Segment ReportingChpt_12_HO.ppt

Segment Reporting and Decentralization

  UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

  Planning Planning

  Decision Making Decision Making

  Organizing & Directing Organizing & Directing

  Controlling Controlling

  Evaluating Evaluating

  The Work of Management

Controlling Operations

• Management by exception
• Responsibility Accounting
• Delegation of authority
• Management by walking around

Responsibility Accounting

  . . . is a reporting system in which a

• cost is charged to the lowest level of management that has responsibility for it.
_{P r e s i d e n t a n d C E O}

  V i c e P r e s i d e n t V i c e P r e s i d e n t V i c e P r e s i d e n t _{M a r k e t i n g P r o d u c t i o n C o n t r o l l e r}

Installing Responsibility Accounting

  Create a set of financial

• performance goals (budgets). Measure and report actual
• performance. Evaluate based on comparison of
• actual with budget.
Responsibility Accounting
• Evaluation of responsibility centers depends on . . .
• – The extent of delegation of authority; and
• – A manager’s preference

Decentralization . .

  . . . the delegation of authority to the

• lowest level of management responsibility that can make decisions.

Centralization . .

  . . . A centralized organization is one in

• which little authority is delegated to lower level managers.
Decentralization
• The more decentralized the firm, the greater the need for control.
• – Monitor employees
• – Motivate employees

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.
Disadvantages of Decentralization

  Upper level management loses some

• control. Lack of goal congruence.
>Duplication of eff
Decentralization and Segment Reporting An Individual Store Quick Mart Quick Mart

  A segment is any A Sales Territory part or activity of an organization about which a manager seeks cost, revenue, or

  A Service Center profit data. A segment can be Cost, Profit, and Investments Centers Responsibility Responsibility Centers Centers Cost Profit Investment Cost Profit Investment Center Center Center Center Center Center

  

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 DM DL MOH Goods, Services,

  Ideas Goods, Services,

  Ideas

Working

Capital

  

Equipment

Etc.

  

Working

Capital Equipment Etc.

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

  

Cost, Profit, and Investments

Centers

Cost Center

  A segment whose manager has control over costs, but not over revenues or investment funds.

  Responsibility Centers: Responsibility Centers: A Systems Perspective A Systems Perspective Input Output Input

  Output Process Process Cost Center Cost Center

Evaluation . .

  A cost center is evaluated by means of

• performance reports (i.e., comparison of actual with standard).

  

Segments Classified as Cost,

Profit and Investment Centers

Responsibility Centers:

  

Responsibility Centers:

A Systems Perspective

  

A Systems Perspective

Input Process Output

  

Input Process Output Profit Center Profit Center Cost, Profit, and Investments Centers

Profit Center Revenues Sales

  A segment whose Interest manager has

  Other control over both

Costs costs and Mfg. costs

  revenues, Commissions Salaries but no control over

  Other investment funds.

A Profit Center . .

  A profit center is evaluated by

• means of contribution margin income statements.

  

Segments Classified as Cost,

Profit and Investment Centers Cost, Profit, and Investments Centers

Investment Center

  A segment whose manager has control over costs, revenues, and investments in operating assets.

  Corporate Headquarters

Responsibility Centers: A Systems Perspective Input Input

  

Responsibility Centers:

A Systems Perspective

  Output Output

Process

  

Process

Investment Center

  

Investment Center

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.

  

Segments Classified as Cost,

Profit and Investment Centers

R es po n sib ilit y C en te rs

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.

  

Levels of Segmented

Statements

  

Levels of Segmented

Statements

  

Levels of Segmented

Statements

  

Let’s look more closely at the Television

Division’s income statement.

  

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 . Our approach to segment reporting uses the contribution format.

  Cost of goods Income Statement Cost of goods sold consists of Contribution Margin Format sold consists of variable Television Division variable manufacturing manufacturing Sales

$ 300,000 costs. costs. Variable COGS 120,000 Other variable costs 30,000 Fixed and Fixed and Total variable costs 150,000 variable costs variable costs Contribution margin 150,000 are listed in are listed in Traceable fixed costs 90,000 separate separate Division margin $ 60,000 sections. sections. Our approach to segment reporting uses the contribution format.

  Income Statement Contribution Margin Format Television Division Sales $ 300,000 Segment margin Segment margin Variable COGS 120,000 is Television’s is Television’s Other variable costs 30,000 contribution contribution Total variable costs 150,000 to profits. to profits. Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000 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 Don’t allocate common costs.

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

  No computer No computer division means . . . division means . . . No computer No computer division manager. division manager. 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.

  No computer No computer division but . . . division but . . . We still have a We still have a company president. company president. 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 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 $ 60,000 $ 40,000 Common costs 25,000 Common costs should not Common costs should not Net operating be allocated to the be allocated to the income $ 75,000 divisions. These costs divisions. These costs would remain even if one would remain even if one of the divisions were of the divisions were

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!

  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 Webber’s Television Division

  Traceable Costs Can Become Common Costs 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 Fixed costs directly traced Fixed costs directly traced to the Television Division to the Television Division

Traceable Costs Can Become Common Costs

  

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 Of the $90,000 cost directly traced to the Television Division, $45,000 is traceable to Regular and $35,000

Traceable Costs Can Become Common Costs

  

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 The remaining $10,000 cannot be traced to Segment Margin The segment margin is the best gauge best gauge of the long-run profitability of a segment.

  P ro fi ts P ro fi ts

  Responsibility and Controllability

Controllability is . .

  The degree of influence that a specific

• manager has over costs, revenues, or other items in question.

Controllability

  Few costs are

• clearly under the sole influence of one manager.

Controllability

  With a long

• enough time

  span, all costs will come under someone’s control.

The Controllability Principle Management Actions Management Actions Uncontrollable Environmental Effects Uncontrollable Environmental Effects Costs Costs Managers only partially control costs. Managers only partially control costs.

  Rewards Rewards . . . lead to more predictable rewards for managers. . . . lead to more predictable rewards for managers. Management Actions Management Actions Uncontrollable Environmental Effects Uncontrollable Environmental Effects Performance Measures Performance Measures Costs Costs

  The Controllability Principle Performance measurement systems that are based on Performance measurement systems that are based on controllable costs . . .

  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. Management Actions Management Actions Performance Measures Performance Measures Costs Costs

  Rewards Rewards The Controllability Principle

  Performance Measures Performance Measures

  When performance measures are affected by uncontrollable When performance measures are affected by uncontrollable Management Actions Management Actions Uncontrollable Environmental Effects Uncontrollable Environmental Effects Performance Measures Performance Measures Costs Costs

  Rewards Rewards The Controllability Principle

  . . . management may try to control the performance measure rather than . . . management may try to control the performance measure rather than Management Actions Management Actions Uncontrollable Environmental Effects Uncontrollable Environmental Effects Performance Measures Performance Measures Costs Costs

  Rewards Rewards The Controllability Principle

  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

  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

  

Business Functions

Business Functions

  

Making Up The

Making Up The

  

Value Chain

Value Chain

  

Product Customer

R&D Design Manufacturing Marketing Distribution Service

  Inappropriate Methods of Allocating Costs Among Segments

Arbitrarily dividing

common costs among segments Inappropriate Failure to trace allocation base costs directly Segment Segment

  Segment Segment

  2

  1

  3

  4 Return on Investment

• The ROI formula is expressed as:
Return on Investment Where . . .
• Income Margin = -------------------- Sales
Return on Investment Where . . .
• Sales Turnover = ------------------------------ Invested Capital

  Income ------------------------------ Sales

Sales ------------------------------ Invested Capital

  

x

Return on Investment

  The ratio of operating income to sales The efficiency of asset utilization.

  Income ------------------------------ Sales Sales ------------------------------ Invested Capital

x

  

Return on Investment

The ratio of operating income to sales The efficiency of asset utilization.

  Income ------------------------------ Invested Capital = ROI

Return on Investment

  Sales Cost of Net Oper. Goods Sold Sales - OE Income Selling Operating Margin Expense Expenses NOI / Sales Admin.

  Sales Expense

Margin is a measure of management’s

ability to control operating expenses in

relation to sales.

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

investment center for each dollar invested

in operating assets.

  Cash Sales Accounts Current Receivable Assets

  Turnover Sales / AOA Inventory Ave Oper CA + NCA Assets PP&E Noncurr. Assets Other

  Selling Expense Admin. Expense Accounts Receivable Inventory PP&E 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

  Measuring Income and Invested Capital Income

  Sales

• ------------------------------ ------------------------------

  

x

Sales

  Invested Capital Measuring Income

• Variety of possibilities
• Text uses EBIT (Net Operating Income)
• – E arnings B efore I nterest and T axes
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.
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 Cash, accounts receivable, inventory, plant and equipment, and other Income before interest and taxes (EBIT) Income before interest and taxes (EBIT)

  Improving the ROI 

  Increase Increase Sales Sales 

  Reduce Reduce

Expenses

  

Expenses



  Reduce Reduce Assets Assets

XYZ Company

  Income (EBIT) $30,000 Sales

  $500,000 Invested Capital $200,000

  

Return on Investment

$30,000 $500,000

• -------------- --------------

  

x

$500,000 $200,000

  6% 2.5 x

  

15%

  

Approach #1: Increase Sales 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?

  

Return on Investment

$42,000 $600,000

x

• -------------- --------------

  $600,000 $200,000

  

x

7%

  3.0 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?

  $40,000 -------------- $500,000 $500,000 -------------- $200,000

x

  

Return on Investment

8%

  2.5

x 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?

  

Return on Investment

$30,000 $500,000

x

• -------------- --------------

  $500,000 $125,000

  

x

6%

  2.4

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.

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.

Overinvestment

  Evaluation in terms of profit can lead

• to overinvestment .
Overinvestment
• Increases in Assets

  Manager Company

• Increases in Profits
Underinvestment

  Evaluation in terms of ROI can lead to

• underinvestment .
Overinvestment
• Decreases in Assets

  Manager Company

• Increases in ROI

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.

Multiple Criteria . .

• Growth in market share

• Increases in productivity
• Dollar profits
• Receivables turnover
• Inventory turnover
• Product innovation
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

Residual Income Example

  Division A Division B

Invested Capital $1,000,000 $3,000,000

EBIT Last Year

  200,000 450,000

• *Min. Required R of R 120,000 360,000

  Residual Income $80,000 $90,000

Problem with RI . .

  RI cannot be used to compare

• performance of divisions of different sizes.

Advantage of RI . .

  RI encourages managers to make

• profitable investments that would be rejected under the ROI approach.

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?

Marsh Company Return on Investment

  Present New Overall

Invested Capital (1) $1,000,000 $250,000 $1,250,000

NOPAT (2) 200,000 *40,000 240,000

ROI (1)/(2)

  20% 16% 19.2%

• $250,000 x 16% = $40,000

  

Marsh Company

Return on Investment

Reject - Reduces overall ROI!!!

  Present New Overall

Invested Capital (1) $1,000,000 $250,000 $1,250,000

NOPAT (2) 200,000 *40,000 240,000

ROI (1)/(2)

  20% 16% 19.2%

• $250,000 x 16% = $40,000

  

Marsh Company

Residual Income

Accept - Positive Residual Income!!!

  Present New Overall

Invested Capital (1) $1,000,000 $250,000 $1,250,000

NOPAT (2) 200,000 40,000 240,000

Minimum RofR* $120,000 $30,000 $150,000

Residual Income $80,000 $10,000 $90,000 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. 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