Module 23

Segment Reporting and

Transfer Pricing

Segment Reports

Segment Reports Follow the Organization Structure: Cost Center – Ex.: Maintenance

Department Compare actual costs with the budget

Revenues—Ex.: Western Sales Territory Compare actual sales with the budgeted

sales Profits—A Movie

Compare profits with the budgeted profits Profits and Investment—Electronics,

Inc. (Sub.) Compare Ret. on Investment to required

ROI

Terms for Costs of Segments

Variable costs Ex: Materials usage

Direct fixed costs FC directly traceable to segment:

Segment manager Allocated common costs

Indirect tracing of costs to a unit: share of a engineering cost by product lines on time

Unallocated common costs Central costs of many segments: Home

office should not be allocated, but some companies do…

Example

Profit CentersNorth Territory South Territory Total

Sales $16,000. $18,000. $34,000. Less variable costs (5,600) (6,100) (11,700) Contribution margin 10,400. 11,900. 22,300. Less direct fixed costs (2,000) (1,600) (3,600) Territory margin 8,400. 10,300. 18,700. Less allocated segment costs (1,200) (1,400) (2,600) Territory income $ 7,200. $ 8,900. 16,100. Less unallocated common costs (1,500) Net income $14,600.

Segment income is relevant for measuring the long-term

effects of decisions to continue or discontinue a segment.

Segment margin is relevant for measuring the short-term effects of decisions to continue or discontinue a segment.

Return on Investment (ROI)

A measure of the earnings per dollar of an investment

Assumes financing decisions are made at the corporate levelInvestment center income

Investment center asset base

Investment center incomeInvestment center asset base ROI = ROI =

Evaluated by comparing to previously identified performance criteria, such as Overall company ROI Budget ROI

Often rank ordered with awards of bonuses/raises to highest performers and bottom performers warned or dumped.

However… High ROI divisions tend to only take on

extremely high return projects resulting in slow growth.

Example: West Texas Division has an ROI of 50% on

an asset base of $20 million: Superstars—BIG Bonuses!

Now Project X12 has a promised return of 30% and requires an investment of $10 million.

If West Texas takes on the project then ROI decreases:

[50%*$20MM + 30%*$10MM]/[$20MM+$10MM)=

[$10,000,000 + $3,000,000]/$30,000,000 = 43.3%

Superstars would be less shiny! Will West Texas Division take on this

project? (Never…) Also, West Texas would be better off to

shrink any part of their organization that earns less than 50%!

Residual Income Residual Income is an alternative

measure to ROI: RI = Division Income – Min Rate of Return X

Asset Base West Texas:

Set required return to 15%. Residual income before X12:

50%*$20MM – 15%*$10MM = $8,500,000 Residual income with X12:

$8,500,000 + [30%*$10 MM – 15%*$10MM]= $10,000,000

West Texas Division should expand as long as projects earn more than the required return.

Economic Value Added (EVA®)

Used to evaluate investment center performance A variation of residual income

Significant differences from residual income1. Weighted average cost of capital used

instead of required rate of return2. Net assets are used as the evaluation

base3. After-tax income is used as investment

center income4. Corrects for potential distortions in

economic net income caused by GAAP

Total assets less current liabilitiesTotal assets less current liabilities

An average of the after-tax cost of all long-term borrowing and the cost of equity financing

An average of the after-tax cost of all long-term borrowing and the cost of equity financing

Economic Value AddedAST Distributors has an 10% cost of capital and a 40% income tax rate. Amounts for the West Texas Division for 2012 are: Assets $20,000,000

Division income $ 10,000,000 Current liabilities $ 5,000,000

EVA = Division income after tax - Cost of capital x (Assets – Current Liabilities]

= ($10,000,000×(1.0-0.4) – 0.10×($20,000,000–$5,000,000) == $6,000,000 - $1,500,000 = $4,500,000

The West Texas Division added $4,500,000 in value to AST Distributors.

The West Texas Division added $4,500,000 in value to AST Distributors.

Balanced Scorecard In general: “We get what we measure”

With ROI, Residual Income, EVA we tend to get short-term behaviors!

Long-term performance requires customer relations, new products, well trained & loyal employees…

Balanced Scorecard: A comprehensive performance measurement system that includes financial measures and measures related to: Customers Internal processes Innovation and learning

Examples of Key Indicators

Key financial indicatorsCost, Revenue, Profit, or Cash FlowReturn on investment (ROI), Residual Income, or Economic Value Added

Key customer indicatorsAverage customers per hourNumber of customer complaints per periodNumber of sales returns per period

Key operating indicatorsOn-time deliveryQuality of units producedEmployee turnover per period

Key growth and innovation indicatorsNew products introduced during periodProducts discontinued during periodNumber of sales promotionsSpecial offers, discounts, etc.

Transfer Pricing The transfer price is an internal

value assigned a product or service that one division provides to another. Normally occurs between profit or

investment centers Higher transfer prices result in:

More profits to the selling divisions and less to the buying divisions

Lower volume and profit for company as a whole

Transfer prices may be based on market prices (where available) or costs, or they may be negotiated.

Market Price as the Transfer Price

Best method of setting transfer prices, if there is an existing market with established prices for internal products, BUT most often there is not an established market.

Preserves divisional autonomy and leads divisions to act in a manner that maximizes corporate profits Assuming divisions are free to buy and

sell outside the firm Often specified as market price minus a

discount when selling and administrative costs are lower on transfers.

Cost Plus Markup as Transfer Price

Allows supplying divisions to increase earnings

May result in some undesired behavior: Passing along inefficiencies, no penalty for

inefficiency Stifle buyers’ demand and profits in low

volume periods Supplying divisions tend to have higher

ROI than buying divisions… Variations on “cost” and “markup”:

variable only, standardized, total costs including administration, dual transfer price (e.g. VC and FC+MU%), opportunity costs, fixed fees versus % markup

Negotiated Price as the Transfer Price

Supplying and buying divisions agree on a price through negotiation

Use for relatively few transfers with similar powered negotiators

Divisions should be free to withdraw and go elsewhere