Chpt_12_HO

Segment Reporting and DecentralizationUAA ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

The Work of ManagementPlanningOrganizing & DirectingControllingEvaluating

Controlling Operations Management by exceptionResponsibility Accounting Delegation of authorityManagement 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.

Installing Responsibility AccountingCreate a set of financial performance goals (budgets).Measure and report actual performance.Evaluate based on comparison of actual with budget.

Responsibility AccountingEvaluation of responsibility centers depends on . . .The extent of delegation of authority; andA managers 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.

DecentralizationThe more decentralized the firm, the greater the need for control.Monitor employeesMotivate employees

Advantages of DecentralizationTop level managers are relieved of making routine decisions.Higher employee moraleTrainingDecisions are made where the action is taking place.

Disadvantages of DecentralizationUpper level management loses some control.Lack of goal congruence.Duplication of effort.

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

Cost, Profit, and Investments CentersResponsibilityCentersCostCenterProfitCenterInvestmentCenter

Responsibility Centers: A Systems PerspectiveProcessing StepsWithinInformation SystemsDMDLMOHGoods, Services, Ideas WorkingCapitalEquipmentEtc.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:A Systems PerspectiveControl only thisCost 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:A Systems PerspectiveControl theseProfit Center

Cost, Profit, and Investments Centers Profit Center A segment whose manager has control over both costs and revenues, but no control over 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 PerspectiveControl theseInvestment Center

Investment CenterAn 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 CentersResponsibility Centers

Profit Center Vs. Investment CenterA 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

Webber, Inc. has two divisions.

Our approach to segment reporting uses the contribution format.

Segment marginis Televisions contributionto profits.Our approach to segment reporting uses the contribution format.Division Segment Margin

Traceable and Common CostsCosts arise becauseof the existence ofa particular segmentA cost that supports more than onesegment but that would not goaway if any particular segment were eliminated.Dont allocatecommon costs.

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

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.

Levels of Segmented StatementsCommon costs should not be allocated to the divisions. These costs would remain even if one of the divisions were eliminated.

Traceable Costs Can Become Common CostsFixed costs that are traceable on one segmented statement can become common if the company is divided into smaller segments.Lets see how this works!

Traceable Costs Can Become Common CostsProductLinesSalesTerritoriesWebbers Television Division

Traceable Costs Can Become Common CostsFixed costs directly tracedto the Television Division $80,000 + $10,000 = $90,000

Traceable Costs Can Become Common CostsOf 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.

Traceable Costs Can Become Common CostsThe remaining $10,000 cannot be traced toeither the Regular or Big Screen product lines.

Segment MarginThe segment margin is the best gauge of the long-run profitability of a segment.TimeProfits

Responsibility and Controllability

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

ControllabilityFew costs are clearly under the sole influence of one manager.

ControllabilityWith a long enough time span, all costs will come under someones control.

The Controllability PrincipleManagement ActionsUncontrollable Environmental EffectsCostsManagers only partially control costs.

The Controllability Principle. . . lead to more predictable rewards for managers.Management ActionsUncontrollable Environmental EffectsCostsPerformance measurement systems that are based on controllable costs . . .

The Controllability PrincipleThe performance measures and rewards will influence management to focus on the controllable costs.Management ActionsCostsRewardsPerformance Measures

The Controllability PrincipleWhen performance measures are affected by uncontrollable environmental effects . . .

The Controllability Principle. . . management may try to control the performance measure rather than the underlying cost.

Hindrances to Proper Cost AssignmentThe Problems

Omission of CostsCosts assigned to a segment should include all costs attributable to that segment from the companys entire value chain.Business FunctionsMaking Up TheValue Chain

Inappropriate Methods of Allocating Costs Among SegmentsSegment3Segment4 Arbitrarily dividingcommon costsamong segmentsInappropriateallocation baseSegment2

Return on InvestmentThe ROI formula is expressed as:

Return on InvestmentWhere . . . Income Margin = -------------------- Sales

Return on InvestmentWhere . . . SalesTurnover = ------------------------------ Invested Capital

Income------------------------------SalesSales------------------------------Invested CapitalxReturn on InvestmentThe ratio of operating income to salesThe efficiency of asset utilization.

Income------------------------------Invested Capital=ROIReturn on Investment

SellingExpenseAdmin.ExpenseCost ofGoods SoldSalesOperatingExpensesNet Oper.IncomeSalesMarginSales - OENOI / SalesMargin is a measure of managements ability to control operating expenses in relation to sales.

AccountsReceivableInventoryPP&EOtherAssetsCashCurrentAssetsNoncurr.AssetsAve OperAssetsSalesTurnoverCA + NCASales / AOATurnover is a measure of the amount of sales that can be generated in an investment center for each dollar invested in operating assets.

SellingExpenseAdmin.ExpenseAccountsReceivableInventoryPP&EOtherAssetsCost ofGoods SoldCashSalesOperatingExpensesNet Oper.IncomeSalesMarginROICurrentAssetsNoncurr.AssetsAve OperAssetsSalesTurnoverSales - OECA + NCAM x TNOI / SalesSales / AOA

Measuring Income and Invested Capital

Income------------------------------SalesSales------------------------------Invested Capitalx

Measuring IncomeVariety of possibilitiesText uses EBIT (Net Operating Income)Earnings Before Interest and Taxes

Measuring Invested CapitalVariety of possibilitiesText uses Net Book ValueConsistent with how PP&E is listed on the Balance Sheet.Consistent with the computation of operating income.

Return on Investment (ROI) FormulaCash, accounts receivable, inventory,plant and equipment, and otherproductive assets.Income before interestand taxes (EBIT)

Improving the ROIIncreaseSalesReduceExpensesReduceAssets

XYZ CompanyIncome (EBIT)SalesInvested Capital$30,000$500,000$200,000

$30,000--------------$500,000$500,000--------------$200,000xReturn on Investment6%2.5x15%=

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?

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?

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?

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 ROIIt 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.

OverinvestmentEvaluation in terms of profit can lead to overinvestment.

OverinvestmentIncreases in AssetsIncreases in ProfitsManagerCompany

UnderinvestmentEvaluation in terms of ROI can lead to underinvestment.

OverinvestmentDecreases in AssetsIncreases in ROIManagerCompany

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 shareIncreases in productivityDollar profitsReceivables turnoverInventory turnoverProduct 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 ExampleDivision BDivision AInvested CapitalEBIT Last Year*Min. Required R of RResidual Income$1,000,000200,000120,000$80,000$3,000,000450,000360,000$90,000*Minimum Required Rate of Return = 12%

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 Companys Division A has an opportunity to make an investment of $250,000 that would generate a 16% return. The Divisions current ROI is 20%. Should the investment be made?

Marsh CompanyReturn on InvestmentOverallNewInvested Capital (1)NOPAT (2)ROI (1)/(2)*$250,000 x 16% = $40,000$250,000*40,00016%$1,250,000240,00019.2%20%200,000$1,000,000Present

Marsh CompanyReturn on InvestmentOverallNewInvested Capital (1)NOPAT (2)ROI (1)/(2)*$250,000 x 16% = $40,000$250,000*40,00016%$1,250,000240,00019.2%20%200,000$1,000,000PresentReject - Reduces overall ROI!!!

Marsh CompanyResidual IncomeOverallNewInvested Capital (1)NOPAT (2)Minimum RofR*Residual Income$250,00040,000$30,000$1,250,000240,000$150,000$120,000200,000$1,000,000Present$80,000$10,000$90,000*Minimum Required Rate of Return = 12% x Invested CapitalAccept - Positive Residual Income!!!

Economic Value AddedEconomic Value Added (EVA) is after-tax operating profit minus the total annual cost of capitalIf 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 capitalDetermine total dollar amount of capital employed

Segment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred BarbeeSegment Reporting and DecentralizationDr. Fred Barbee

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Chpt_12_HO