Segment Reporting and Decentralization
Chapter Twelve
Decentralization in Organizations
Benefits of
Decentralization
Lower-level managers
gain experience in
decision-making.
Lower-level decision
often based on
better information.
Top management
freed to concentrate
on strategy.
Decision-making
authority leads to
job satisfaction.
Lower level managers
can respond quickly
to customers.
Decentralization in Organizations
Lower-level managers
may make decisions
without seeing the
“big picture.”
Lower-level manager’s
objectives may not
be those of the
organization.
May be a lack of
coordination among
autonomous
managers.
Disadvantages of
Decentralization
May be difficult to
spread innovative ideas
in the organization.
Decentralization and Segment Reporting
An Individual Store
Quick Mart
A segment is any part or
activity of an organization
about which a manager
seeks cost, revenue, or
profit data. A segment can
be . . .
A Sales Territory
A Department
Cost, Profit, and Investments Centers
Cost
Center
Cost, profit,
and investment
centers are all
known as
responsibility
centers.
Profit
Center
Responsibility
Center
Investment
Center
Measuring Managers Performance
Cost
Center
Evaluation
Tool
Standard Cost/Flexible
Budget Variances
Profit
Center
Budgeted income
statement
Investment
Center
Return on investment
or residual income
Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
Net operating income
ROI =
Average operating assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.
Return on Investment (ROI) Formula
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating assets
ROI = Margin  Turnover
Improving R0I
Decrease
Expenses
Increase
Sales
Reduce
Operating
Assets
Three ways to improve ROI
Improving ROI – An Example
Regal Company reports the following:
Net operating income
Average operating assets
Sales
Operating expenses
$ 30,000
$ 200,000
$ 500,000
$ 470,000
What is Regal Company’s ROI?
ROI = Margin  Turnover
ROI =
Net operating income
Sales
×
Sales
Average operating assets
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.
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.
Regal Company reports the following:
Net operating income
Average operating assets
Sales
Operating expenses
$ 40,000
$ 200,000
$ 500,000
$ 460,000
Let’s calculate the new ROI.
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.
Regal Company reports the following:
Net operating income
Average operating assets
Sales
Operating expenses
$ 30,000
$ 180,000
$ 500,000
$ 470,000
Let’s calculate the new ROI.
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.
Regal Company reports the following:
Net operating income
Average operating assets
Sales
Operating expenses
$ 50,000
$ 230,000
$ 535,000
$ 485,000
Let’s calculate the new ROI.
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.
B.
C.
D.
E.
5.33%.
7.00%.
12.00%.
20.00%.
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)
B)
C)
D)
1
1.5
2
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 required
return 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.
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. Yes
b. 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. Yes
b. 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. $240,000
b. $ 45,000
c. $ 15,000
d. $ 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. Yes
b. 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?
Recall the following
information for the Retail
Division of Zepher, Inc.
Assume the following
information for the Wholesale
Division of Zepher, Inc.
Retail
Wholesale
Operating assets
$ 100,000 $ 1,000,000
Required rate of return ×
20%
20%
Minimum required return $ 20,000 $ 200,000
Retail
Wholesale
Actual income
$ 30,000 $ 220,000
Minimum required return
(20,000)
(200,000)
Residual income
$ 10,000 $
20,000
Practice
At Pittsburgh Pipe Fittings the required rate of return on
invested capital is 8%.
Div A
Sales Revenue
Operating Income
Average Assets
Margin
Turnover
ROI
Residual Income
$10,000,000
$ 2,000,000
$ 2,500,000
Practice, continued
At Pittsburgh Pipe Fittings the required rate of return on
invested capital is 8%.
Div B
Sales Revenue
Operating Income
Average Assets
Margin
Turnover
ROI
Residual Income
$400,000
20%
1
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)
B)
C)
D)
$ 37,080
$ 33,750
$ 45,000
$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.
B.
C.
D.
E.
2.5%.
10.0%.
12.5%.
20.0%.
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.
B.
C.
D.
E.
$(24,000).
$24,000.
$96,000.
$120,000.
some other amount.