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.