Segment Reporting & Decentralization

(Go through the reference books for details)

Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

A decentralized organization is one in which decision making is not confined to a few top executives but rather is spread throughout the organization with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity.

Advantages of Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

A decentralized organization does not confine decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages of decentralization are as follows: 1. 2. 3. 4. 5. Top management freed to concentrate on strategy. Decision-making authority leads to job satisfaction. Lower level managers can respond quickly to customers. Lower-level managers gain experience in decision-making. Lower-level decision often based on better information.

Disadvantages of Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

1. 2. 3. 4. May be a lack of coordination among autonomous managers. Lower-level managers may make decisions without seeing the big picture. Lower-level managers objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization.

Segment (Managerial Accounting, Garrison, 10th edition, p. 527)

A segment is a part or activity of an organization about which managers would like cost, revenue, or profit data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers, and product lines. A companys operations can be segmented in many ways. For example, segment the business by geographic region, by individual store, by the nature of the merchandise, by brand name and so on.

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 Responsibility Center (Managerial Accounting, Garrison, 10th edition, p. 529)

Responsibility accounting systems link lower-level managers decision-making authority with accountability for the outcomes of those decisions. Responsibility center is broadly defined as any part of an organization whose manager has control over, and is accountable for cost, profit, or investment funds. The three primary types of responsibility centers are cost centers, profit centers, and investment centers. Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

Investment Centers
O p e r a tio n s V ic e P r e s id e n t S a lty S n a c k s P ro d u c t M a n g e r B o ttlin g P la n t M anager B e vera g es P ro d u c t M a n a g er W a reh o u se M anager

S u p e r io r F o o d s C o r p o r a tio n C o r p o r a te H e a d q u a r te rs P r e s id e n t a n d C E O F in a n c e C h ie f F In a n c ia l O ffic e r C o n fe c tio n s P ro d u c t M a n a g er D is tr ib u tio n M anager Legal G e n e ra l C o u n s e l P e rs o n n e l V ic e P r e s id e n t

Profit Centers Cost Centers

Cost Center (Managerial Accounting, Garrison, 10th edition, p. 527)

A cost center is a business segment whose manager has control over costs, but not over revenue or investment funds. Service departments such as accounting, general administration, legal and personnel are usually considered to be cost centers. In addition, manufacturing facilities are often considered to be cost center. The manager of the cost center are expected to minimize cost while providing the level of services or the amount of products demanded by the other parts of the organization. Standard cost variances and flexible budget variances are often used to evaluate cost center performance.

Profit Center (Managerial Accounting, Garrison, 10th edition, p. 528)

In contrast to a cost center, a profit center is any business segment whose manager has control over both costs and revenue. Like a cost center, however, a profit center generally does not nave control over investment funds. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. An example of a profit center is a companys cafeteria.

Investment Center (Managerial Accounting, Garrison, 10th edition, p. 528)

An investment center is any segment of an organization whose manager has control over cost, revenue, and investments in operating assets. Investment center managers are usually evaluated using return on investment (ROI) or residual income. An example of an investment center would be the corporate headquarters.

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 Segment Margin (Managerial Accounting, Garrison, 10th edition, p. 536)

To prepare an income statement for a particular segment, variable expenses are deducted from sales to yield the contribution margin for the segment. The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin . It represents the margin available after a segment has covered all of its own costs. The segment margin is the best gauge of the long-run profitability of a segment. There are two keys to building segmented income statements: 1. A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. 2. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. Income Statement Contribution Margin Format Television Division Sales Variable COGS Other variable costs Total variable costs Contribution margin Traceable fixed costs Division margin $300,000 120,000 30,000 150,000 150,000 90,000 $ 60,000

Traceable Fixed Cost (Managerial Accounting, Garrison, 10th edition, p. 533)

A Traceable costs or a segment is a fixed cost that is incurred because of the existence of a particular segment and would disappear over time if the segment itself disappeared. Only the traceable fixed costs are charged to a segment in the segmented income statements in the report. It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

Common Fixed Cost (Managerial Accounting, Garrison, 10th edition, p. 534)

A common cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. Common costs are not allocated to segments.

Income Statement
Sales Variable costs CM Traceable FC Division margin Common costs Net operating income Company $ 500,000 230,000 270,000 170,000 100,000 25,000 $ 75,000 Television $ 300,000 150,000 150,000 90,000 $ 60,000 Computer $ 200,000 80,000 120,000 80,000 $ 40,000

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 Return on Investment (ROI) (Managerial Accounting, Garrison, 10th edition, p. 542)

Rate of return is an approach for measuring managerial performance of a segment. The return on investment (ROI) is defined as net operating income divided by average operating assets. The higher the ROI of a business segment, the greater the profit generated in a segment operating assets. ROI measures net operating income earned relative to the investment in average operating assets. Return on Investment (ROI) = Net Operating Income Average Operating Assets

Net operating income, rather than net income, is used in the ROI formula. Net operating income is income before interest and taxes and is sometimes referred to as earning before interest and taxes (EBIT). Operating assets include cash, account receivable, inventory, plant and equipment, and all other assets held for productive use in the organization. Most companies use the net book value of depreciable assets to calculate average operating assets. We can modify this formula slightly by introducing sales as follows Return on Investment (ROI) = Net Operating Income Sales X Sales Average Operating Assets

The first term on the right-hand side of the equation is the margin. Margin is a measure of managements ability to control operating expenses in relation to sales. The lower the operating expenses per taka of sales, the higher the margin earned. Margin = Net Operating Income Sales

The second term of the right-hand side of the equation is turnover. Turnover is a measure of the sales that are generated for each taka invested in operating assets. Turnover = Sales Average Operating Assets

The following alternative form of the ROI formula, which will be used most frequently, combines margin and turnover: Return on Investment (ROI) = Margin X Turnover

Improve or Increase the ROI (Managerial Accounting, Garrison, 10th edition, p. 544)
There are three ways to increase ROI; 1. Increase Sales: With the help of increase in sales we can be able to increase ROI 2. Reduce Expenses: If we can be able to reduce expense, operating income will be increased. Due to the increase in operating income ROI will be increase 3. Reduce Assets: If we can be able to reduce average operating assets, ROI will be increased. By using JIT inventory as an operating asset can be reduced.

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 Criticisms of ROI (Managerial Accounting, Garrison, 10th edition, p. 547)

1. In the absence of the balanced scorecard, management may not know how to increase ROI. They may increase ROI in a way that is inconsistent with the companys strategy or they may take actions that increase ROI in the short run but harm the company in the long run. Example, cutting back on research and development cost. 2. Managers often inherit many committed costs over which they have no control. These committed costs may be relevant in assessing the performance of the business segment. 3. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but that would have negative impact on the managers performance evaluation.

Residual Income (Managerial Accounting, Garrison, 10th edition, p. 548)

Another approach to measuring an investment centers performance is residual income. Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. That means, Residual income measures net operating income earned less the minimum required return on average operating assets. Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.
Operating assets $ 100,000 Required rate of return 20% Minimum required return $ 20,000 Actual income Minimum required return Residual income $ 30,000 (20,000) $ 10,000

Transfer Pricing (Managerial Accounting, Garrison, 10th edition, p. 554)

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. There are three primary approaches to setting transfer prices: 1. Negotiated Transfer Prices 2. Transfer at Cost Prices at the selling division a. Variable Cost b. Full (Absorption Cost) Cost 3. Transfer at Market Prices

Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions. Advantages of negotiated transfer prices: a) They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. b) The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

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 Transfer at Cost Prices

Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. The drawbacks of this approach include: 1. Using full cost as a transfer price can lead to suboptimization because it does not distinguish between variable costs, which may be relevant to the transfer pricing decision, and fixed costs, which may be irrelevant. 2. If cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sale to an outside party. 3. Cost-based transfer prices do not provide incentives to control costs. If the actual costs of one division are passed on to the next, there is little incentive for anyone to work on reducing costs.

Transfer at Market Prices

A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem. It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. With no idle capacity the real cost of the transfer from the companys perspective is the opportunity cost of the lost revenue on the outside sale. It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole.

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 Problem 1
Caltec, Inc., produces and sells recordable CD and DVD packs. Revenue and cost information relating to the products follows: Product Sales Variable expenses per pack Traceable fixed expenses per year CD Tk. 8 3.20 138,000 DVD Tk. 25 17.50 45,000

Common fixed expenses in the company total Tk. 105000 annually. Last year the company produced and sold 37500 CD and 18000 DVD packs. Required Prepare an income statement for the year segmented by product lines. Show both amount and percent columns for the company as a whole and for each of the products.

Problem 2
The Magnetic Imaging Division of Medical Diagnostics, Inc., has reported the following results for last years operations Sales Net operating income Average operating assets Required 1. Compute the margin, turnover, and ROI for the Magnetic Imaging Division 2. Top management of has set a minimum required rate of return on average operating assets of 25%, What is the residual income for the year? Tk. 25 million Tk. 3 million Tk. 10 million

Problem 3
Regal Company reports the following: Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000 Required 1. What is Regal Companys ROI? 2. Regals manager was able to increase sales to $600,000 while operating expenses increased to $558,000. What will be the new ROI? 3. Assume that Regals manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets. What will be the new ROI? 4. Assume that Regals manager was able to reduce inventories by $20,000 using just-in-time techniques without affecting sales or operating expenses. What will be the new ROI?

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 Problem 4
Collyer Products, Inc., has a Valve Division that manufactures and sells a standard valve as follows: Capacity in units Selling price to outside customers Variable cost per unit Fixed cost per unit based on capacity 100,000 Tk. 30 Tk. 16 Tk. 9

The company has a pump division that could use this valve in one of its pumps. The Pump Division is currently purchasing 10,000 valves per year from an overseas supplier at a cost of Tk. 29 per valve. Required 1. Assume that the Valve Division has ample idle capacity to handle all of the Pump Divisions needs. What is the acceptable range, if any, for the transfer price between the two divisions? 2. Assume that the Valve Division is selling all of the valve that it can produce to outside customers. What is the acceptable range, if any, for the transfer price between the two divisions? 3. Assume again that the Valve Division is selling all of the valves that it can produce to outside customers. Also assume that Tk. 3 in variable expenses can be avoided on transfers within the company, due to reduce selling cost. What is the acceptable range, if any, for the transfer price between the two divisions? 4. Assume that the Pump Division needs 20,000 special high-pressure valves per year. The Valve Division variable costs to manufactures and ship the special valve would be Tk. 20 per unit. To produce these special valve, the Valve Division would gave to reduce its production and sales of regular valves from 100,000 units per year to 70,000 units per year. What is the lowest acceptable transfer price?

Problem 5
Marple Associates is a consulting firm that specializes in information systems for construction companies. A segmented income statement for the companys most recent year is given below: Company Sales Variable expenses Contribution Margin Traceable Fixed expenses Segment Margin Common Fixed expenses Net Operating income 750,000 405,000 345,000 168,000 177,000 120,000 57,000 Segment Houston Dallas 150,000 600,000 45,000 360,000 105,000 240,000 78,000 90,000 27,000 150,000

Required 1. By how much would the companys net operating income increase if Dallas increased its sales by Tk. 75,000 per year? Assume no change in cost behavior patterns. 2. Assume that sales in Houston increase by Tk. 50,000 next year and that sales in Dallas remain unchanged. Prepare a new segmented income statement for the company showing both amount and percentages.

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 Problem 6
A company has two segments, A and B. A segmented income statement for the companys most recent year is given below: Company Sales Variable expenses Contribution Margin Traceable Fixed expenses Segment Margin Common Fixed expenses Net Operating income 600,000 360,000 240,000 72,000 168,000 18,000 150,000 Segment A 400,000 260,000 140,000 20,000 120,000 B 200,000 100,000 100,000 52,000 48,000

The company would like to initiate an intensive advertising campaign in one of the two markets during the next month. The campaign cost Tk. 8000. Market studies indicate that such a campaign would increase sales in the A market by Tk. 70,000 or increase sales in the B market by 60,000 Required In which of the market would you recommend that the company focus its advertising campaign? Show computations to support your answer.

Problem 7
Bovine Company, a wholesale distributor of DVDs, has been experiencing losses for some time, as shown by its most recent monthly income statement below: Sales Variable expenses Contribution Margin Fixed expenses Net Operating income Taka 1,500,000 588,000 912,000 945,000 (33,000)

In an effort to isolate the problem, the president has asked for an income statement segmented by geographic market. Accordingly, the Accounting Department has developed the following data: Geographic Market South Central North Tk. 400,000 Tk. 600,000 Tk. 500,000
230000 320000 130000

Sales Variable expenses Traceable Fixed expenses

Tk. 240,000

Tk. 330,000

Tk. 200,000

Required 1. Prepare an income statement segmented by geographic market, as desired by the president. 2. The companys sales manager believes that sales in the Central geographic market could be increased by 15% if advertising were increased by Tk. 25000 each month. Would you recommend the increased advertising? Show computations to support your answer.

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 Problem 8
Provide the missing data in the following tabulation: X Tk. 800,000 72,000 ? ? ? 18% Division Y Tk. ? ? 130,000 4% 5 ? Z Tk. ? 40,000 ? 8% ? 20%

Sales Net operating income Average operating assets Margin Turnover ROI

Problem 9
Rains Nickless Ltd. has two divisions that operate in Rajshahi and Dhaka. Selected data on the two divisions follows: Division Sales Net operating income Average operating assets Required 1. Compute the ROI for each division 2. Assume that the company evaluates performance by use of residual income and that the minimum required return for any division is 16%. Compute the residual income for each division 3. Is the Dhaka Divisions greater residual income an indication that it is better managed? Explain. Rajshahi Tk. 9,000,000 630,000 3,000,000 Dhaka Tk. 20,000,000 1,800,000 10,000,000

Problem 10
Selected sales and operating data fo9r three divisions of three different companies are given below: A 6,000,000 300,000 1,500,000 15% Division B 10,000,000 900,000 5,000,000 18% C 8,000,000 180,000 2,000,000 12%

Sales Net operating income Average operating assets Minimum required rate of return Required

1. Compute the ROI for each division, using the formula stated in terms of margin and turnover. 2. Compute the residual income for each division

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 Problem 11
Nelcro Companys Electrical Division produces a high-quality transformer. Sales and cost data on the transformer follows: Selling price per unit on the outside market Variable cost per unit Fixed cost per unit based on capacity Capacity in units Tk. 40 Tk. 21 Tk. 9 60,000

Nelcro Company has a Motor Division that would like to begin purchasing this transformer from the Electrical Division. The Motor Division is currently purchasing 10,000 transformers each year from another company at a cost of Tk. 38 per transformer. Nelcro Company evaluates its division managers on the basis of divisional profits. Required 1. Assume that the Electrical Division is now selling only 50,000 transformer each year to outside customers. a. From the standpoint of Electrical Division, what is the lowest acceptable transfer price for transformers sold to the Motor Division? b. From the standpoint of Motor Division, what is the highest acceptable transfer price for transformers acquired from the Electrical Division? c. If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 10,000 transformers from the Electrical Division to the Motor Division? Why or why not? d. From the standpoint of the entire company, should a transfer take place? Why or why not? 1. Assume that the Electrical Division is now selling all of the transformers it can produce to outside customers a. From the standpoint of Electrical Division, what is the lowest acceptable transfer price for transformers sold to the Motor Division? b. From the standpoint of Motor Division, what is the highest acceptable transfer price for transformers acquired from the Electrical Division? c. If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 10,000 transformers from the Electrical Division to the Motor Division? Why or why not? d. From the standpoint of the entire company, should a transfer take place? Why or why not?

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 Problem 12
In each of the case below, assume that Division X has a product that can be sold either to outside customers or to Division Y of the same company for use in its production process. The managers of the divisions are evaluated based on their divisional profit. Case A Division X Capacity in units Number of units being sold to outside customers Selling price per unit to outside customers Variable cost per unit Fixed cost per unit based on capacity Division Y Number of units needed for production Purchase price paid to outside customer Required 1. 2. Refer to the data in case of A above, assume that Tk. 2 per unit in variable selling costs can be avoided on intracompany sales. If the managers are free to negotiate and make decisions on their own, will a transfer take place? If so, within what range will the transfer price fall? Explain Refer to the data in case of B above, assume that there is on reduction in variable selling costs on intracompany sales. If the managers are free to negotiate and make decisions on their own, will a transfer take place? If so, within what range will the transfer price fall? Explain 100,000 100,000 Tk. 50 Tk. 30 Tk. 8 20,000 Tk. 47 B 100,000 80,000 Tk. 35 Tk. 20 Tk. 6 20,000 Tk. 34

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