Segment Reporting

1
Segment Reporting
2
LEARNING OBJECTIVES
After studying this chapter, you should be able
to

• 1. Differentiate among cost centres, profit
  centres, and investment centres, and explain how
  performance is measured in each.
• 2. Prepare a segmented income statement using the
  contribution format, and explain the difference
  between traceable fixed costs and common fixed
  costs.
• 3. Identify three business practices that hinder
  proper cost assignment.
• 4. Analyze variances from revenue targets.

3
LEARNING OBJECTIVES
After studying this chapter, you should be able
to

• 5. Analyze marketing expenses using cost drivers.
  
• 6. Compute the return on investment (ROI).
• 7. Show how changes in sales, expenses, and
  assets affect an organizations ROI.
• 8. Compute residual income, and understand the
  strengths and weaknesses of this method of
  measuring performance.
• 9. (Appendix 12A) Determine the range, if any,
  within which a negotiated transfer price should
  fall.

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Decentralization in Organizations
Benefits of Decentralization
Top management freed to concentrate on strategy.
Lower-level managers gain experience
in decision-making.
Decision-making authority leads to job
satisfaction.
Lower-level decision often based on better
information.
Improves ability to evaluate managers.
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Decentralization in Organizations
May be a lack of coordination among autonomous man
agers.
Lower-level managers may make decisions without
seeing the big picture.
Disadvantages of Decentralization
Lower-level managers objectives may not be those
of the organization.
May be difficult to spread innovative ideas in
the organization.
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Decentralization and Segment Reporting
An Individual Store

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

Canadian Tire
A Sales Territory
A Service Centre
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Cost, Profit, and Investment Centres

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

Cost
Cost
Cost
8
Cost, Profit, and Investment Centres

• Profit Centre
• 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
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Cost, Profit, and Investment Centres

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

Corporate Headquarters
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Cost, Profit, and Investment Centres
Cost Centre
Profit Centre
Investment Centre
Cost, profit, and investment centres are
all known as responsibility centres.
Responsibility Centre
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Traceable and Common Fixed Costs
Fixed Costs
Traceable
Common
Costs arise because of the existence of a
particular segment.
Costs arise because of overall operating activitie
s.
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Traceable and Common Fixed Costs
Fixed Costs
Dont allocate common costs.
Traceable
Common
Costs arise because of the existence of a
particular segment.
Costs arise because of overall operating activitie
s.
13
Identifying Traceable Fixed Costs

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

No computer division means . . .
No computer division manager.
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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 division but . . .
We still have a company president.
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Levels of Segmented Statements
Webber, Inc. has two divisions.
Lets look more closely at the Television
Divisions income statement.
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Levels of Segmented Statements

• Our approach to segment reporting uses the
  contribution format.

Cost of goods sold consists of variable
manufacturing costs.
Fixed and variable costs are listed
in separate sections.
17
Levels of Segmented Statements

• Our approach to segment reporting uses the
  contribution format.

Segment margin is Televisions contribution to
overall operations.
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Levels of Segmented Statements
Lets see how the Television Division fits into
Webber, Inc.
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Levels of Segmented Statements
Segment margin has now become division margin.
Lets add the Computer Divisions numbers.
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Levels of Segmented Statements
21
Levels of Segmented Statements
Common costs arise because of overall operating
activities. ABC may be helpfulin the analysis of
common costs.
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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.

Lets see how this works!
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Traceable Costs Can Become Common Costs
Webbers Television Division
Product Lines
Sales Territories
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Traceable Costs Can Become Common Costs
We obtained the following information from the
Regular and Big Screen segments.
25
Traceable Costs Can Become Common Costs
Fixed costs directly traced to the Television
Division 80,000 10,000 90,000
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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.
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Traceable Costs Can Become Common Costs
The remaining 10,000 cannot be traced to either
the Regular or Big Screen product lines.
28
Segment Margin

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

Profits
Time
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Hindrances to Proper Cost Assignment
Three Problems
Omission of some costs in the assignment
process.
Assignment to segments of costs that are really
common costs of the entire organization.
Use of inappropriate methods for allocating
costs among segments.
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Omission of Costs

• Costs assigned to a segment should include all
  costs attributable to that segment from the
  companys entire value chain.
• Life cycle costing focuses on all costs along the
  value chain that will be generated throughout the
  entire life of the product.

Business Functions Making Up The Value Chain

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Inappropriate Methods of Allocating Costs Among
Segments
Arbitrarily dividing common costs among segments
Inappropriate allocation base
Failure to trace costs directly
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Revenue Variance Analysis
Consider the following example for
CardCo Budget Actual Sales in
units Deluxe cards 14,000 17,000 Standard
cards 6,000 5,000 Price per unit Deluxe
cards 18 16 Standard cards
9 10 Market volume Deluxe
cards 75,000 85,000 Standard
cards 95,000 90,000 Variable cost per
unit Deluxe cards 8 8 Standard
cards 3 3
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Revenue Variance Analysis
Actual results are based on the actual quantity
sold multiplied by the actual selling price
or variable cost
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Revenue Variance Analysis
Flexible budget results are based on the actual
quantity sold multiplied by the budgeted selling
price or variable cost
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Revenue Variance Analysis
Master budget results are based on the budgeted
quantity sold multiplied by the budgeted selling
price or variable cost
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Revenue Variance Analysis
Sales Price Variance 29,000 U
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Revenue Variance Analysis
29,000U
or Sales Price Variance(Actual - Budgeted
price)x Actual sales volume Deluxe (16-18) x
17,000 units 34,000 U
Standard (10-9) x 5,000 units 5,000
F Total sales price variance 29,000 U
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Revenue Variance Analysis
Sales Volume Variance 24,000 F
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Revenue Variance Analysis
24,000F
or Sales Volume Variance(Actual - Budgeted
quantity) x Budgeted CM Deluxe (17,000-14,000)
x (18-8) units 30,000 F
Standard (5,000-6,000) x (9-3) 6,000
U Total sales volume variance 24,000 F
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Revenue Variance Analysis

• The Sales Volume Variance can further be broken
  down into the
• Market Volume Variance
• Market Share Variance

Budgeted CM per unit
Actual market volume
Budget market volume
Expected market share
-
x
x


Budgeted CM per unit
Actual sales quantity
x
-
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Revenue Variance Analysis

• For CardCo, the Sales Volume Variance of 24,000
  F breakdown further as follows
• Market Volume Variance
• Deluxe(85,000-75,000) x (14,000/75,000) x
  (18-8) 18,667 F
• Standard(90,000-95,000) x (6,000/95,000) x
  (9-3) 1,895 U
• Total Market Volume Variance (1) 16,772 F
• Market Share Variance
• Deluxe17,000-(85,000 x 14,000/75,000) x
  (18-8) 11,333 F
• Standard5,000-(90,000 x 6,000/95,000) x
  (9-3) 4,105 U
• Total Market Share Variance (2) 7,228 F
• Sales Volume Variance (1) (2) 24,000 F

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Revenue Variance Analysis

• The Sales Volume Variance can also be broken down
  into the
• Sales Mix Variance
• Sales Quantity Variance

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Revenue Variance Analysis

• For CardCo, the Sales Volume Variance of 24,000F
  is made up of
• Sales Mix Variance
• Deluxe17,000-(22,000 x14/20) x (18-8) 16,000
  F
• Standard(5,000-22,000 x 6/20) x (9-3)
  9,600 U
• Total Sales Mix Variance (1) 6,400 F
• Sales Quantity Variance
• Deluxe(22,000 x 14/20)-14,000 x (18-8) 14,000
  F
• Standard(22,000 x 6/20)-6,000 x (9-3)
  3,600 F
• Total Sales Quantity Variance (2) 17,600F
• Sales Volume Variance (1) (2) 24,000F

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Costs factors to consider in marketing strategy
Transport
Warehousing
Marketing Strategy
Advertising
Selling
Credit
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Order Getting and Order Filling
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Return on Investment (ROI) Formula
Income before interest and taxes (EBIT)
Cash, accounts receivable, inventory, plant and
equipment, and other productive assets.
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Return on Investment (ROI) Formula

• Regal Company reports the following
• Net operating income 30,000
• Average operating assets 200,000
• Sales
  500,000

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Controlling the Rate of Return

• Three ways to improve ROI . . .

• Reduce
• Expenses

• Reduce
• Assets

• Increase
• Sales

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Controlling the Rate of Return

• Regals manager was able to increase sales to
  600,000, which increased net operating income to
  42,000.
• There was no change in the average operating
  assets of the segment.

Lets calculate the new ROI.
50
Return on Investment (ROI) Formula
We can modify our original formula slightly
Margin
Turnover

Net operating income Sales
Sales Average
operating assets

ROI
42,000 600,000
600,000 200,000
ROI

21
ROI
We increased ROI from 15 to 21
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ROI and the Balanced Scorecard

• The balanced scorecard provides managers with a
  roadmap that indicates how the company intends to
  increase its ROI.

Im glad we used thebalanced scorecardto tell
which approach is best.

• Reduce
• Expenses

• Increase
• Sales

• Reduce
• Assets

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Criticisms of ROI
In the absence of the balanced scorecard,
management may not know how to increase ROI.
Managers often inherit many committed costs over
which they have no control.
Managers evaluated on ROI may reject
profitable investment opportunities.
53
Criticisms of ROI

• As division manager at Winston, Inc., your
  compensation package includes a salary plus bonus
  based on your divisions ROI -- 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?
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Criticisms of ROI
As division manager, I wouldnt invest in that
project because it would lower my pay!
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Criticisms of ROI
Your division before new investment Net
operating income 60,000 Average operating
assets 200,000 ROI 30 New
investment Net operating income
10,000 Average operating assets
50,000 ROI 20 Your division after new
investment Net operating income
70,000 Average operating assets
250,000 ROI 28
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Criticisms of ROI
Gee . . . I thought we were supposed to do what
was best for the company!
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Residual Income - Another Measure of Performance
Net operating income above some minimum return on
operating assets
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Residual Income

• A 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.

Lets calculate residual income.
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Residual Income
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Motivation and Residual Income
Residual income encourages managers to make
profitable investments that would be rejected by
managers using ROI.
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Your division before new investment Net
operating income 60,000 Average operating
assets 200,000 ROI 30
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Your division after new investment Net
operating income 70,000 Average operating
assets 250,000 ROI 28
An increase of 2,500 in residual income!!
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Transfer Pricing
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Transfer Pricing

• Fundamental Objective
• Setting transfer prices to motivate the managers
  to act in the
• best interest of the overall company

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Three Common Approaches
66
Transfer Pricing
When division managers work well together, a
negotiated transfer price is an excellent
solution to the transfer pricing problem. The
following formula, representing the minimum
transfer price, provides a good starting point in
determining the appropriate transfer
price Transfer Price Variable cost per unit
Lost contribution margin on outside sales
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Transfer Pricing
EXAMPLE The battery division of a company
makes a standard 12-volt battery. Production
capacity 300,000 batteries Selling price to
outsiders 40 Variable cost per
battery 18 Fixed costs per battery 7 (based
on capacity)
The companys vehicle division could use this
battery in its forklift trucks. The vehicle
division is now buying 100,000 batteries per year
from an outside supplier at 39 per battery.
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Transfer Pricing
Battery Division
Vehicle Division
Transfer Price?
39
40
Outside Suppliers
Outside Customers
69
Transfer Pricing
Situation 1 The battery division operates at
full capacity (i.e., sells presently 300,000
batteries to outside customers).

• Transfer Price 18 (40 - 18) 40
• No transfer will happen since the vehicle
  division
• can buy batteries for 39 on the outside market.

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Transfer Pricing
Situation 2 The battery division operates at
full capacity (i.e., sells presently 300,000
batteries to outsider customers), but can avoid
4 in variable costs (e.g., sales commissions)
on sales to the vehicle division.

• Transfer Price (18 - 4) (40 - 18) 36
• Transfer will happen if the transfer price is set
  
• between 36 and 39.

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Transfer Pricing
Situation 3 The battery division operates at
less than full capacity, selling presently
250,000 batteries to outside customers.

• Transfer Price 18 (40 - 18)50,000/100,00
  0
• 29
• Transfer will happen if the transfer price is set
• between 29 and 39.

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Transfer Pricing
Situation 4 The battery division operates at
less than full capacity, selling presently
200,000 batteries to outsider customers.

• Transfer Price 18 0 18
• Transfer will happen if the transfer price is set
  
• between 18 and 39.

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End of Chapter 12
Lets get to workon my ROI . . .