
minimum dollar return on the amount of
investment.

( )
Net Average Minimum
Residual
= operating - operating  required rate of
income
income assets return

43
Residual Income – An Example
• A Retail Division 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.
• What is the company’s residual income?
Operating assets $100,000
Required rate of return × 20%
Minimum required return $ 20,000

Actual income $ 30,000

Minimum required return (20,000)
Residual income $ 10,000
44
Motivation and Residual Income
• Residual income encourages managers to make
profitable investments that would be rejected by
managers using ROI.
• Advantages:
 Focuses on accepting projects that are
advantageous to the company
• Disadvantages:
 Focuses on the short term at the expense of the
long term
 An absolute measure of profitability makes it
difficult to compare alternatives or divisions of
different sizes.

45
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%
46
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
47
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

48
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

49
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

50
ROI versus Residual Income

Performance Does the company Does the manager

Measure want the manager want to make the
to make the investment?
investment?
ROI Yes, because the ROI No, because the ROI
of the investment is of the investment is
18%, greater than 18%, lower than the
the company’s division’s current ROI
required rate of 20%.
return 15%.
Residual Income Yes, because the Yes, because the
investment generates investment generates
positive residual positive residual
income for the income for the
company. division.

51
ROI versus Residual Income

• Residual income as a performance measure eliminates the

concern of rejecting profitable investment projects under
ROI method of performance evaluation.
• However, one should always bear in mind the sizes of
different divisions. A higher residual income may be simply
because larger size rather than better performance. E.g.,
Division A Division B
Required rate of return for the company 15% 15%
Average operating assets $300,000 $30,000
Net operating income $60,000 $15,000
ROI 20% 50%
Residual income $15,000 $10,500

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