Chapter
12
Decentralization
and
Segment Reporting
12-2
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Differentiate between a cost centre, profit
centre and investment centre 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.
© McGraw-Hill Ryerson Limited., 2001
12-3
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 organization’s 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.
© McGraw-Hill Ryerson Limited., 2001
12-4
Decentralization in Organizations
Benefits of
Decentralization
Top
Top management
management
freed
freed to
to concentrate
concentrate
on
onstrategy.
strategy.
Lower-level
Lower-level managers
managers
gain
gain experience
experience in
in
decision-making.
decision-making.
Decision-making
Decision-making
authority
authority leads
leads to
to
job
jobsatisfaction.
satisfaction.
Lower-level
decision
Lower-level decision
often
oftenbased
based on
on
better
betterinformation.
information.
Improves
Improves ability
ability to
to
evaluate
evaluate managers.
managers.
© McGraw-Hill Ryerson Limited., 2001
12-5
Decentralization in Organizations
Lower-level
Lower-level managers
managers
may
may make
make decisions
decisions
without
without seeing
seeing the
the
“big
“bigpicture.”
picture.”
Lower-level
Lower-level manager’s
manager’s
objectives
objectives may
may not
not
be
be those
those of
of the
the
organization.
organization.
May
May be
be aa lack
lack of
of
coordination
coordination among
among
autonomous
autonomous
managers.
managers.
Disadvantages of
Decentralization
May
May be
be difficult
difficult to
to
spread
spreadinnovative
innovative ideas
ideas
in
in the
the organization.
organization.
© McGraw-Hill Ryerson Limited., 2001
12-6
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
Canadian Tire
Tire
A Sales Territory
A Service Centre
© McGraw-Hill Ryerson Limited., 2001
12-7
Cost, Profit and Investment Centres
os
t
C
o
st
C
st
Co
Cost Centre
A segment whose
manager has
control over costs,
but not over
revenues or
investment funds.
© McGraw-Hill Ryerson Limited., 2001
12-8
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
© McGraw-Hill Ryerson Limited., 2001
12-9
Cost, Profit and Investment Centres
Investment Centre
A segment whose
manager has
control over costs,
revenues, and
investments in
operating assets.
Corporate Headquarters
© McGraw-Hill Ryerson Limited., 2001
12-10
Cost, Profit and Investment Centres
Cost
Cost
Centre
Centre
Cost, profit
and investment
centres are all
known as
responsibility
centres.
Profit
Profit
Centre
Centre
Investment
Investment
Centre
Centre
Responsibility
Responsibility
Centre
Centre
© McGraw-Hill Ryerson Limited., 2001
12-11
Traceable and Common Costs
Fixed
Costs
Traceable
Costs arise because
of the existence of
a particular segment
Common
Costs arise because
of overall operating
activities.
© McGraw-Hill Ryerson Limited., 2001
12-12
Traceable and Common Costs
Fixed
Costs
Traceable
Costs arise because
of the existence of
a particular segment
Don’t allocate
common costs.
Common
Costs arise because
of overall operating
activities.
© McGraw-Hill Ryerson Limited., 2001
12-13
Identifying Traceable Fixed Costs
Traceable costs would disappear over
time if the segment itself disappeared.
No computer
division means . . .
No computer
division manager.
© McGraw-Hill Ryerson Limited., 2001
12-14
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.
© McGraw-Hill Ryerson Limited., 2001
12-15
Levels of Segmented Statements
W ebber,Inc.has tw o divisions.
Webber, Inc.
Computer Division
Television Division
Let’s
Let’s look
look more
more closely
closely at
at the
the Television
Television
Division’s
Division’s income
income statement.
statement.
© McGraw-Hill Ryerson Limited., 2001
12-16
Levels of Segmented Statements
Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales
$300,000
Variable COGS
120,000
Other variable costs
30,000
Total variable costs
150,000
Contribution margin
150,000
Traceable fixed costs
90,000
Segment margin
$ 60,000
Cost
Cost of
of goods
goods
sold
sold consists
consists of
of
variable
variable
manufacturing
manufacturing
costs.
costs.
Fixed
Fixed and
and
variable
variable costs
costs
are
are listed
listed in
in
separate
separate
sections.
sections.
© McGraw-Hill Ryerson Limited., 2001
12-17
Levels of Segmented Statements
Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales
$300,000
Variable COGS
120,000
Other variable costs
30,000
Total variable costs
150,000
Contribution margin
150,000
Traceable fixed costs
90,000
Segment margin
$ 60,000
Segment
Segment margin
margin
is
is Television’s
Television’s
contribution
contribution
to
to overall
overall
operations.
operations.
© McGraw-Hill Ryerson Limited., 2001
12-18
Levels of Segmented Statements
Let’s see how the Television
Division fits into Webber, Inc.
© McGraw-Hill Ryerson Limited., 2001
12-19
Levels of Segmented Statements
Sa les
Va ria ble costs
CM
Tra ce a ble FC
Division m a rgin
Com m on costs
Ne t incom e
Incom e Statem ent
Com pany
Television
$ 300,000
(150,000)
150,000
(90,000)
60,000
Com pute r
Segment
Segment margin
margin has
has now
now
become
become division
division margin.
margin.
Let’s add the C om puter
D ivision’s num bers.
© McGraw-Hill Ryerson Limited., 2001
12-20
Levels of Segmented Statements
Sa les
Va ria ble costs
CM
Tra ce a ble FC
Division m a rgin
Com m on costs
Ne t incom e
Incom e Statem ent
Com pany
Television
$ 500,000
$ 300,000
(230,000)
(150,000)
270,000
150,000
(170,000)
(90,000)
100,000
60,000
Com pute r
$ 200,000
(80,000)
120,000
(80,000)
40,000
© McGraw-Hill Ryerson Limited., 2001
12-21
Levels of Segmented Statements
Sa les
Va ria ble costs
CM
Tra ce a ble FC
Division m a rgin
Com m on costs
Ne t incom e
Incom e Statem ent
Com pany
Television
$ 500,000
$ 300,000
(230,000)
(150,000)
270,000
150,000
(170,000)
(90,000)
100,000
60,000
(25,000)
$ 75,000
Com pute r
$ 200,000
(80,000)
120,000
(80,000)
40,000
Common
Common costs
costs arise
arise because
because of
of overall
overall
operating
operating activities.
activities. ABC
ABC may
may be
be helpful
helpful
in
in the
the analysis
analysis of
of common
common costs.
costs.
© McGraw-Hill Ryerson Limited., 2001
12-22
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.
Let’s see how this w orks!
© McGraw-Hill Ryerson Limited., 2001
12-23
Traceable Costs Can Become Common Costs
Webber’s Television Division
Product
Lines
Television
Division
Regular
U.S. Sales
Big Screen
Foreign Sales
U.S. Sales
Foreign Sales
Sales
Territories
© McGraw-Hill Ryerson Limited., 2001
12-24
Traceable Costs Can Become Common Costs
Income Statement
Television
Division
Regular
S ale s
$ 200,000
Variable costs
(95,000)
CM
105,000
Tra ce able FC
(45,000)
Product line margin
60,000
Commo n costs
Divisional margin
Big Screen
$ 100,000
(55,000)
45,000
(35,000)
10,000
W e obtained the follow ing inform ation from
the R egular and B ig Screen segm ents.
© McGraw-Hill Ryerson Limited., 2001
12-25
Traceable Costs Can Become Common Costs
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
(150,000)
(95,000)
CM
150,000
105,000
Traceable FC
(80,000)
(45,000)
Product line margin
70,000
60,000
Common costs
10,000
Divisional margin
$ 60,000
Big Screen
$ 100,000
(55,000)
45,000
(35,000)
10,000
Fixed
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000
© McGraw-Hill Ryerson Limited., 2001
12-26
Traceable Costs Can Become Common Costs
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
(150,000)
(95,000)
CM
150,000
105,000
Traceable FC
(80,000)
(45,000)
Product line margin
70,000
60,000
Common costs
10,000
Divisional margin
$ 60,000
Big Screen
$ 100,000
(55,000)
45,000
(35,000)
10,000
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.
© McGraw-Hill Ryerson Limited., 2001
12-27
Traceable Costs Can Become Common Costs
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
(150,000)
(95,000)
CM
150,000
105,000
Traceable FC
(80,000)
(45,000)
Product line margin
70,000
60,000
Common costs
10,000
Divisional margin
$ 60,000
Big Screen
$ 100,000
(55,000)
45,000
(35,000)
10,000
The remaining $10,000 cannot be traced to
either the Regular or Big Screen product lines.
© McGraw-Hill Ryerson Limited., 2001
12-28
Segment Margin
Profits
The segment margin is the best gauge of
the long-run profitability of a segment.
Time
© McGraw-Hill Ryerson Limited., 2001
12-29
Hindrances to Proper Cost Assignment
Three Problem s
Omission of some
costs in the
assignment process.
Assignment of costs
to segments that are
really common costs of
the entire organization.
The use of inappropriate
methods for allocating
costs among segments.
© McGraw-Hill Ryerson Limited., 2001
12-30
Omission of Costs
Costs assigned to a segment should include all
costs attributable to that segment from the
company’s entire value chain.
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
R&D
Product
Design
Customer
Manufacturing Marketing Distribution Service
© McGraw-Hill Ryerson Limited., 2001
12-31
Inappropriate Methods of Allocating
Costs Among Segments
Arbitrarily dividing
common costs
among segments
Inappropriate
allocation base
Failure to trace
costs directly
Segment
1
Segment
2
Segment
3
Segment
4
© McGraw-Hill Ryerson Limited., 2001
12-32
Revenue Variance Analysis
Consider the following example for CardCo:
Budget sales in units:
Deluxe cards
Standard cards
Budget price per unit:
Deluxe cards
Standard cards
Market volume expected:
Deluxe cards
Standard cards
Variable cost per unit:
Deluxe cards
Standard cards
Budget
Actual
14,000
6,000
17,000
5,000
$18
$ 9
$16
$10
75,000
95,000
85,000
90,000
$ 8
$ 3
$ 8
$ 3
© McGraw-Hill Ryerson Limited., 2001
12-33
Revenue Variance Analysis
CardCo Actual and Budgeted Results
Actual Results
Revenue:
Deluxe
Standard
(17,000x16) $ 272,000
(5,000x10)
50,000
322,000
Variable expenses:
Deluxe
(17,000x8)
136,000
Standard
(5,000x3)
15,000
151,000
Contribution margin
$ 171,000
Flexible Budget
Master Budget
Actual results are based on
the actual quantity sold
multiplied by the actual
selling price
or
variable cost
© McGraw-Hill Ryerson Limited., 2001
12-34
Revenue Variance Analysis
CardCo Actual and Budgeted Results
Actual Results
Flexible Budget
Master Budget
Revenue:
Deluxe
Standard
(17,000x16) $ 272,000 (17,000x18) $ 306,000
(5,000x10)
50,000
(5,000x9)
45,000
322,000
351,000
Variable expenses:
Deluxe
(17,000x8)
136,000 (17,000x8)
136,000
Standard
(5,000x3)
15,000
(5,000x3)
15,000
151,000
151,000
Contribution
margin
$ 171,000
$ 200,000
Flexible
budget
results are
based on the actual quantity
sold multiplied by the budgeted
selling price
or
variable cost
© McGraw-Hill Ryerson Limited., 2001
12-35
Revenue Variance Analysis
CardCo Actual and Budgeted Results
Actual Results
Flexible Budget
Revenue:
Deluxe
Standard
Master Budget
(17,000x16) $ 272,000 (17,000x18) $ 306,000 (14,000x18) $
(5,000x10)
50,000
(5,000x9)
45,000
(6,000x9)
322,000
351,000
Variable expenses:
Deluxe
(17,000x8)
136,000 (17,000x8)
136,000 (14,000x8)
Standard
(5,000x3)
15,000
(5,000x3)
15,000
(6,000x3)
Master budget
results
are
151,000
151,000
based onmargin
the budgeted
quantity
Contribution
$ 171,000
$ 200,000
$
252,000
54,000
306,000
112,000
18,000
130,000
176,000
sold multiplied by the budgeted
selling price
or
variable cost
© McGraw-Hill Ryerson Limited., 2001
12-36
Revenue Variance Analysis
CardCo Actual and Budgeted Results
Actual Results
Revenue:
Deluxe
Standard
Flexible Budget
(17,000x16) $ 272,000 (17,000x18) $
(5,000x10)
50,000
(5,000x9)
322,000
Variable expenses:
Deluxe
(17,000x8)
136,000 (17,000x8)
Standard
(5,000x3)
15,000
(5,000x3)
151,000
Contribution margin
$ 171,000
$
Master Budget
306,000 (14,000x18) $ 252,000
45,000 (6,000x9)
54,000
351,000
306,000
136,000
15,000
151,000
200,000
(14,000x8)
(6,000x3)
112,000
18,000
130,000
$ 176,000
Sales Price Variance
$29,000 U
© McGraw-Hill Ryerson Limited., 2001
12-37
Revenue Variance Analysis
CardCo Actual and Budgeted Results
Actual Results
Flexible Budget
Revenue:
Deluxe
Standard
(17,000x16) $ 272,000 (17,000x18) $
(5,000x10)
50,000
(5,000x9)
322,000
Variable expenses:
Deluxe
(17,000x8)
136,000 (17,000x8)
Standard
(5,000x3)
15,000
(5,000x3)
151,000
Contribution margin
$ 171,000
$
Master Budget
306,000 (14,000x18) $ 252,000
45,000 (6,000x9)
54,000
351,000
306,000
136,000
15,000
151,000
200,000
(14,000x8)
(6,000x3)
112,000
18,000
130,000
$ 176,000
$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
© McGraw-Hill Ryerson Limited., 2001
12-38
Revenue Variance Analysis
CardCo Actual and Budgeted Results
Actual Results
Revenue:
Deluxe
Standard
Flexible Budget
(17,000x16) $ 272,000 (17,000x18) $
(5,000x10)
50,000
(5,000x9)
322,000
Variable expenses:
Deluxe
(17,000x8)
136,000 (17,000x8)
Standard
(5,000x3)
15,000
(5,000x3)
151,000
Contribution margin
$ 171,000
$
Master Budget
306,000 (14,000x18) $ 252,000
45,000 (6,000x9)
54,000
351,000
306,000
136,000
15,000
151,000
200,000
(14,000x8)
(6,000x3)
112,000
18,000
130,000
$ 176,000
Sales Quantity Variance
$24,000 F
© McGraw-Hill Ryerson Limited., 2001
12-39
Revenue Variance Analysis
! The Sales Quantity Variance can further
be broken down into the:
"Market Volume Variance
{
=
Actual
market
volume
-
}
Budget
market
volume
x
Expected
market
share %
x
Budgeted
CM per
unit
"Market Share Variance
[ {
=
Actual
sales
quantity
-
Actual
market
share
-
}]
Expected
market
share
x
Budgeted
CM per
unit
© McGraw-Hill Ryerson Limited., 2001
12-40
Revenue Variance Analysis
! For CardCo, the Sales Quantity 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
❶ =16,772 F
Total Market Volume Variance
"Market Share Variance
Deluxe=[17,000-(85,000 x 14,000/75,000)] x (18-8) =11,333 F
Standard=[5,000-(90,000 x 6,000/95,000)] x (9-3) = 4,105 U
❷ = 7,228 F
Total Market Share Variance
Sales Quantity Variance = ❶ + ❷
=24,000 F
© McGraw-Hill Ryerson Limited., 2001
12-41
Revenue Variance Analysis
! The Sales Quantity Variance can also be
broken down into the:
"Sales Mix Variance
=
{
}
Actual sales
Actual sales - quantity at
quantity expected sales
mix
x Budgeted CM
per unit
"Sales Quantity Variance
=
{
Actual sales
quantity at
expected sales
mix
-
}
Anticipated
sales quantity
x Budgeted CM
per unit
© McGraw-Hill Ryerson Limited., 2001
12-42
Revenue Variance Analysis
! For CardCo, the Sales Quantity Variance
of $24,000F is made up of:
"Sales Mix Variance
Deluxe=[17,000-(22,000 x14/20)] x (18-8)
Standard=[(5,000-22,000 x 6/20)] x (9-3)
Total Sales Mix Variance
=16,000 F
= 9,600 U
❶ = 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
❷= 17,600F
Sales Quantity Variance = ❶ + ❷ = 24,000F
© McGraw-Hill Ryerson Limited., 2001
12-43
Costs factors to consider in
marketing strategy:
Transport
Warehousing
Marketing Strategy
Advertising
Selling
Credit
© McGraw-Hill Ryerson Limited., 2001
12-44
Order Getting and Order Filling
More Discretionary
Order Getting
Advertising
Selling Com m issions
Travel
Ord er Filling
W arehousing
Tran sportation
Packin g
Credit
© McGraw-Hill Ryerson Limited., 2001
12-45
Return on Investment (ROI) Formula
Income
Incomebefore
beforeinterest
interest
and
andtaxes
taxes(EBIT)
(EBIT)
N etoperating incom e
R O I=
A verage operating assets
Cash,
Cash,accounts
accountsreceivable,
receivable,inventory,
inventory,
plant
plant and
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.
© McGraw-Hill Ryerson Limited., 2001
12-46
Return on Investment (ROI) Formula
Regal Company reports the following:
Net operating income
Average operating assets
Sales
R O I=
$30,000
$200,000
$ 30,000
$ 200,000
$ 500,000
= 15%
© McGraw-Hill Ryerson Limited., 2001
12-47
Controlling the Rate of Return
Three ways to improve ROI . . .
#Increase
Sales
$Reduce
Expenses
%Reduce
Assets
© McGraw-Hill Ryerson Limited., 2001
12-48
Controlling the Rate of Return
! Regal’s 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.
Let’s calculate the new R O I.
© McGraw-Hill Ryerson Limited., 2001
12-49
Return on Investment (ROI) Formula
We can modify our original formula slightly:
Margin
RO I =
×
Netoperating incom e
Sales
R O I = $42,000
$600,000
×
×
Turnover
Sales
A verage operating assets
$600,000
$200,000
R O I = 21%
We
We increased
increased ROI
ROI from
from 15%
15% to
to 21%
21%
© McGraw-Hill Ryerson Limited., 2001
12-50
ROI and the Balanced Scorecard
The balanced scorecard provides managers with
a roadmap that indicates how the company
intends to increase its ROI.
$Reduce
Expenses
#Increase
%Reduce
Sales
Assets
I’m
I’m glad
glad we
we used
used the
the
balanced
balanced scorecard
scorecard
to
to tell
tell which
which approach
approach
is
is best.
best.
© McGraw-Hill Ryerson Limited., 2001
12-51
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.
© McGraw-Hill Ryerson Limited., 2001
12-52
Criticisms of ROI
! As division manager at Winston, Inc., your
compensation package includes a salary plus bonus
based on your division’s 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?
© McGraw-Hill Ryerson Limited., 2001
12-53
Criticisms of ROI
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!
© McGraw-Hill Ryerson Limited., 2001
12-54
Criticisms of ROI
Gee . . .
I thought we were
supposed to do what
was best for the
company!
© McGraw-Hill Ryerson Limited., 2001
12-55
Residual Income - Another Measure of
Performance
Net operating income
above some minimum
return on operating
assets
© McGraw-Hill Ryerson Limited., 2001
12-56
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.
Let’s calculate residualincom e.
© McGraw-Hill Ryerson Limited., 2001
12-57
Residual Income
Operating
$$100,000
Operating assets
assets
100,000
Required
20%
Required rate
rate of
ofreturn
return ××
20%
Required
$$ 20,000
Required return
return
20,000
Actual
Actual return
return
Required
Required return
return
Residual
Residual income
income
$$ 30,000
30,000
(20,000)
(20,000)
$$ 10,000
10,000
© McGraw-Hill Ryerson Limited., 2001
12-58
Motivation and Residual Income
R esidualincom e encourages m anagers to
m ake profitable investm ents thatw ould
be rejected by m anagers using R O I.
© McGraw-Hill Ryerson Limited., 2001
Appendix
12A
Transfer Pricing
12-60
Transfer Pricing
! Fundamental Objective:
" Setting transfer prices to motivate the
managers to act in the
“best interest of the overall company”
© McGraw-Hill Ryerson Limited., 2001
12-61
Three Common Approaches:
❷
Set transfer price using either:
1. Variable Cost, or
2. Full (Absorption) Cost
❶
Managers negotiate
their own transfer price
❸
Set transfer price at
market price
© McGraw-Hill Ryerson Limited., 2001
12-62
End of Chapter 12
Let’s getto w ork
on m y R O I ...
© McGraw-Hill Ryerson Limited., 2001