Segment Reporting and Decentralization

(1)

Segment Reporting and Decentralization

UAA – ACCT 202 Principles of Managerial

Accounting Dr. Fred Barbee

(2)

Planning Planning

Decision Making Decision

Making Organizing

& Directing Organizing

& Directing

Controlling Controlling Evaluating

Evaluating

The Work of Management

(3)

Controlling Operations

•

Management by exception

•

Responsibility Accounting

•

Delegation of authority

•

Management by walking around

(4)

Responsibility Accounting

• . . . is a reporting system in which a cost is charged to the lowest level of

management that has responsibility for it.

V i c e P r e s i d e n t M a r k e t i n g

V i c e P r e s i d e n t P r o d u c t i o n

V i c e P r e s i d e n t C o n t r o l l e r P r e s i d e n t

a n d C E O

(5)

Installing Responsibility Accounting

•

Create a set of financial

performance goals (budgets).

•

Measure and report actual performance.

•

Evaluate based on comparison of

actual with budget.

(6)

Responsibility Accounting

• Evaluation of responsibility centers depends on . . .

– The extent of delegation of authority; and – A manager’s preference

(7)

Decentralization . . .

• . . . the delegation of authority to the lowest level of management

responsibility that can make decisions.

(8)

Centralization . . .

• . . . A centralized organization is one in which little authority is delegated to

lower level managers.

(9)

Decentralization

• The more decentralized the firm, the greater the need for control.

– Monitor employees – Motivate employees

(10)

Advantages of Decentralization

• Top level managers are relieved of making routine decisions.

• Higher employee morale

• Training

• Decisions are made where the action is taking place.

(11)

Disadvantages of Decentralization

• Upper level management loses some control.

• Lack of goal congruence.

• Duplication of effort.

(12)

Decentralization and Segment Reporting

Quick Mart Quick Mart

An Individual Store

A Sales Territory

A Service Center

A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A

segment can be

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Cost, Profit, and Investments Centers

Responsibility Centers

Cost Center

Cost

Center Profit Center

Profit

Center Investment Center Investment

Center

(14)

Responsibility Centers: A Systems Perspective Responsibility Centers: A Systems Perspective

Processing Steps Within

Information Systems Processing Steps

Within

Information Systems

Data (Inputs)

Information (Outputs)

DM DL MOH

Goods, Services,

Ideas Goods, Services,

Ideas Working

Capital Equipment

Etc.

Working Capital Equipment

Etc.

Resources used . . . Capital . . . Output . . .

(15)

Cost, Profit, and Investments Centers

Cost Center

A segment whose manager has

control over costs,

but not over revenues or investment funds.

(16)

Responsibility Centers:

A Systems Perspective Responsibility Centers:

A Systems Perspective

Input

Input Output Output

Process Process

Control only this

Cost Center

(17)

Evaluation . . .

• A cost center is evaluated by means of performance reports (i.e., comparison of actual with standard).

(18)

Segments Classified as Cost,

Profit and Investment Centers

(19)

Responsibility Centers:

A Systems Perspective Responsibility Centers:

A Systems Perspective

Input

Input Process Process Output Output

Control these

Profit Center

(20)

Cost, Profit, and Investments Centers

Profit Center

A segment whose manager has

control over both costs and

revenues,

but no control over investment funds.

Revenues

Sales Interest Other

Costs

Mfg. costs Commissions Salaries

Other

(21)

A Profit Center . . .

•

A profit center is evaluated by

means of contribution margin

income statements.

(22)

Segments Classified as Cost,

Profit and Investment Centers

(23)

Cost, Profit, and Investments Centers

Investment Center A segment whose

manager has

control over costs, revenues, and investments in operating assets.

Corporate Headquarters

(24)

Responsibility Centers:

A Systems Perspective Responsibility Centers:

A Systems Perspective

Input

Input Output Output

Process Process

Control these

Investment Center

(25)

Investment Center

• An investment center is evaluated by means of the Return on Investment

(ROI) or the Residual Income (RI) it is able to generate.

(26)

Segments Classified as Cost, Profit and Investment Centers

Responsibility Centers

(27)

Profit Center Vs. Investment Center

• A profit center is focused on profits as measured by the difference between revenues and expenses.

• An investment center is compared with the assets employed in earning

revenues.

(28)

Levels of Segmented

Statements

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Levels of Segmented

Statements

(30)

Levels of Segmented

Statements

(31)

Let’s look more closely at the Television Division’s income statement.

Webber, Inc. has two divisions.

C o m p u t e r D i v i s i o n T e l e v i s i o n D i v i s i o n W e b b e r , I n c .

(32)

Our approach to segment reporting uses the contribution format.

Income Statement

Contribution Margin Format Television Division

Sales $ 300,000

Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Cost of goods sold consists of

variable

manufacturing costs.

Cost of goods sold consists of

variable

manufacturing costs.

Fixed and variable costs

are listed in separate sections.

Fixed and variable costs

are listed in separate sections.

(33)

Segment margin is Television’s

contribution to profits.

Segment margin is Television’s

contribution to profits.

Contribution Margin Format Television Division

Sales $ 300,000

Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Our approach to segment reporting uses the contribution format.

Division Segment Margin

(34)

Traceable and Common Costs

Fixed Costs

Traceable Traceable

Costs arise because of the existence of a particular segment

Common

A cost that supports more than one segment but that would not go away if any particular segment

were eliminated.

Don’t allocate common costs.

(35)

Identifying Traceable Fixed Costs

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

No computer No computer

division means . . . division means . . .

division manager.

(36)

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.

division but . . . division but . . .

We still have a We still have a

company president.

(37)

Levels of Segmented Statements

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 operating

income $ 75,000

Common costs should not be allocated to the

divisions. These costs would remain even if one

of the divisions were eliminated.

Common costs should not be allocated to the

divisions. These costs would remain even if one

of the divisions were eliminated.

(38)

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!

(39)

U . S . S a l e s F o r e i g n S a l e s R e g u l a r

U . S . S a l e s F o r e i g n S a l e s B i g S c r e e n

T e l e v i s i o n D i v i s i o n

Traceable Costs Can Become Common Costs

Product Product

Lines Lines

Sales Sales

Territories Territories

Webber’s Television Division

(40)

Income 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

Traceable Costs Can Become Common Costs

Fixed costs directly traced to the Television Division

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

Fixed costs directly traced to the Television Division

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

(41)

Traceable Costs Can Become Common Costs

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.

(42)

Traceable Costs Can Become Common Costs

The remaining $10,000 cannot be traced to either the Regular or Big Screen product lines.

(43)

Segment Margin

The segment margin is the best gaugebest gauge of the long-run profitability of a segment.

TimeTime

ProfitsProfits

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Responsibility and Controllability

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Controllability is . . .

• The degree of influence that a specific manager has over costs, revenues, or other items in question.

(47)

Controllability

•

Few costs are

clearly under the

sole influence of

one manager.

(48)

Controllability

•

With a long enough time span, all costs will come under someone’s

control.

(49)

The Controllability Principle

Management Actions Management

Actions

Uncontrollable Environmental

Effects

Costs Costs

Managers only partially control

costs.

Managers only partially control

costs.

(50)

Rewards Rewards

. . . lead to more predictable rewards for managers.

Actions

Effects

Performance Measures Performance

Measures Costs

Costs

The Controllability Principle

Performance measurement systems that are based on

controllable costs . . . Performance measurement

systems that are based on controllable costs . . .

(51)

The performance measures and rewards will influence management to focus on the

controllable costs.

The performance measures and rewards will influence management to focus on the

controllable costs.

Actions

Costs RewardsRewards

The Controllability Principle

Measures

(52)

When performance measures are affected by uncontrollable

environmental effects . . . When performance measures are affected by uncontrollable

environmental effects . . .

Actions

Effects

The Controllability Principle

(53)

. . . management may try to control the performance measure rather than

the underlying cost.

. . . management may try to control the performance measure rather than

the underlying cost.

Actions

Effects

The Controllability Principle

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Hindrances to Proper Cost Assignment

The Problems The Problems

Omission of some costs in the

assignment process.

Assignment of costs to segments that are really common costs of

the entire organization.

The use of inappropriate methods for allocating costs among segments.

(56)

Omission of Costs

Costs assigned to a segment should include all costs attributable to that segment from

the company’s entire value chain.value chain

Product Customer R&D Design Manufacturing Marketing Distribution Service

Business Functions Business Functions

Making Up The Making Up The

Value Chain Value Chain

(57)

Inappropriate Methods of Allocating Costs Among Segments

Segment 1

Segment 3

Segment 4

Failure to trace costs directly

Arbitrarily dividing common costs among segments

Inappropriate allocation base

Segment 2

(58)

Return on Investment

• The ROI formula is expressed as:

(59)

Return on Investment

• Where . . .

Income

Margin = ---

Sales

(60)

Return on Investment

• Where . . .

Sales

Turnover = ---

Invested Capital

(61)

Income

---

Sales

---

Invested Capital

x

Return on Investment

The ratio of operating income to sales

The efficiency of asset

utilization.

(62)

Income

--- Sales

Sales

--- Invested Capital

x

Return on Investment

The ratio of operating income to sales

The efficiency of asset

utilization.

(63)

Income

---

Invested Capital

= ^ROI

Return on Investment

(64)

Selling Expense

Admin.

Expense Cost of Goods Sold

Sales

Operating Expenses

Net Oper.

Income

Sales

Margin Sales - OE

NOI / Sales

Margin is a measure of management’s

ability to control operating expenses in

relation to sales.

(65)

Accounts Receivable

Inventory

PP&E Other Assets Cash

Current Assets

Noncurr.

Assets

Ave Oper Assets

Sales

Turnover CA + NCA

Sales / AOA

Turnover is a measure of the amount of sales that can be generated in an

investment center for each dollar invested

in operating assets.

(66)

Selling Expense

Admin.

Expense

Accounts Receivable

Inventory

PP&E Other Assets Cost of Goods Sold

Cash

Sales

Operating Expenses

Net Oper.

Income

Sales

Margin

ROI

Current Assets

Noncurr.

Assets

Ave Oper Assets

Sales

Turnover Sales - OE

CA + NCA

M x T NOI / Sales

Sales / AOA

(67)

Measuring Income and Invested Capital

Income

--- Sales

Sales

--- Invested Capital

x

(68)

Measuring Income

• Variety of possibilities

• Text uses EBIT (Net Operating Income)

– Earnings Before Interest and Taxes

(69)

Measuring Invested Capital

• Variety of possibilities

• Text uses Net Book Value

– Consistent with how PP&E is listed on the Balance Sheet.

– Consistent with the computation of operating income.

(70)

Return on Investment (ROI) Formula

ROI =

ROI = Net operating income Net operating income

Average 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 interest and taxes (EBIT)

(71)

Improving the ROI

IncreaseIncrease Sales Sales

ReduceReduce Expenses

Expenses ReduceReduce Assets Assets

(72)

XYZ Company

Income (EBIT)

Sales

Invested Capital

$30,000

$500,000

$200,000

(73)

$30,000 ---

$500,000

$500,000 ---

$200,000

x

Return on Investment

6%

x

2.5

=

15%

(74)

Approach #1:

Increase Sales

(75)

Increase Sales . . .

• Assume that XYZ is able to increase sales to $600,000.

• Net Operating Income increases to

$42,000.

• Average Operating Assets remain unchanged.

• What is the impact on ROI?

(76)

$42,000 ---

$600,000

$600,000 ---

$200,000

x

Return on Investment

7%

x

3.0

=

21%

(77)

Reduce Expenses . . .

• Assume that XYZ is able to reduce expenses by $10,000

• Net Operating Income increases to

$40,000.

• Average Operating Assets and sales remain unchanged.

• What is the impact on ROI?

(78)

$40,000 ---

$500,000

$500,000 ---

$200,000

x

Return on Investment

8%

x

2.5

=

20%

(79)

Reduce Assets . . .

•

Assume that XYZ is able to reduce its operating assets from $200,000 to $125,000.

•

Sales and Net Operating Income remain unchanged.

•

What is the impact on ROI?

(80)

$30,000 ---

$500,000

$500,000 ---

$125,000

x

Return on Investment

6%

x

2.4

=

24%

(81)

Advantages of ROI . . .

• It encourages managers to focus on the relationship among sales, expenses,

and investment.

• It encourages managers to focus on cost efficiency.

• It encourages managers to focus on operating asset efficiency.

(82)

Disadvantages of ROI

• It can produce a narrow focus on

divisional profitability at the expense of profitability for the overall firm.

• It encourages managers to focus on the short run at the expense of the long

run.

(83)

(84)

Overinvestment

• Evaluation in terms of profit can lead to overinvestment.

(85)

Overinvestment

• Increases in Assets

• Increases in Profits

Manager

Company

(86)

Underinvestment

• Evaluation in terms of ROI can lead to underinvestment.

(87)

Overinvestment

• Decreases in Assets

• Increases in ROI

Manager

Company

(88)

(89)

Criticisms of ROI . . .

• ROI tends to emphasize short-run

performance over long-run profitability.

• ROI may not be completely controllable by the division manager due to

committed costs.

(90)

Multiple Criteria . . .

• Growth in market share

• Increases in productivity

• Dollar profits

• Receivables turnover

• Inventory turnover

• Product innovation

(91)

Residual Income . . .

•

. . . is the net operating income

that an investment center is able to earn above some minimum rate of return on its operating assets.

Residual Income = EBIT – Required Profit

= EBIT – Cost of Capital x Investment

(92)

Residual Income Example

Division B Division A

Invested Capital EBIT Last Year

*Min. Required R of R Residual Income

$1,000,000 200,000 120,000

$80,000

$3,000,000 450,000 360,000

$90,000

*Minimum Required Rate of Return = 12%

(93)

Problem with RI . . .

• RI cannot be used to compare

performance of divisions of different sizes.

(94)

Advantage of RI . . .

• RI encourages managers to make

profitable investments that would be rejected under the ROI approach.

(95)

Example . . .

• Assume that ABC Company’s Division A has an opportunity to make an

investment of $250,000 that would generate a 16% return.

• The Division’s current ROI is 20%.

Should the investment be made?

(96)

Marsh Company

Return on Investment

Overall New

Invested Capital (1)

NOPAT (2) ROI (1)/(2)

*$250,000 x 16% = $40,000

$250,000

*40,000 16%

$1,250,000

240,000 19.2%

20%

200,000

$1,000,000 Present

(97)

Marsh Company

Return on Investment

Overall New

Invested Capital (1)

NOPAT (2) ROI (1)/(2)

*$250,000 x 16% = $40,000

$250,000

*40,000 16%

$1,250,000

240,000 19.2%

20%

200,000

$1,000,000 Present

Reject - Reduces overall ROI!!!

(98)

Marsh Company Residual Income

Overall New

Invested Capital (1) NOPAT (2)

Minimum RofR*

Residual Income

$250,000 40,000

$30,000

$1,250,000 240,000

$150,000

$120,000 200,000

$1,000,000 Present

$80,000 $10,000 $90,000

*Minimum Required Rate of Return = 12% x Invested Capital

Accept - Positive Residual Income!!!

(99)

Economic Value Added

• Economic Value Added (EVA) is after- tax operating profit minus the total annual cost of capital

– If EVA is positive, the company is creating wealth.

– If EVA is negative, the company is destroying capital.

(100)

Calculating EVA . . .

• EVA = After-tax operating income

minus (the weighted-average cost of capital times total capital employed)

– Determine weighted average cost of capital – Determine total dollar amount of capital

employed