ADVANCED MANAGEMENT
ACCOUNTING
PPT 10-1

PPT 10-2

Learning Objectives
 Explain why firms choose to decentralize
 Explain the role of transfer pricing in a decentralized firm.
 Discuss the methods of setting transfer prices.
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Decentralization:
The Major Issues
 The degree of decentralization
 Performance measurement
 Management compensation
 The setting of transfer prices
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Reasons for Decentralization
There are many reasons to explain why firms decide to decentralize, including:
1. better access to local information
2. cognitive limitations
3. more timely response
4. focusing of central management
5. training and evaluation
6. motivation
7. enhanced competition
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10-6
Decentralization in Organizations
Advantages of
Decentralization
Lower-level managers
Top management freed to concentrate on strategy.
gain experience in decision-making.
Decision-making authority leads to job satisfaction.
Lower-level decisions often based on better information.
Lower level managers can respond quickly
PPT 10-6 to customers.

10-7
Decentralization in Organizations
May be a lack of coordination among autonomous managers.
Lower-level managers may make decisions without seeing the
“big picture.”
Disadvantages of
Decentralization
Lowerlevel manager’s objectives may not be those of the organization.
May be difficult to spread innovative ideas in the organization.
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10-8
Decentralization and Segment
Reporting
A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data.
An Individual Store
Quick Mart
A Sales Territory
A Service Center
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10-9
Superior Foods: Segmented by
Geographic Regions
Superior Foods Corporation
$500,000,000
East
$75,000,000
Oregon
$45,000,000
West
$300,000,000
Washington
$50,000,000
California
Midwest
$55,000,000
$120,000,000
South
$70,000,000
Mountain States
$85,000,000
Superior Foods Corporation could segment its business by geographic region.
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10-10
Superior Foods: Segmented by
Customer Channel
Convenience Stores
$80,000,000
Superior Foods Corporation
$500,000,000
Supermarket Chains
$280,000,000
Wholesale Distributors
$100,000,000
Supermarket Chain A
$85,000,000
Supermarket Chain B
$65,000,000
Supermarket Chain C
$90,000,000
Supermarket Chain D
$40,000,000
Drugstores
$40,000,000
Superior Foods Corporation could segment its business by customer channel.
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10-11
Keys to Segmented Income
Statements
There are two keys to building segmented income statements:
A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin.
Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.
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10-12
Identifying Traceable Fixed
Costs
Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared.
No computer division means . . .
No computer division manager.
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10-13
Identifying Common Fixed Costs
Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated.
No computer division but . . .
We still have a
CEO.
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10-14
Traceable Costs Can Become
Common Costs
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.
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10-15
Segment Margin
The segment margin , which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment.
Time PPT 10-15

10-16
Traceable and Common Costs
Traceable
Fixed
Costs
Don’t allocate common costs to segments.
Common
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10-17
Activity-Based Costing
Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments.
Assume that three products, 9-inch, 12-inch, and 18-inch pipe, share 10,000 square feet of warehousing space, which is leased at a price of $4 per square foot.
If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then ABC can be used to trace the warehousing costs to the three products as shown.
Warehouse sq. ft.
Lease price per sq. ft.
Total lease cost
9-inch
1,000
$ 4
$ 4,000
Pipe Products
12-inch
4,000
18-inch
5,000
$ 4
$ 16,000
$
$
4
20,000
Total
10,000
$ 4
$ 40,000
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10-18
Levels of Segmented Statements
Webber, Inc. has two divisions.
Webber, Inc.
Computer
Division
Television
Division
Let’s look more closely at the
Television Division’s income statement.
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10-19
Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales
Variable COGS
Other variable costs
Total variable costs
Contribution margin
Traceable fixed costs
Segment margin
$ 300,000
120,000
$
30,000
150,000
150,000
90,000
60,000
Cost of goods sold consists of variable manufacturing costs.
Fixed and variable costs are listed in separate

10-20
Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales
Variable COGS
Other variable costs
Total variable costs
Contribution margin
Traceable fixed costs
Segment margin
$ 300,000
120,000
$
30,000
150,000
150,000
90,000
60,000
Contribution margin is computed by taking sales minus variable costs.
Segment margin is Television’s contribution to profits.
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10-21
Levels of Segmented Statements
Income Statement
Sales
Variable costs
CM
Traceable FC
Company Television Computer
$ 500,000
230,000
270,000
170,000
Segment margin 100,000
$ 300,000
150,000
150,000
$
90,000
60,000
$ 200,000
80,000
120,000
$
80,000
40,000
Common costs
Net operating
income
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10-22
Levels of Segmented Statements
Income Statement
Sales
Variable costs
CM
Traceable FC
Company Television Computer
$ 500,000
230,000
270,000
170,000
Segment margin 100,000
$ 300,000
150,000
150,000
$
90,000
60,000
$ 200,000
80,000
120,000
$
80,000
40,000
Common costs
Net operating
income
25,000
$ 75,000
Common costs should be allocated to the not divisions. These costs would remain even if one of the divisions were eliminated.
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10-23
Traceable Costs Can Become
Common Costs
As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into smaller segments.
Let’s see how this works using the Webber, Inc. example!
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10-24
Traceable Costs Can Become
Common Costs
Webber’s Television Division
Television
Division
LCD Plasma
Product
Lines
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10-25
Traceable Costs Can Become
Common Costs
Sales
Variable costs
CM
Traceable FC
Product line margin
Income Statement
Television
Division LCD
$ 200,000
95,000
105,000
45,000
$ 60,000
Common costs
Divisional margin
Plasma
$ 100,000
55,000
45,000
35,000
$ 10,000
We obtained the following information from the LCD and Plasma segments.
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10-26
Traceable Costs Can Become
Common Costs
Sales
Variable costs
CM
Traceable FC
Product line margin
Income Statement
Television
Division
$ 300,000
150,000
150,000
80,000
70,000
LCD
$ 200,000
95,000
105,000
45,000
$ 60,000
Common costs
Divisional margin
10,000
$ 60,000
Plasma
$ 100,000
55,000
45,000
35,000
$ 10,000
Fixed costs directly traced to the Television Division

10-27
External Reports
The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports.
1.
Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports.
2.
Since the contribution approach to segment reporting does not comply with GAAP , it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP .
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10-28
Omission of Costs
Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain .
Business Functions
Making Up The
Value Chain
Product Customer
R&D Design Manufacturing Marketing Distribution Service
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10-29
Inappropriate Methods of Allocating
Costs Among Segments
Failure to trace costs directly
Inappropriate allocation base
Segment
1
Segment
2
Segment
3
Segment
4
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10-30
Common Costs and Segments
Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:
1. This practice may make a profitable business segment appear to be unprofitable.
2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control.
Segment
1
Segment
2
Segment
3
Segment
4
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10-31
Quick Check 
Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
Income Statement
Hoagland's
Lakeshore
$ 800,000
310,000
490,000
246,000
244,000
200,000
$ 44,000
Bar
$ 100,000
60,000
40,000
26,000
$ 14,000
Restaurant
$ 700,000
250,000
450,000
220,000
$ 230,000
Assume that Hoagland's Lakeshore prepared its segmented income statement as shown.
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10-32
Quick Check 
How much of the common fixed cost of
$200,000 can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
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10-33
Quick Check 
How much of the common fixed cost of
$200,000 can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
A common fixed cost cannot be eliminated by dropping one of the segments.
PPT 10-33

10-34
Quick Check 
Suppose square feet is used as the basis for allocating the common fixed cost of
$200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?
a. $20,000 b. $30,000 c. $40,000 d. $50,000
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10-35
Quick Check 
Suppose square feet is used as the basis for allocating the common fixed cost of
$200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?
a. $20,000 b. $30,000 c. $40,000 d. $50,000
The bar would be allocated 1 /
10 of the cost or $20,000.
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10-36
Quick Check 
If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment?
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10-37
Allocations of Common Costs
Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
Income Statement
Hoagland's
Lakeshore
$ 800,000
310,000
490,000
246,000
244,000
200,000
$ 44,000
Bar
$ 100,000
60,000
40,000
26,000
14,000
20,000
$ (6,000)
Restaurant
$ 700,000
250,000
450,000
220,000
230,000
180,000
$ 50,000
Hurray, now everything adds up!!!
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10-38
Quick Check 
Should the bar be eliminated?
a. Yes b. No
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10-39
Quick Check 
Should the bar be eliminated?
a. Yes b. No
The profit was $44,000 before eliminating the bar. If we eliminate
Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
Hoagland's
Lakeshore
$ 700,000
250,000
450,000
220,000
230,000
200,000
$ 30,000
Bar Restaurant
$ 700,000
250,000
450,000
220,000
230,000
200,000
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$ 30,000

Transfer Pricing
The transferred good is revenue to the selling division and cost to the buying division. This value is called transfer pricing .
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Transfer Pricing: General Concerns
Some Major Issues
 Impact on divisional performance measures
 Impact on firm wide profits
 Impact on divisional autonomy
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Transfer Pricing Approaches
 Market price
 Negotiated transfer prices
 Cost-based transfer prices
 Full cost
 Full cost plus markup
 Variable cost plus fixed fee
PPT 10-42

A Transfer Pricing Problem
Assume the following data for Division A:
Capacity in units
Selling price to outside
Variable cost per unit
Fixed costs per unit (based on capacity)
50,000
$15
8
5
Division B would like to purchase units for Division
A. Division B is currently purchasing 5,000 units per year from an outside source at a cost of $14.
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A Transfer Problem Example
(continued)
1.
Assume division A has idle capacity in excess of 10,000 units:
Minimum transfer price = Variable cost + Lost contribution margin
= $8 + $0
= $8
2.
Assume division A is working at capacity:
Transfer Price = Variable cost + Lost contribution margin
= $8 + $7
= $15 (market price)
3. Assume division A is working at capacity, but a negotiated $2 in variable costs can be avoided on intercompany sales.
Transfer Price = Variable cost + Lost contribution margin
= $6 + $7
= $13 (negotiated price)
PPT 10-44

End of Week
PPT 10-45