Segmented Reporting,

Investment Center Evaluation

Chapter 10 HM

Last Meeting Review

1.
2.
3.
4.
5.
6.

How & Why adopting standard costing

systems
State the purpose of a standard cost sheet.
Describe basic concepts of variance
analysis
Compute materials & labor variances
Calculate variable & fixed overhead
variances.
Prepare journal entries for variances

Fixed Overhead Variances

Total

FO Variances = Actual Fixed

Overhead Applied Fixed
Overhead
Applied Fixed overhead =
(Standard fixed overhead rate) x
(Standard hours allowed for
actual production)
Budgeted fixed overhead =
(Standard fixed overhead rate) x
(Practical activity)
3

Exercise 9-14

Exercise 9-14
Actual

Fixed Overhead = $ 4,140,200

Budgeted Fixed Overhead = 288,000 x
$14.4 = $4,147,200
Applied Fixed Overhead = 280,000 x
$14.4 = $4,032,000
Fixed Overhead Spending Variance
Fixed Overhead Volume Variance
Total Fixec Overhead Variances

$
(7,000.00)
$
115,200.00
$
108,200.00

F
U
Underappli
ed

LEARNING OBJECTIVES
1.
2.

3.
4.

Explain how & why firms choose to

decentralize.
Explain the difference between
absorption & variable costing, &
prepare segmented income statements.
Compute & explain return on
investment (ROI).
Compute & explain residual income &
economic value added (EVA)
6

Responsibility Accounting
System
Management

Control System
measures the results of
responsibility centers according
to information managers need to
operate their centers
approaches to manage their
diverse and complex activities:
centralized
Decentralized freedom for lower
manager to make decision
(autonomy)

LO 1

Management Control System

Approach

Pros & Cons of

Decentralization
Benefit

Cost

For ease of
gathering, using
local information
To focus central
management
To train & motivate
segment
managers,
To enhance
competition &
expose segments
to market forces

Leads to
suboptimal
(incongruent)
decision making
Focuses the
managers
attention on the
subunit rather than
company as a
whole
Increase the costs
of gathering
information
9

LO 1

Divisions
Divisions
Firm

commonly desentralize by
creating divisions differentiated
by:
types of goods or services
produced
geographic lines
type of responsibility
Responsibility Center: Is a
segment of the business whose
manager is accountable for

10

Decentralized Divisions
Based

on types of goods or
services produced

11

Responsibility centers
Major types of responsibility centers are:
Cost centers
Manager responsible for cost only

Revenue center
Manager responsible for sales only

Profit center
Manager responsible for sales & costs

Investment center
Manager responsible for sales, costs, &
capital investment
12

Measuring Performance of Profit

Centers
2

ways to calculate income

absorption costing
variable costing (direct costing)
They

differ in the treatment of

fixed factory overhead.

13

Inventory
Inventory Valuation:
Valuation: Background
Background
Units in beginning inventory

Units produced
Units sold ($300 per unit)
Variable costs per unit

10,000
8,000

Direct materials

$ 50

Direct labor
Variable overhead

100
50

Fixed costs
Fixed overhead per unit produced

25

Fixed selling & administrative

100,000

14

Absorption Costing
Direct materials
Direct labor
Variable overhead
Fixed overhead per unit produced
Unit product cost

50
100
50
25
$ 225

Value of ending inventory =

2,000 x $ 225 = $ 450,000

15

Variable Costing
Direct materials
Direct labor
Variable overhead
Unit product cost

50
100
50
$ 200

Value of ending inventory =

2,000 x $ 200 = $ 400,000

16

Absorption Income
Statement
Sales ($300 x 8,000)
Less Cost of goods sold
Gross margin
Less S&A expenses
Operating income

$ 2,400000
1,800,000
$ 600,000
100,000
$ 500,000

CGS = 8,000 x $ 225

= $1,800,000

17

Variable Income Statement

Sales
Less variable expenses
Contribution margin
Less fixed costs
Operating income

2,400,000
1,600,000
800,000
350,000
$

450,000

Variable costs: 8,000 x $200

Fixes costs: $250,000 + 100,000

18

Absorption vs. Variable

19

Absorption vs Variable
Generally

accepted accounting principles (GAAP)

require absorption costing for external reporting
variable costing is an invaluable managerial tool,
can supply vital cost information for decision making
and control
The difference between variable costing &
absorption costing year to year is equal to the
change in fixed overhead.
Under absorption costing, fixed overhead is assigned to
inventory produced.
Under variable costing, fixed overhead is a period expense
Absorption-costing income Variable-costing income = Fixed
overhead rate x (Units produced Units sold)
20

Exercise 10-3

24

Solution
Fixed Overhead
10750
1. Rate =
0/ 25000 =
4.3
Perbedaan Income Absorpsi - Variable:
=Fixed Overhead Rate x
(Unit Produced - Unit Sold)
= $4.3 x (25000-23000)
= $8,600

a. Income Statement Variable

Costing

b. Income Statement Absorption

Costing
$
598,000

Sales
Less: Variable Expenses
Variable COGS
Variable Selling & Adm
Expenses

Less: COGS
Gross
Margin

$
294,400
$
92,000
$
386,400
$
211,600

Contribution Margin
Less: Fixed Expenses
$

Sales

$
598,000
$
393,300
$
204,700
$
118,800
$
85,900

Less: Selling
adm
85,900
&77,300
= $8,600
Operating Income

25

Evaluating Profit-Center
Managers
Variable

costing ensures that direct

relationship between sales & income holds
whereas absorption costing does not

The

product cost under variable costing is $10 per unit

for both years
the product cost under absorption costing is $20 per unit
in 2007 and $30 per unit in 2008 (assuming expected
actual volume used to compute predetermined FO rate)

26

Under

variable costing, income increased by

$75,000 (from -$25,000 to a profit of
$50,000).
However, under absorption costing, operating
income decreased by $25,000 (from a profit of
$25,000 to $0) despite the increase in sales! 27

Segment
Segment Reporting
Reporting
Segment

is a subunit of a
company of sufficient importance
to warrant performance reports
Can be in form of: divisions,
department, product lines, etc.
Fixed expenses on Segmented
income statement:
Direct fixed expenses
Common Fixed expenses
28

Fixed
Fixed Expenses
Expenses
Direct

fixed expenses are directly

traceable to a segment & therefore
avoidable. If segment eliminated, so are
expenses
i.e: rent for regional office /a product line
warehouse

Common

fixed jointly caused by two or

more segments. These expenses persist
even if one of the segments to which they
are common is eliminated
i.e: CEO salary, headquarter building
depreciation
29

Comparative income statements

Segment margin is
contribution to firms
common fixed costs.

30

Exercise 10-4

31

Measuring the Performance of

Investment Centers Using ROI
ROI

relates operating profits to

assets employed.
ROI

Operating Income
Average Operating Assets

Operating

income = earnings before interest

and taxes
Operating assets = all assets acquired to
generate operating income, including cash,
receivables, inventories, land, buildings, and
equipment
32

Margin & Turnover

Margin

tells how many cents of

operating income result from
each dollar of sales
Turnover tells how many dollars
of sales result from every dollar
invested in operating assets.

33

Exercise 10-6

OI

= sales expenses
= 50.000 48.000 = 2.000
Margin = OI/Sales
= 2.000/50.000 = 4%
Turnover = Sales/Operating asset
= 50.000/10.000 = 5x
ROI = Margin x Turnover
= 4% x 5 = 20%
34

Illustration

Computing

the

margin and
turnover ratios
for each division
gives a better
picture of what
caused the
change in rates
35

ROI Pros & Cons

Pros

Cons

Encourages
managers to
focus on
Relationship
among sales,
expenses
Cost efficiency
Operating asset
efficiency

Can product a
narrow focus on
divisional
profitability at
expense of
profitability for
overall firm
Encourages
managers to
focus on short
run at expense of
long run

36

Focus on short run at expense of

long run - example
Lay

off five of the highest-paid

salespeople.
Cut the advertising budget for the
fourth quarter by 50 percent.
Delay all promotions within the division
for three months.
Reduce the preventive maintenance
budget by 75 percent.
Use cheaper raw materials for fourthquarter production.
37

Measuring the Performance of

Investment Centers Using Residual
Income
Residual

income is the difference

between operating income and
minimum dollar return on sales.

Minimum

rate of return = hurdle rate

of the divisions/projects

38

LO 4

ADVANTAGES &
DISADVANTAGES: Residual Income
Advantage
Gives
another view
of project
profitability

Disadvantage
s
Can
encourage
short run
orientation
Direct
comparisons
are difficult
39

Exercise 10-11

Required
Compute Residual Income of each scenario
Compute ROI of each scenario

Which alternatives
that should manager
The MP3 player is added.
choose, if the
The voice recorder is added.
performance
Both investments are added.
Neither investment is made; the status quo is maintained
evaluation based on
(1) ROI, (2) Residual
Income?

40

Answer
ROI MP3 Player
ROI Voice recorder
Residual Income MP3 Player
Residual Income Voice Recorder

Alternatives
Operating income
Operating Asset
ROI
Minimum required
rate
Residual income

ROI: Loss on not

selecting both
project

14.50%
14.00%
$20,000.00
$15,000.00

Without
Investment

MP3 Player

Voice recorder

Both Projects

2,700,000.00

2,816,000.00

2,805,000.00

2,921,000.00

18,000,000.00

18,800,000.00

18,750,000.00

19,550,000.00

15.00%

14.98%

14.96%

14.94%

12%

12%

12%

12%

540,000.00

560,000.00

555,000.00

575,000.00

Operating income if invested in

assets
operating asset
Fund invested at 12%
Loss on not invest in projects

$221,000
$1,550,000
$186,000
$35,000

41

Economic Value Added (EVA)

EVA

links net income (return) to capital

employed
Economic value added (EVA)
= After Tax Operating Income (% cost of capital x
Capital employed)

EVA

is a dollar figure, not a percentage rate

of return (as a form of residual income)
if EVA is positive, then the company is
creating wealth; if EVA is negative, then the
company is destroying wealth
42

Cost

of Capital

C* = [y x (Equity/CAPITAL)] +
(1+t) x i x (Debt/CAPITAL)

= required rate of return on

equity
t = marginal tax rate
i = interest rate for debt
Capital = equity + debt
43

Illustration EVA calculation

44

CHAPTER 10

THE
THE END
END

45