Module 23
Segment Reporting
and Transfer Pricing
Segment Reports

Segment Reports Follow the Organization
Structure:

Cost Center – Ex.: Maintenance Department

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Revenues—Ex.: Western Sales Territory

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Compare actual sales with the budgeted sales
Profits—A Movie

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Compare actual costs with the budget
Compare profits with the budgeted profits
Profits and Investment—Electronics, Inc. (Sub.)

Compare Ret. on Investment to required ROI
Terms for Costs of Segments

Variable costs


Direct fixed costs

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FC directly traceable to segment: Segment manager
Allocated common costs


Ex: Materials usage
Indirect tracing of costs to a unit: share of a
engineering cost by product lines on time
Unallocated common costs

Central costs of many segments: Home office should
not be allocated, but some companies do…
Example
Profit Centers
North Territory
South Territory
Sales
Less variable costs
Contribution margin
Less direct fixed costs
Territory margin
Less allocated segment costs
Territory income
Less unallocated common costs
Net income
Segment income is relevant
for measuring the long-term
effects of decisions to continue
or discontinue a segment.
$16,000.
(5,600)
10,400.
(2,000)
8,400.
(1,200)
$ 7,200.
$18,000.
(6,100)
11,900.
(1,600)
10,300.
(1,400)
$ 8,900.
Total
$34,000.
(11,700)
22,300.
(3,600)
18,700.
(2,600)
16,100.
(1,500)
$14,600.
Segment margin is relevant
for measuring the short-term
effects of decisions to
continue or discontinue a
segment.
Return on Investment (ROI)


A measure of the earnings per dollar of an investment
Assumes financing decisions are made at the corporate
level
ROI =

Evaluated by comparing to previously identified
performance criteria, such as
Overall company ROI
 Budget ROI
Often rank ordered with awards of bonuses/raises to highest
performers and bottom performers warned or dumped.


Investment center income
Investment center asset base
However…


High ROI divisions tend to only take on extremely high
return projects resulting in slow growth.
Example:
West Texas Division has an ROI of 50% on an asset base
of $20 million: Superstars—BIG Bonuses!
 Now Project X12 has a promised return of 30% and
requires an investment of $10 million.
 If West Texas takes on the project then ROI decreases:



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[50%*$20MM + 30%*$10MM]/[$20MM+$10MM)=
[$10,000,000 + $3,000,000]/$30,000,000 = 43.3%
Superstars would be less shiny!
Will West Texas Division take on this project? (Never…)
 Also, West Texas would be better off to shrink any part of
their organization that earns less than 50%!

Residual Income

Residual Income is an alternative measure to
ROI:


RI = Division Income – Min Rate of Return X Asset Base
West Texas:
Set required return to 15%.
 Residual income before X12:

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Residual income with X12:
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50%*$20MM – 15%*$20MM = $7,000,000
$7,000,000 + [30%*$10 MM – 15%*$10MM]=
$8,500,000
West Texas Division should expand as long as
projects earn more than the required return.
Economic Value Added (EVA®)

Used to evaluate investment center performance


A variation of residual income
Significant differences from residual income
1. Weighted average cost of capital used instead of
required rate of return
2. Net assets are used as the evaluation base
3. After-tax income is used as investment center income
4. Corrects for potential distortions in economic net
income caused by GAAP
Total assets less
current liabilities
An average of the after-tax cost of all long-term
borrowing and the cost of equity financing
Economic Value Added
AST Distributors has an 10% cost of capital and a 40%
income tax rate. Amounts for the West Texas Division for
2012 are:
Assets
$20,000,000
Division income
Current liabilities
$ 10,000,000
$ 5,000,000
EVA = Division income after tax - Cost of capital x (Assets – Current Liabilities]
= ($10,000,000×(1.0-0.4) – 0.10×($20,000,000–$5,000,000) =
= $6,000,000 - $1,500,000 = $4,500,000
The West Texas Division added $4,500,000 in value to AST
Distributors.
Balanced Scorecard

In general: “We get what we measure”

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With ROI, Residual Income, EVA we tend to get short-term
behaviors!
Long-term performance requires customer relations, new
products, well trained & loyal employees…
Balanced Scorecard: A comprehensive performance
measurement system that includes financial measures
and measures related to:



Customers
Internal processes
Innovation and learning
Examples of Key Indicators
Key financial indicators
Cost, Revenue, Profit, or Cash Flow
Return on investment (ROI), Residual Income,
or Economic Value Added
Key customer indicators
Average customers per hour
Number of customer complaints per period
Number of sales returns per period
Key operating indicators
On-time delivery
Quality of units produced
Employee turnover per period
Key growth and innovation indicators
New products introduced during period
Products discontinued during period
Number of sales promotions
Special offers, discounts, etc.
Transfer Pricing
 The transfer price is an internal value assigned
a product or service that one division provides
to another.
 Normally occurs between profit or investment
centers
 Higher transfer prices result in:
More profits to the selling divisions and less to the
buying divisions
 Lower volume and profit for company as a whole

 Transfer prices may be based on market prices
(where available) or costs, or they may be
negotiated.
Market Price as the Transfer Price



Best method of setting transfer prices, if there is an
existing market with established prices for internal
products, BUT most often there is not an established
market.
Preserves divisional autonomy and leads divisions to act
in a manner that maximizes corporate profits
 Assuming divisions are free to buy and sell outside
the firm
Often specified as market price minus a discount when
selling and administrative costs are lower on transfers.
Cost Plus Markup as
Transfer Price


Allows supplying divisions to increase earnings
May result in some undesired behavior:

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Passing along inefficiencies, no penalty for inefficiency
Stifle buyers’ demand and profits in low volume periods
Supplying divisions tend to have higher ROI than
buying divisions…
Variations on “cost” and “markup”: variable only,
standardized, total costs including administration, dual
transfer price (e.g. VC and FC+MU%), opportunity
costs, fixed fees versus % markup
Negotiated Price
as the Transfer Price



Supplying and buying divisions agree on a price
through negotiation
Use for relatively few transfers with similar
powered negotiators
Divisions should be free to withdraw and go
elsewhere