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11th EditionChapter 12

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Segment Reporting andDecentralization

Chapter Twelve

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Decentralization in Organizations

Disadvantages of

Decentralization

Lower-level managersmay make decisions

without seeing thebig picture.

May be a lack ofcoordination among

autonomousmanagers.

Lower-level managers

objectives may notbe those of theorganization. May be difficult to

spread innovative ideasin the organization.

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Cost, Profit, and Investments Centers

Responsibility

Center

CostCenter

ProfitCenter

InvestmentCenter

Cost, profit,

and investmentcenters areallknown asresponsibility

centers.

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Cost, Profit, and Investments Centers

Cost Center

A segment whosemanager has control

over costs,

but not over revenuesor investment funds.

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Cost, Profit, and Investments Centers

Profit Center

A segment whosemanager has controloverbothcosts and

revenues,

but no control overinvestment funds.

Revenues

Sales

Interest

Other

Costs

Mfg. costs

Commissions

Salaries

Other

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Cost, Profit, and Investments Centers

Investment Center

A segment whosemanager has controlover costs, revenues,

and investments inoperating assets.

Corporate Headquarters

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Responsibility Centers

Salty SnacksProduct Manger

Bottling PlantManager

WarehouseManager

DistributionManager

BeveragesProduct Manager

ConfectionsProduct Manager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Cost

Centers

InvestmentCenters

Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.

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Responsibility Centers

Salty SnacksProduct Manger

Bottling PlantManager

WarehouseManager

DistributionManager

BeveragesProduct Manager

ConfectionsProduct Manager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.

Profit

Centers

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Responsibility Centers

Salty SnacksProduct Manger

Bottling PlantManager

WarehouseManager

DistributionManager

BeveragesProduct Manager

ConfectionsProduct Manager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Cost

Centers

Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.

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Decentralization and Segment Reporting

Asegmentis any partor activity of an

organization about

which a managerseeks cost, revenue,

or profit data. A

segment can be . . .

Quick Mart

An Individual Store

A Sales Territory

A Service Center

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Superior Foods: Geographic Regions

East

$75,000,000

Oregon$45,000,000

Washington$50,000,000

California$120,000,000

Mountain States$85,000,000

West

$300,000,000

Midwest

$55,000,000

South

$70,000,000

Superior Foods Corporation$500,000,000

Superior Foods Corporation could segment its businessby geographic regions.

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Keys to Segmented Income Statements

There are two keys to buildingsegmented income statements:

A contribution format should be used because itseparates 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 ofa segment margin.

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Identifying Traceable Fixed Costs

Traceable costs arise because of the existence of aparticular segment and would disappear over time if

the segment itself disappeared.

No computerdivision means . . .

No computerdivision manager.

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Identifying Common Fixed Costs

Common costs arise because of the overalloperation of the company and would not disappear

if any particular segment were eliminated.

No computerdivision but . . .

We still have acompany president.

Traceable Costs Can Become Common

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Traceable Costs Can Become CommonCosts

It is important to realize that the traceablefixed costs of one segment may be a

common fixed cost of another segment.

For example, the landing feepaid to land an airplane at an

airport is traceable to the

particular flight, but it is nottraceable to first-class,

business-class, andeconomy-class passengers.

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Traceable and Common Costs

FixedCosts

Traceable Common

Dont allocatecommon costs to

segments.

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Activity-Based Costing

9-inch 12-inch 18-inch Total

Warehouse sq. ft. 1,000 4,000 5,000 10,000

Lease price per sq. ft. 4$ 4$ 4$ 4$

Total lease cost 4,000$ 16,000$ 20,000$ 40,000$

Pipe Products

Activity-based costing can help identify how costsshared 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 squarefoot.

If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 squarefeet, respectively, then ABC can be used to trace the warehousing costs to the

three products as shown.

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Levels of Segmented Statements

Lets look more closely at the Television

Divisions income statement.

Webber, Inc. has two divisions.

Computer Division Television Division

Webber, Inc.

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Levels of Segmented Statements

Our approach to segment reporting uses thecontribution format.

Income Statement

Contribution Margin Format

Television Division

Sales 300,000$

Variable COGS 120,000

Other variable costs 30,000

Total variable costs 150,000Contribution margin 150,000

Traceable fixed costs 90,000

Division margin 60,000$

Cost of goodssold consists of

variablemanufacturing

costs.

Fixed andvariable costsare listed in

separatesections.

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Levels of Segmented Statements

Segment marginis Televisions

contributionto profits.

Our approach to segment reporting uses thecontribution format.

Income Statement

Contribution Margin Format

Television Division

Sales 300,000$

Variable COGS 120,000

Other variable costs 30,000

Total variable costs 150,000Contribution margin 150,000

Traceable fixed costs 90,000

Division margin 60,000$

Contribution margin

is computed bytaking sales minus

variable costs.

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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 270,000 150,000 120,000Traceable FC 170,000 90,000 80,000

Division margin 100,000 60,000$ 40,000$

Common costs

Net operatingincome

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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 270,000 150,000 120,000Traceable FC 170,000 90,000 80,000

Division margin 100,000 60,000$ 40,000$

Common costs 25,000

Net operatingincome 75,000$

Common costs should not

be allocated to thedivisions. These costs

would remain even if oneof the divisions were

eliminated.

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Traceable Costs Can Become Common Costs

As previously mentioned, fixed costs that aretraceable to one segment can become commonif the company is divided intosmaller segments.

Lets see how this works

using the Webber Inc.example!

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Traceable Costs Can Become Common Costs

We obtained the following information fromthe Regular and Big Screen segments.

Income StatementTelevision

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

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Income StatementTelevision

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$

Traceable Costs Can Become Common Costs

Fixed costs directly tracedto the Television Division

$80,000 + $10,000 = $90,000

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Inappropriate Methods of Allocating Costs Among

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Inappropriate Methods of Allocating Costs AmongSegments

Segment1

Segment3

Segment4

Inappropriateallocation base

Segment2

Failure to tracecosts directly

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Quick Check

How much of the common fixed cost of $200,000can be avoided by eliminating the bar?

a. None of it.

b. Some of it.c. All of it.

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Q i k Ch k

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Quick Check

Suppose square feet is used as the basis forallocating the common fixed cost of $200,000. Howmuch would be allocated to the bar if the baroccupies 1,000 square feet and the restaurant9,000 square feet?

a. $20,000

b. $30,000

c. $40,000d. $50,000

Q i k Ch k

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Quick Check

Suppose square feet is used as the basis forallocating the common fixed cost of $200,000. Howmuch would be allocated to the bar if the baroccupies 1,000 square feet and the restaurant9,000 square feet?

a. $20,000

b. $30,000

c. $40,000d. $50,000

The bar would be allocated

1/10 of the cost or $20,000.

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Income StatementHaglund'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$

Allocations of Common Costs

Hurray, now everything adds up!!!

Q i k Ch k

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Quick Check

Should the bar be eliminated?

a. Yes

b. No

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Should the bar be eliminated?

a. Yes

b. No

Quick Check

Income Statement

Haglund's

Lakeshore Bar Restaurant

Sales 700,000$ 700,000$

Variable costs 250,000 250,000CM 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$

The profit was $44,000 beforeeliminating the bar. If we eliminate

the bar, profit drops to $30,000!

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N t B k V l G C t

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Net Book Value vs. Gross Cost

Most companies use the net book value ofdepreciable assets to calculate average

operating assets.

Acquisition cost

Less: Accumulated depreciation

Net book value

R t I t t (ROI) F l

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Return on Investment (ROI) Formula

ROI =Net operating income

Average operating assets

Margin = Net operating incomeSales

Turnover =

Sales

Average operating assets

ROI = Margin Turnover

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Incre sing ROI An E le

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Increasing ROI An Example

Regal Company reports the following:Net operating income $ 30,000

Average operating assets $ 200,000

Sales $ 500,000Operating expenses $ 470,000

ROI = Margin Turnover

Net operating incomeSales

SalesAverage operating assets

ROI =

What is Regal Companys ROI?

Increasing ROI An Example

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Increasing ROI An Example

$30,000$500,000

$500,000$200,000

ROI =

6% 2.5 = 15%ROI =

ROI = Margin Turnover

Net operating incomeSales

SalesAverage operating assets

ROI =

Increasing Sales Without an Increase in

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Increasing Sales Without an Increase inOperating Assets

Regals manager was able to increase sales to$600,000 while operating expenses increased to$558,000.

Regals net operating income increased to

$42,000. There was no change in the average operating

assets of the segment.

Lets calculate the new ROI.

Increasing Sales Without an Increase in

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Increasing Sales Without an Increase inOperating Assets

$42,000$600,000

$600,000$200,000

ROI =

7% 3.0 = 21%ROI =

ROI increased from 15% to 21%.

ROI = Margin Turnover

Net operating incomeSales

SalesAverage operating assets

ROI =

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Investing in Operating Assets to

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g Op gIncrease Sales

$50,000$535,000

$535,000$230,000

ROI =

9.35% 2.33 = 21.8%ROI =

ROI increased from 15% to 21.8%.

ROI = Margin Turnover

Net operating incomeSales

SalesAverage operating assets

ROI =

ROI and the Balanced Scorecard

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ROI and the Balanced Scorecard

It may not be obvious to managers how to increase sales,decrease costs, and decrease investments in a way that is

consistent with the companys strategy. A well constructed

balanced scorecard can provide managers with a road map thatindicates how the company intends to increase ROI.

Which internal businessprocess should be

improved?

Which customers shouldbe targeted and how will

they be attracted and

retained at a profit?

Criticisms of ROI

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Criticisms of ROI

In the absence of the balancedscorecard, management may

not know how to increase ROI.

Managers often inherit manycommitted costs over whichthey have no control.

Managers evaluated on ROI

may reject profitableinvestment opportunities.

Residual Income - Another Measure of

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Performance

Net operating incomeabove some minimum

return on operatingassets

Calculating Residual Income

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Calculating Residual Income

Residual

income=

Net

operating

income

-

Average

operating

assets

Minimum

required rate of

return( )

This computation differs from ROI.

ROI measures net operating income earned relativeto the investment in average operating assets.

Residual income measures net operating incomeearned less the minimum required return on average

operating assets.

Residual Income An Example

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Residual Income An Example

The Retail Division of Zepher, Inc. has averageoperating assets of $100,000 and is required toearn a return of 20% on these assets.

In the current period the division earns $30,000.

Lets calculate residual income.

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Motivation and Residual Income

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Motivation and Residual Income

Residual income encourages managers tomake profitable investments that would

be rejected by managers using ROI.

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Quick Check

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Quick Check

Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of

$300,000. The required rate of return for thecompany is 15%. What is the divisions ROI?

a. 25%

b. 5%c. 15%

d. 20%

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%

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Quick Check

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Quick Check

The companys required rate of return is 15%.Would the company want the manager of theRedmond Awnings division to make an investmentof $100,000 that would generate additional net

operating income of $18,000 per year?

a. Yes

b. No

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Quick Check

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Quick Check

Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of$300,000. The required rate of return for thecompany is 15%. What is the divisionsresidual income?

a. $240,000

b. $ 45,000c. $ 15,000

d. $ 51,000

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Quick Check

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Quick Check

If the manager of the Redmond Awnings division isevaluated based on residual income, will she wantto make an investment of $100,000 that wouldgenerate additional net operating income of

$18,000 per year?

a. Yes

b. No

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Transfer Pricing

Appendix 12A

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Negotiated Transfer Prices

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g

A negotiated transfer price results from discussionsbetween the selling and buying divisions.

Advantages of negotiated transfer prices:

1. They preserve the autonomy of thedivisions, which is consistent withthe spirit of decentralization.

2. The managers negotiating thetransfer price are likely to have muchbetter information about the potentialcosts and benefits of the transferthan others in the company.

Upper limit isdetermined by thebuying division.

Lower limit isdetermined by the

selling division.

Range of AcceptableTransfer Prices

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Harris and Louder An Example

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p

The selling divisions (Imperial Beverages) lowest acceptable transferprice is calculated as:

Variable cost Total contribution margin on lost sales

per unit Number of units transferredTransfer Price +

Transfer Price Cost of buying from outside supplier

The buying divisions (Pizza Maven) highest acceptable transfer price is

calculated as:

Lets calculate the lowest and highest acceptabletransfer prices under three scenarios.

Transfer Price Profit to be earned per unit sold (not including the transfer price)

If an outside supplier does not exist, the highest acceptable transfer priceis calculated as:

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Harris and Louder An Example

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p

If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice othercustomer orders (2,000 barrels) to meet Pizza Mavens demands (2,000

barrels), then the lowest and highest possible transfer prices are computedas follows:

( 20 - 8) 2,000

2,000= 20Transfer Price +8

Selling divisions lowest possible transfer price:

Transfer Price Cost of buying from outside supplier = 18

Buying divisions highest possible transfer price:

Therefore, there is no range ofacceptable transfer prices.

Harris and Louder An Example

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p

If Imperial Beverages has some idle capacity (1,000 barrels) and mustsacrifice other customer orders (1,000 barrels) to meet Pizza Mavens

demands (2,000 barrels), then the lowest and highest possible transfer pricesare computed as follows:

Transfer Price Cost of buying from outside supplier = 18

Buying divisions highest possible transfer price:

Therefore, the range of acceptabletransfer price is 14 18.

Selling divisions lowest possible transfer price:

( 20 - 8) 1,000

2,000= 14Transfer Price +8

Evaluation of Negotiated TransferPrices

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Prices

If a transfer within a company would result in

higher overall profits for the company, there isalways a range of transfer prices within whichboth the selling and buying divisions would

have higher profits if they agree to thetransfer.

If managers are pitted against each otherrather than against their past performance or

reasonable benchmarks, a noncooperativeatmosphere is almost guaranteed.

Given the disputes that often accompany thenegotiation process, most companies rely onsome other means of setting transfer prices.

Transfers at the Cost to the SellingDivision

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Division

Many companies set transfer prices at eitherthe variable cost or full (absorption) cost

incurred by the selling division.

Drawbacks of this approach include:1. Using full cost as a transfer price

and can lead to suboptimization.

2. The selling division will nevershow a profit on any internal

transfer.

3. Cost-based transfer prices donot provide incentives to controlcosts.

Transfers at Market Price

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A market price (i.e., the price charged for anitem on the open market) is often regarded as

the best approach to the transfer pricingproblem.

1. A market price approach worksbest when the product or serviceis sold in its present form tooutside customers and the

selling division has no idlecapacity.

2. A market price approach doesnot work well when the sellingdivision has idle capacity.

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End of Chapter 12

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