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Segment Reporting and Decentralization
Chapter Twelve
Decentralization in Organizations
Benefits ofDecentralization Top management
freed to concentrateon strategy.
Top managementfreed to concentrate
on strategy.Lower-level managers
gain experience indecision-making.
Lower-level managersgain experience indecision-making. Decision-making
authority leads tojob satisfaction.
Decision-makingauthority leads tojob satisfaction.
Lower-level decisionoften based on
better information.
Lower-level decisionoften based on
better information.Lower level managers can respond quickly
to customers.
Lower level managers can respond quickly
to customers.
Decentralization in Organizations
Disadvantages ofDecentralization
Lower-level managersmay make decisionswithout seeing the
“big picture.”
Lower-level managersmay make decisionswithout seeing the
“big picture.”
May be a lack ofcoordination among
autonomousmanagers.
May be a lack ofcoordination among
autonomousmanagers.
Lower-level manager’sobjectives may not
be those of theorganization.
Lower-level manager’sobjectives may not
be those of theorganization. May be difficult to
spread innovative ideasin the organization.
May be difficult tospread innovative ideas
in the organization.
Decentralization and Segment Reporting
A segment is any part or activity of an organization about which a manager seeks cost, revenue, or
profit data. A segment can be . . .
Quick MartQuick Mart
An Individual Store
A Sales Territory
A Department
Cost, Profit, and Investments Centers
ResponsibilityCenter
ResponsibilityCenter
CostCenterCost
CenterProfit
CenterProfit
CenterInvestment
CenterInvestment
Center
Cost, profit,and investmentcenters are allknown asresponsibilitycenters.
Measuring Managers Performance
CostCenter
Standard Cost/FlexibleBudget Variances
ProfitCenter
Budgeted incomestatement
InvestmentCenter
Return on investmentor residual income
Evaluation Tool
Return on Investment (ROI) Formula
ROI = ROI = Net operating incomeNet operating incomeAverage operating assets Average operating assets
Cash, accounts receivable, inventory,plant and equipment, and other
productive assets.
Cash, accounts receivable, inventory,plant and equipment, and other
productive assets.
Income before interestand taxes (EBIT)
Income before interestand taxes (EBIT)
Return on Investment (ROI) Formula
ROI = ROI = Net operating incomeNet operating incomeAverage operating assets Average operating assets
Margin = Margin = Net operating incomeNet operating incomeSales Sales
Turnover = Turnover = SalesSalesAverage operating assets Average operating assets
ROI = ROI = Margin Margin Turnover Turnover
Improving R0I
Three ways to improve ROI
IncreaseSales
Decrease Expenses
Reduce Operating
Assets
Improving ROI – An Example
Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000
Average operating assets $ 200,000Average operating assets $ 200,000
Sales $ 500,000Sales $ 500,000
Operating expenses $ 470,000Operating expenses $ 470,000
ROI = ROI = Margin Margin Turnover Turnover
Net operating income Sales
Sales Average operating assets×ROI =
What is Regal Company’s ROI?
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.
Let’s calculate the new ROI.Let’s calculate the new 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.
Let’s calculate the new ROI.Let’s calculate the new ROI.
Regal Company reports the following:Regal Company reports the following:
Net operating income $ 40,000Net operating income $ 40,000
Average operating assets $ 200,000Average operating assets $ 200,000
Sales $ 500,000Sales $ 500,000
Operating expenses $ 460,000Operating 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.
Let’s calculate the new ROI.Let’s calculate the new ROI.
Regal Company reports the following:Regal Company reports the following:
Net operating income $ 30,000Net operating income $ 30,000
Average operating assets $ 180,000Average operating assets $ 180,000
Sales $ 500,000Sales $ 500,000
Operating expenses $ 470,000Operating expenses $ 470,000
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.
Let’s calculate the new ROI.Let’s calculate the new ROI.
Regal Company reports the following:Regal Company reports the following:
Net operating income $ 50,000Net operating income $ 50,000
Average operating assets $ 230,000Average operating assets $ 230,000
Sales $ 535,000Sales $ 535,000
Operating expenses $ 485,000Operating expenses $ 485,000
Pop Quiz
Applebaum Enterprises had a margin of 8%, sales of $3,000,000, and average operating assets of $2,000,000. The company's ROI was:
A. 5.33%. B. 7.00%. C. 12.00%. D. 20.00%. E. some other figure.
Pop Quiz
The Brookshire Company had a 12% return on a $50,000 investment in new equipment. The investment resulted in increased sales, and the resultant increase in income amounted to 4% of the increase in sales. Brookshire’s turnover was:
A) 1 B) 1.5 C) 2 D) 3
ROI - A Major Drawback
As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- i.e., 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?
Residual Income - Another Measure of Performance
Net operating income that an investment center earns
above the minimum requiredreturn on its operating assets
Calculating Residual Income
Residual income
=Net
operating income
-Average
operating assets
Minimum
required rate of return
( )
Residual income measures net operating income earned less the minimum required return on average
operating assets.
Residual Income – An Example
The Retail Division of Zepher, Inc. 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.Let’s calculate residual income.
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. Yesb. 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. Yesb. 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. $240,000b. $ 45,000c. $ 15,000d. $ 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 $18,000 per year?
a. Yesb. No
Divisional Comparisons and Residual Income
The residual income approach
has one major disadvantage.
It cannot be used to compare
performance of divisions of
different sizes.
Zepher, Inc.
Is Wholesale performing better than Retail?
Retail WholesaleOperating assets 100,000$ 1,000,000$ Required rate of return × 20% 20%Minimum required return 20,000$ 200,000$
Retail WholesaleActual income 30,000$ 220,000$ Minimum required return (20,000) (200,000) Residual income 10,000$ 20,000$
Retail WholesaleOperating assets 100,000$ 1,000,000$ Required rate of return × 20% 20%Minimum required return 20,000$ 200,000$
Retail WholesaleActual income 30,000$ 220,000$ Minimum required return (20,000) (200,000) Residual income 10,000$ 20,000$
Recall the following information for the Retail Division of Zepher, Inc.
Assume the following information for the Wholesale
Division of Zepher, Inc.
Practice
At Pittsburgh Pipe Fittings the required rate of return on invested capital is 8%.
Div A Sales Revenue $10,000,000 Operating Income $ 2,000,000 Average Assets $ 2,500,000 Margin Turnover ROI Residual Income
Practice, continued
At Pittsburgh Pipe Fittings the required rate of return on invested capital is 8%.
Div B Sales Revenue Operating Income $400,000 Average Assets Margin 20% Turnover 1 ROI Residual Income
Quick Check
Johanssen Company reported the following information for 2007:
Sales $787,000 Average Operating Assets $375,000 Minimum Required Rate of Return 9% Residual Income $ 11,250 The company's operating income for 2007 was:
A) $ 37,080 B) $ 33,750 C) $ 45,000 D) $363,750
Pop Quiz
Extron Division reported a residual income of $200,000 for the year just ended. The division had $8,000,000 of average assets and $1,000,000 of operating income. On the basis of this information, the minimum required rate of return was:
A. 2.5%. B. 10.0%. C. 12.5%. D. 20.0%. E. some other figure.
Pop Quiz
Hasty Corporation minimum required rate of return of 12%. Division C, which is part of Hasty, had average operating assets of $800,000 and an ROI of 15%. On the basis of this information, C's residual income was:
A. $(24,000). B. $24,000. C. $96,000. D. $120,000. E. some other amount.