Segment Reporting and Decentralization

1
Segment Reporting and Decentralization

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

2
The Work of Management
Planning
Organizing Directing
Evaluating
Controlling
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.

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 managers 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

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

13
Cost, Profit, and Investments Centers
Responsibility Centers
Cost Center
Profit Center
Investment Center
14
Responsibility Centers A Systems Perspective
Processing Steps Within Information Systems
Resources used . . .
Capital . . .
Output . . .
DM DL MOH
Goods, Services, Ideas
Working Capital Equipment Etc.
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
Cost Center
Control only this
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
Profit Center
Control these
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.

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
Investment Center
Control these
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
29
Levels of Segmented Statements
30
Levels of Segmented Statements
31
Webber, Inc. has two divisions.
32

• Our approach to segment reporting uses the
  contribution format.

33
Our approach to segment reporting uses the
contribution format.
Segment margin is Televisions contribution to
profits.
Division Segment Margin
34
Traceable and Common Costs
Dont allocate common costs.
Costs arise because of the existence of a
particular segment
A cost that supports more than one segment but
that would not go away if any particular segment
were eliminated.
35
Identifying Traceable Fixed Costs

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

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.
37
Levels of Segmented Statements
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.

Lets see how this works!
39
Traceable Costs Can Become Common Costs
Webbers Television Division
Product Lines
Sales Territories
40
Traceable Costs Can Become Common Costs
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 gauge of the
  long-run profitability of a segment.

Profits
Time
44
An Out-of-the-Text
Out-of-the-Text
Experience
45
Responsibility and Controllability
46
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 someones control.

49
The Controllability Principle
Management Actions
Managers only partially control costs.
Costs
Uncontrollable Environmental Effects
50
The Controllability Principle
. . . lead to more predictable rewards for
managers.
Management Actions
Costs
Uncontrollable Environmental Effects
Performance measurement systems that are based on
controllable costs . . .
51
The Controllability Principle
The performance measures and rewards will
influence management to focus on the controllable
costs.
Management Actions
Performance Measures
Costs
Rewards
You get what you measure!
52
The Controllability Principle
When performance measures are affected by
uncontrollable environmental effects . . .
53
The Controllability Principle
. . . management may try to control the
performance measure rather than the underlying
cost.
54
Now . . .
Back to the text
55
Hindrances to Proper Cost Assignment
The Problems
56
Omission of Costs

• Costs assigned to a segment should include all
  costs attributable to that segment from the
  companys entire value chain.

Business Functions Making Up The Value Chain

57
Inappropriate Methods of Allocating Costs Among
Segments
Arbitrarily dividing common costs among
segments
Inappropriate allocation base
Segment 2
Segment 3
Segment 4
58
Return on Investment

• The ROI formula is expressed as

Margin x Turnover ROI
59
Return on Investment

• Where . . .

Income Margin
--------------------
Sales
60
Return on Investment

• Where . . .

Sales Turnover
------------------------------
Invested Capital
61
Return on Investment
Income ------------------------------ Sales
Sales ------------------------------ Invested
Capital
x
The ratio of operating income to sales
The efficiency of asset utilization.
62
Return on Investment
Income ------------------------------ Sales
Sales ------------------------------ Invested
Capital
x
The ratio of operating income to sales
The efficiency of asset utilization.
63
Return on Investment
Income ------------------------------ Invested
Capital
ROI

64
Sales
Cost of Goods Sold
Net Oper. Income
Sales - OE
Margin
Selling Expense
Operating Expenses
NOI / Sales
Admin. Expense
Sales
Margin is a measure of managements ability to
control operating expenses in relation to sales.
65
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 Receivable
Current Assets
Turnover
Sales / AOA
Inventory
Ave Oper Assets
CA NCA
PPE
Noncurr. Assets
Other Assets
66
Sales
Cost of Goods Sold
Net Oper. Income
Sales - OE
Margin
Selling Expense
Operating Expenses
NOI / Sales
Admin. Expense
Sales
ROI
M x T
Cash
Sales
Accounts Receivable
Current Assets
Turnover
Sales / AOA
Inventory
Ave Oper Assets
CA NCA
PPE
Noncurr. Assets
Other Assets
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 PPE is listed on the Balance
  Sheet.
• Consistent with the computation of operating
  income.

70
Return on Investment (ROI) Formula
Income before interest and taxes (EBIT)
Cash, accounts receivable, inventory, plant and
equipment, and other productive assets.
71
Improving the ROI

• Reduce
• Expenses

• Reduce
• Assets

• Increase
• Sales

72
XYZ Company
Income (EBIT)
30,000
Sales
500,000
Invested Capital
200,000
73
Return on Investment
30,000 -------------- 500,000
500,000 -------------- 200,000
x
6
2.5
x
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
Return on Investment
42,000 -------------- 600,000
600,000 -------------- 200,000
x
7
3.0
x
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
Return on Investment
40,000 -------------- 500,000
500,000 -------------- 200,000
x
8
2.5
x
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
Return on Investment
30,000 -------------- 500,000
500,000 -------------- 125,000
x
6
2.4
x
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
An Out-of-the-Text
Out-of-the-Text
Experience
84
Overinvestment

• Evaluation in terms of profit can lead to
  overinvestment.

85
Overinvestment

• Increases in Assets

Company
Manager

• Increases in Profits

86
Underinvestment

• Evaluation in terms of ROI can lead to
  underinvestment.

87
Overinvestment

• Decreases in Assets

Company
Manager

• Increases in ROI

88
Now . . .
Back to the text
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
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
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 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?

96
Marsh Company Return on Investment
Overall
New
Present
Invested Capital (1)
250,000
1,250,000
1,000,000
NOPAT (2)
40,000
240,000
200,000
ROI (1)/(2)
16
19.2
20
250,000 x 16 40,000
97
Marsh Company Return on Investment
Reject - Reduces overall ROI!!!
Overall
New
Present
Invested Capital (1)
250,000
1,250,000
1,000,000
NOPAT (2)
40,000
240,000
200,000
ROI (1)/(2)
16
19.2
20
250,000 x 16 40,000
98
Marsh Company Residual Income
Accept - Positive Residual Income!!!
Overall
New
Present
Invested Capital (1)
250,000
1,250,000
1,000,000
NOPAT (2)
40,000
240,000
200,000
Minimum RofR
30,000
150,000
120,000
Residual Income
80,000
10,000
90,000
Minimum Required Rate of Return 12 x
Invested Capital
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