Chapter 2 - Texas A&M University–Corpus Christifaculty.tamucc.edu/shall/2302/Chapter...

Chapter 12

Segment Reporting and Decentralization

Learning Objectives

LO1. Prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed costs.

LO2. Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI.

LO3. Compute residual income and understand the strengths and weaknesses of this method of measuring performance.

LO4. (Appendix 12A) Determine the range, if any, within which a negotiated transfer price should fall.

New in this Edition• This chapter has been extensively rewritten.• Many new In Business boxes have been added.• Additional exercises have been written.

Chapter Overview A. Responsibility Accounting. Responsibility accounting is concerned with designing reports that help motivate managers to make decisions and to take actions that are in the best interests of the overall organization.

1. The benefits of decentralization. In a decentralized organization, decision making is not confined to a few top executives, but rather is spread throughout the organization. Responsibility accounting functions most effectively in an organization that is decentralized. A number of benefits result from decentralization.

a. Top management is relieved of much day-to-day problem solving and is left free to concentrate on strategy, higher-level decision-making and coordinating activities.

b. Lower-level managers generally have more detailed and up-to-date information about local conditions than top managers. Therefore, lower-level managers are often capable of making better operational decisions.

c. Delegating decision-making authority to lower-level managers enables them to quickly respond to customers.

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d. Decentralization provides lower-level managers with the decision-making experience they will need when promoted into higher-level positions.

e. Delegating decision-making authority to lower-level managers often increases their motivation. The end result can be increased job satisfaction and employee retention, as well as improved organizational performance.

2. Disadvantages of decentralization. Particularly in larger organizations, the benefits of decentralization usually outweigh the disadvantages. Nevertheless, it is important to be aware of the potential problems with decentralization.

a. Lower-level managers may make decisions without fully understanding the “big picture.” While top-level managers typically have less detailed information about local operations than the lower-level managers, they usually have more information about the company as a whole and should have a better understanding of the company’s strategy.

b. In a truly decentralized organization, there may be a lack of coordination among autonomous managers. This problem can be reduced by clearly defining the company’s strategy and communicating it effectively throughout the organization through the use of a well-designed Balanced Scorecard (see Chapter 10).

c. Lower-level managers may have objectives that are different from the objectives of the entire organization. For example, some managers may be more interested in increasing the sizes of their departments than in increasing the profits of the company. To some degree, this problem can be overcome by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company.

3. Investment, Profit, and Cost Centers. There are at least three types of responsibility centers.

a. A cost center manager has control over cost. Cost center managers are evaluated based on how well costs are controlled, given the level of activity.

b. A profit center manager has control over both cost and revenue. Profit center managers are usually evaluated based on performance relative to profit targets.

c. An investment center manager has control over cost and revenue and also has control over the use of investment funds. Investment center managers are usually evaluated based on rate of return on investment (ROI).

B. Segmented Reporting. (Exercises 12-1, 12-5, 12-7, and 12-8.) To operate effectively, managers need a great deal more information than is provided by a single, company-wide income statement. Income statements are needed that focus on segments of the company.

1. Segments. A segment is any part or activity of an organization about which a manager seeks cost or revenue data. Examples of segments include sales territories, manufacturing facilities, service centers, individual products, and individual customers.

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2. Segmented statements. Segmented statements can be prepared for activity at many different levels in an organization. Exhibit 12-2 in the text illustrates three levels of segmented statements.

3. Sales and contribution margin. Sales for each segment should be identified along with

variable costs, resulting in a contribution margin. The segment contribution margin is especially valuable in decisions that involve the use of excess capacity.

4. Traceable vs. Common Fixed Costs. Whether a fixed cost is assigned to a segment should depend on whether it is traceable to that segment or is a common cost. A cost may be traceable to one segment and common to another.

a. Traceable Fixed Costs. Traceable costs arise because of the existence of a particular segment. If a cost is avoidable if a segment were discontinued, then it is a traceable cost of that segment.

b. Common Fixed Costs. A common fixed cost is a fixed cost that supports more than one business segment, but is not traceable in whole or in part to any one of the business segments. A fixed cost that is common to a particular segment would continue even if that particular segment were discontinued. Since common costs are not avoidable costs of the segment, they should not be considered costs of the segment for purposes such as product drop decisions or pricing. Of course, it is always possible to arbitrarily allocate any cost—including common fixed costs—among segments. However, if common costs are allocated among segments, the resulting segment statements are potentially very misleading and erroneous decisions may result. For example, a manager might drop a segment that appears to be operating at a loss, only to discover later that the common fixed costs that were arbitrarily allocated to the segment do not disappear and are simply reallocated to the remaining segments.

c. Do common costs exist? There is a great deal of disagreement about what costs are and are not traceable to segments.

• Some people allege that essentially the only costs traceable to products are direct materials whereas others assert that all costs can be traced to products. That is, some commentators believe almost all costs are common with respect to products whereas others believe there are no common costs at all. (For example, the early ABC literature implicitly assumed common costs do not exist.) Our belief is that the truth lies somewhere in the middle—a lot of costs can be traced to products but by no means all costs. The illustrations in the text and in the exercises, problems, and cases reflect that belief.

• Cooper and Kaplan, the leading architects of activity-based costing, have advocated a system of segmented reports that is very much in the spirit of what we recommend in this chapter. They define a hierarchy of costs in which costs can be usefully aggregated upwards but should not be allocated downwards. Essentially, costs at each level of the hierarchy are common to the activities carried out lower down in the hierarchy. For example, they advocate that facility-sustaining costs, which are common to products, should not be allocated to the products. (See Cooper and Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May-June 1991, pp. 130-135.)

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• With so much disagreement among the experts concerning which costs can and cannot be traced to products, it should not be surprising that there is a great deal of uncertainty in practice concerning whether a particular cost is traceable or not. The text and problem material have been carefully worded to eliminate this sort of ambiguity. The introductory course does not seem to us to be the most appropriate place to grapple with all of the complexities of this issue.

d. What is common and what is traceable depends on the segment. A cost that is traceable to a segment may not be traceable when the segment is further divided into smaller segments. The salary of the vice president of the automotive products division is a traceable cost of the segment “automotive products division” but it is not a traceable cost of any particular product that is sold by the division. This is true even if someone were to keep track of how much time the vice president devotes to each particular product.

5. Segment Margin. The segment margin is obtained by deducting the traceable fixed costs of a segment from the segment’s contribution margin. The segment margin indicates how much the segment is contributing toward covering common costs and towards profits.

C. Return on Investment (ROI) for Measuring Managerial Performance. (Exercises 12-2, 12-6, 12-9, 12-10, 12-11, and 12-13.) Investment centers are usually evaluated based on some measure of the rate of return on investment; that is, some measure of profits divided by some measure of investment. This presumably provides incentives to increase profits while controlling the amount of funds tied up in an organization.

1. The definition of ROI. Companies measure the rate of return on investment in many different ways. To keep things simple, we use the following definition in the book:

Net operating income is income before interest and taxes. Average operating assets are discussed below.

2. Measuring Average Operating Assets.

a. From a theoretical standpoint, one can argue that the denominator in the ROI formula should be the market value of the segment at the beginning of the period. The investment in the segment is implicitly the proceeds that could have been realized from its sale. Unfortunately, reliable estimate of the market value of a segment are difficult to obtain. So that approach is rarely, if ever, used in practice.

b. In the text we define operating assets as cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization. And after some discussion of net book value versus original cost as a basis for valuation, we settle on net book value. This way of measuring the denominator in the ROI calculations is pretty typical of practice. We suggest you not dwell on this issue in class; the figures for average operating assets are given in all of the exercises and problems.

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3. ROI in terms of Margin and Turnover. A company’s ROI can be expressed as a simple function of its margin and turnover:

ROI = Margin Turnoveror

ROI in this format provides some valuable insights. Very roughly speaking, in long-run equilibrium the ROI should be about the same across all industries. If the ROI is above the norm in any industry, investment dollars will flood into that industry until the ROI becomes comparable to the ROIs in other industries. Therefore in industries characterized by large turnovers, margins should be relatively small and in industries characterized by relatively small turnovers, margins should be relatively large. The trick for a company is to try to break out of this long-run equilibrium position and to realize some combination of margins and turnover that is higher than the norm.

4. How actions affect the rate of return. ROI can be improved by doing at least one of the following: increasing sales, reducing expenses, or reducing assets.

a. Ordinarily, an increase in sales will increase margin and turnover because of leverage. Since fixed costs do not increase with sales, net operating income should increase faster than sales, and the margin should go up. And modest increases in sales can often be supported with very little increase in operating assets.

b. A decrease in expenses will increase margins through an increase in net operating income. In hard times, managers often turn to cost cutting as the first line of defense. Conventional wisdom holds that “fat” can creep into an organization during good times and that such fat can be cut away without a great deal of pain when necessary. Critics point out that morale suffers during and after periodic cost cutting binges. It is now generally acknowledged that it is best to always be “lean and mean” and to avoid the wrenching effects caused by cost cutting campaigns.

c. Many approaches to increasing ROI involve increasing operating assets or expenses in order to improve sales and margins.

5. The problem of allocated expenses and assets. In practice, corporate headquarters

expenses and other common costs are usually allocated to divisions. Arbitrary allocations of common costs should be avoided in ROI computations. They undermine the credibility of the measure of performance, generate arguments among managers, and serve no apparent useful purpose.

6. Criticisms of ROI. The use of ROI as a performance measure has been criticized.

a. ROI tends to emphasize short-run rather than long-term performance. Managers can often improve short-term profitability by taking actions that hurt the company in the long-term. Prominent examples include neglecting maintenance and training, slashing prices at the end of the fiscal year to induce customers to make unusually large purchases in advance of their needs, purchasing lower quality inputs, and skimping on quality control.

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b. A manager who takes over an investment center typically inherits many committed costs over which the manager has little control. These committed costs may be relevant for assessing how well the investment center has performed as an investment, but are less relevant for assessing how well the current manager is performing.

c. A division may reject an investment that would lower its own ROI even though it would increase the ROI for the entire company.

D. Residual Income. (Exercises 12-3, 12-12, 12-14, and 12-16.) Residual income (or economic value added) is an alternative to ROI for measuring the performance of an investment center. 1. Motivation for the residual income approach. Profitable investments may be rejected if a

segment is evaluated based on the ROI formula. For example, suppose a company’s minimum required rate of return on new investments is 15% and one of its investment centers currently has an ROI of 20%. If a new investment promises a return of greater than 15%, the company would want that investment made. However, if the investment’s rate of return is less than 20%, it would be rejected by the manager of the investment center. The residual income approach does not suffer from this particular problem, but it does suffer from many of the other problems with ROI.

2. Definition of residual income. Residual income is the net operating income that an investment center is able to earn above the minimum required rate of return on its operating assets. Ideally, the minimum required rate of return should be the company’s cost of capital or opportunity cost of funds. When residual income is used to measure performance, the goal is to maximize the total amount of residual income generated for a period.

3. Divisional comparison and residual income. A major disadvantage of the residual income approach is that it cannot be easily used to compare the performance of divisions of different sizes. Larger divisions naturally have more residual income than smaller divisions, not necessarily because they are better managed, but simply because they are bigger. Nevertheless, residual income can be used to track the performance of a division over time and actual residual income can be compared to target residual income.

4. Economic Valued Added (EVA). The residual income approach, which was never as popular as ROI in practice, has been given new life and is now being used by a number of prominent companies in the form of “economic value added” or EVA. The consulting firm Stern Stewart is largely responsible for this revival and has trademarked the terms economic value added and EVA. Many other consulting firms have jumped on the bandwagon and give residual income their own unique twists and marketing nomenclature. The major differences between traditional residual income and economic value added in the Stern Stewart approach center on the accounting treatment of some transactions. For example, research and development costs are capitalized and then amortized under the EVA approach rather than being currently expensed in their entirety. However, we believe it is best not to emphasize these differences between residual income and EVA in the introductory course.

E. (Appendix 12A) Transfer Pricing. (Exercises 12-4, 12-15, and 12-17.) A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. Transfer prices are necessary to calculate costs and revenues in cost,

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profit, and investment centers. Clearly, the division that is selling the good or service would prefer a high transfer price while the division that is buying would prefer a low transfer price.

1. Do transfer prices matter? From the standpoint of the company as a whole, the transfer price has no effect on aggregate income (other than perhaps from tax effects when divisions are in different states or countries). What is counted as revenue to one division is a cost to the other and is eliminated in the consolidation process. From an economic perspective, it is like taking money out of one pocket and putting it into the other. What does matter is how the transfer price affects the decisions made by the segment managers. In companies in which decentralization is really practiced, segment managers are given a lot of latitude in dealing with each other. Based on the transfer price, a division manager will decide whether to sell a service on the outside market or sell it internally to another division, or whether to buy a part from an outside supplier or internally from another division.

2. Negotiated transfer prices. In principle, if managers understand their own businesses and are cooperative, negotiated transfer prices should work quite well.

a. If a transfer is in the best interests of the entire company, the profits of the entire company should increase. It is always possible in such a situation (barring externalities) to find a transfer price that would increase each participating division’s profits. A pie analogy is helpful to explain this principle. The profits of the entire company are the pie. By cooperating in a transfer, the division managers can make the pie bigger. With a bigger pie, it is always possible to divide it in such a way that everyone gets a bigger piece. And transfer prices provide a means for dividing up the pie.

b. While negotiated transfer prices can work quite well under the right conditions, if managers are uncooperative and highly competitive, negotiations may go nowhere.

3. The lowest acceptable transfer price for the selling division. Clearly, the selling division

would like for the transfer price to be as high as possible, but how low would the manager of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost.” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits. The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer. Therefore, the lowest acceptable transfer price as far as the selling division is concerned is:

When there is idle capacity, there are no lost sales and so the total contribution margin of lost sales is zero.

4. Highest transfer price the buying division is willing to pay. In the book and in problems, we generally consider only the situation in which the buying division can buy the transferred item from an outside supplier. In that case, the buying division clearly would not voluntarily agree to a transfer unless:

Transfer price ≤ Cost of buying from outside supplier

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5. The range of acceptable negotiated transfer prices. Combining the selling and buying divisions’ perspectives, we can find the range within which a negotiated transfer price will lie. Two situations should be considered.

a. A transfer makes sense from the standpoint of the company if the item can be made inside the company (including opportunity costs) for less that it costs to buy the item from the outside. In algebraic form:

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In this case, any transfer price within the following range will increase the profits of both divisions:

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b. A transfer does not make sense from the standpoint of the company if the item can be purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs). In algebraic form:

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In this case, it is impossible to satisfy both the selling division and the buying division and no transfer will be made voluntarily. And, of course, no transfer should be forced on the managers since a transfer would not be in the best interests of the entire company.

6. Alternative approaches to transfer pricing. If managers understand their own businesses and are cooperative, negotiated transfer prices should work very well. But, if managers do not understand their own businesses or are uncooperative, negotiations are likely to be fruitless. As a consequence, most companies rely on either cost-based or market price-based transfer prices.

a. Cost-based transfer prices. In many companies, transfers are recorded at variable cost, at full cost, or at variable or full cost plus some arbitrary mark-up. These transfer pricing systems are easy to administer, but suffer from serious limitations.

• Cost-based transfer prices can easily lead to bad decisions. If variable costs are used, the transfer price will be too low when there is no idle capacity. If full cost is used, the transfer price will never be correct for decision-making purposes—it will always indicate to the buying division that the cost of the transfer is something other than what it really is to the entire company.

• If there is no profit margin built into the transfer price, then the selling division has no incentive to cooperate in the transfer.

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• If the costs of one division are simply passed on to the next division, then there is little incentive for cost control anywhere in the organization. If transfer prices are to be based on cost, then standard cost rather than actual cost should be used.

b. Market-based transfer prices. When there is a competitive outside market for the good or service transferred between the divisions, the market price is often used as a transfer price. This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity. However, when there is idle capacity in the selling division, the transfer price will be too high and the buying division may inappropriately purchase from an outside supplier or cut back on volume.

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Assignment Materials

Assignment TopicLevel of

DifficultySuggested

TimeExercise 12-1 Basic segmented income statement......................................... Basic 15 min.Exercise 12-2 Compute the return on investment (ROI)................................ Basic 10 min.Exercise 12-3 Residual income...................................................................... Basic 10 min.Exercise 12-4 (Appendix 12A) Transfer pricing basics................................. Basic 30 min.Exercise 12-5 Segmented income statement.................................................. Basic 20 min.Exercise 12-6 Effects of changes in sales, expenses, and assets on ROI....... Basic 20 min.Exercise 12-7 Working with a segmented income statement......................... Basic 20 min.Exercise 12-8 Working with a segmented income statement......................... Basic 15 min.Exercise 12-9 Effects of changes in profits and assets on return on

investment (ROI)................................................................ Basic 30 min.Exercise 12-10 Cost-volume-profit analysis and return on investment

(ROI)................................................................................... Basic 20 min.Exercise 12-11 Return on investment (ROI).................................................... Basic 15 min.Exercise 12-12 Evaluating new investments using return on investment

(ROI) and residual income................................................. Basic 30 min.Exercise 12-13 Computing and interpreting return on investment (ROI)........ Basic 15 min.Exercise 12-14 Contrasting return on investment (ROI) and residual

income................................................................................ Basic 20 min.Exercise 12-15 (Appendix 12A) Transfer pricing from the viewpoint of the

entire company................................................................... Basic 15 min.Exercise 12-16 Return on investment (ROI) and residual income relations.... Basic 15 min.Exercise 12-17 (Appendix 12A) Transfer pricing situations........................... Basic 20 min.Problem 12-18 Segment reporting and decision-making................................. Basic 30 min.Problem 12-19 Comparison of performance using return on investment

(ROI)................................................................................... Basic 30 min.Problem 12-20 Return on investment (ROI) and residual income................... Basic 30 min.Problem 12-21 (Appendix 12A) Transfer price with an outside market.......... Basic 45 min.Problem 12-22 Basic segmented reporting; activity-based cost assignment. . . Basic 60 min.Problem 12-23 Return on investment (ROI) and residual income................... Basic 20 min.Problem 12-24 (Appendix 12A) Basic transfer pricing................................... Basic 60 min.Problem 12-25 Restructuring a segmented income statement......................... Basic 60 min.Problem 12-26 Segment reporting; activity-based cost assignment................ Medium 60 min.Problem 12-27 Return on investment (ROI) analysis...................................... Medium 30 min.Problem 12-28 Return on investment (ROI) and residual income;

decentralization................................................................... Medium 30 min.Problem 12-29 (Appendix 12A) Market-based transfer price.......................... Medium 45 min.Problem 12-30 Multiple segmented income statements.................................. Medium 60 min.Problem 12-31 (Appendix 12A) Cost-volume-profit analysis; return on

investment (ROI); transfer pricing..................................... Medium 45 min.Problem 12-32 (Appendix 12A) Negotiated transfer price.............................. Medium 30 min.Case 12-33 Segmented statements; product line analysis.......................... Difficult 90 min.Case 12-34 (Appendix 12A) Transfer pricing; divisional performance..... Difficult 45 min.Case 12-35 Service organization; segment reporting................................. Difficult 75 min.

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Essential Problems: Problem 12-19, Problem 12-20, Problem 12-22 or Problem 12-25.Supplementary Problems: Problem 12-18, Problem 12-23, Problem 12-26, Problem 12-27,

Problem 12-28, Problem 12-30, Case 12-33, Case 12-35.

Appendix 12A Essential Problems: Problem 12-24.Appendix 12A Supplementary Problems: Problem 12-21, Problem 12-29, Problem 12-31,

Problem 12-32, Case 12-34.

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Chapter 12Lecture Notes

Helpful Hint: Before beginning the lecture, show students the 14th and 15th segments from the McGraw-Hill/Irwin Managerial/Cost Accounting video library. These segments discuss many of the concepts included in chapter 12. The lecture notes reinforce the concepts in the video.

Chapter theme: Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, segmented income statements, and return on investment (ROI) and residual income measures are used to help control decentralized organizations.

I. Decentralization in organizations

A. A decentralized organization does not confine decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages and disadvantages of decentralization are as follows:

i. Advantages of decentralization

1. It enables top management to concentrate on strategy, higher-level decision-making, and coordinating activities.

2. It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions.

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3. It enables lower-level managers to quickly respond to customers.

4. It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions.

5. It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance.

ii. Disadvantages of decentralization

1. Lower-level managers may make decisions without fully understanding the “big picture.”

2. There may be a lack of coordination among autonomous managers.

a. The balanced scorecard can help reduce this problem by communicating a company’s strategy throughout the organization.

3. Lower-level managers may have objectives that differ from those of the entire organization.

a. This problem can be reduced by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company.

4. It may difficult to effectively spread innovative ideas in a strongly decentralized organization.

a. This problem can be reduced through the effective use of intranet systems, which enable globally dispersed

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employees to electronically share ideas.

II. Responsibility accounting

A. Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions. The term responsibility center is used for any part of an organization whose manager has control over, and is accountable for cost, profit, or investments. The three primary types of responsibility centers are cost centers, profit centers, and investment centers.

i. Cost center

1. The manager of a cost center has control over costs, but not over revenue or investment funds.

a. Service departments such as accounting, general administration, legal, and personnel are usually classified as cost centers, as are manufacturing facilities.

b. Standard cost variances and flexible budget variances, such as those discussed in Chapters 10 and 11, are often used to evaluate cost center performance.

ii. Profit center

1. The manager of a profit center has control over both costs and revenue.

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a. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit.

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iii. Investment center

1. The manager of an investment center has control over cost, revenue, and investments in operating assets.

a. Investment center managers are usually evaluated using return on investment (ROI) or residual income, as discussed later in this chapter.

“In Business Insights”It is important to correctly manage the incentives offered to responsibility center managers, otherwise the consequences can be disastrous. For example:

“Extreme Incentives” (page 542) In 2003 Tyco International, Ltd. was rocked by a

series of scandals including disclosure of $2 billion of accounting-related problems. Was this foreseeable? Well, in a word, yes.

Business Week reported in 1996 that the CEO of Tyco International, Ltd., Dennis Kozlowski, was putting unrelenting pressure on his managers to deliver growth. If his managers met or exceeded their targets they were given a bonus that could be many times their salary. But if they fell even a bit short, the bonus plummeted.

If a manager is barely under the target, this type of bonus scheme creates pressure the accelerate earnings. If a manager is barely over the bonus

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threshold, it creates an incentive to push earnings to the next period.

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If top executives, such as Kozlowski, set profit targets too high or turn a blind eye to how managers achieve them, the incentive for managers to cut corners is enormous.

B. An organizational view of responsibility centers

i. Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

1. The President and CEO as well as the Vice President of Operations manage investment centers.

2. The Chief Financial Officer, General Counsel, and Vice President of Personnel all manage cost centers.

3. Each of the three product managers that report to the Vice President of Operations (e.g., salty snacks, beverages, and confections) manages a profit center.

4. The bottling plant manager, warehouse manager, and distribution manager all manage cost centers that report to the Beverages product manager.

III. Decentralization and segment reporting

A. Key concepts/definitions

i. A segment is a part or activity of an organization about which managers would like cost, revenue, or profit data.

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1. Examples of segments include divisions of a company, sales territories, individual

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stores, service centers, manufacturing plants, marketing departments, individual customers, and product lines.

a. Superior Foods Corporation could segment its business as follows:

By geographic region By customer channel

Helpful Hint: If students have been introduced to database software, Exhibit 12-2 can be used to review how segmentation could be accomplished with the aid of a computer. The number of possible breakdowns, or segmentations, is only limited by the list of attributes coded along with each transaction. To accomplish the breakdown in Exhibit 12-2, the attributes geographic region (e.g., east, west, etc.), state, customer channel, and supermarket chain would need to be recorded for each sale.

ii. There are two keys to building segmented income statements.

1. First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin.

a. The contribution margin is especially useful in decisions involving temporary uses of capacity such as special orders.

2. Second, traceable fixed costs should be separated from common fixed costs to

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enable the calculation of a segment margin. Further clarification of these terms is as follows:

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a. A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. If the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include:

The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo.

The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.

b. A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include:

The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors.

The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments – groceries, produce, bakery, etc.

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“In Business Insights”

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Common fixed costs are often arbitrarily allocated to segments for cost recovery purposes. Invariably, this leads to disputes about the fairness of the allocation process. For example:

“The Big Gouge” (page 555) The Big Dig in Boston is a $14 billion-plus

project to bury major roads underground in downtown Boston. Two companies – Bechtel and Parsons Brinckerhoff (PB) – manage the 20 year project, which is $1.6 billion over budget.

Bechtel and PB have many projects underway at any one time and many common fixed costs. These common fixed costs are not caused by the Big Dig project and yet portions of these costs have been claimed as reimbursable expenses under the premise that someone must pay for these costs.

Massachusetts has lodged a number of complaints concerning Bechtel’s cost recovery claims. Such complaints are almost inevitable when common fixed costs are allocated to segments.

c. 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 a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

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Helpful Hint: In practice, a great deal of disagreement exists about what costs are traceable and what costs are common. Some people claim that except for direct

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materials, virtually all costs are common fixed costs that cannot be traced to products. Others assert that all costs are traceable to products; there are no common costs. The truth probably lies somewhere in the middle – many costs can be traced to products but not all costs.

d. A segment margin is computed by

subtracting the traceable fixed costs of a segment from its contribution margin.

The segment margin is a valuable tool for assessing the long-run profitability of a segment.

Allocating common costs to segments reduces the value of the segment margin as a guide to long-run segment profitability.

“In Business Insights”Segment margins can be computed in numerous ways depending upon the industry. For example:

“What’s in a Segment?” (page 552) Continental Airlines could figure out the

profitability of a specific route on a monthly basis – for example Houston to Los Angeles – but management did not know the profitability of a particular flight on that route.

The company’s CFO responded by developing a flight profitability system that would break out the profit (or loss) for each individual flight.

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Once completed the new cost system revealed such money-losing flights as two December flights

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that left Houston for London within a four-hour period with only about 30 passengers each.

With the data on the profitability of individual flights, Continental was able to design more appropriate schedules.

Helpful Hint: Explain that a segment shouldn’t automatically be eliminated if its segment margin is negative. If a company that produces hair-styling products discontinues its styling gel, sales on its shampoo and conditioner might fall due to the unavailability of the eliminated product.

iii. Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments. For example:

1. 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.

2. If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then activity-based costing can be used to trace the warehousing costs to the three products as shown.

a. When using activity-based costing to trace fixed costs to segments, managers must still ask themselves if the traceable costs that they have been identified would disappear over time if the segment disappeared.

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b. In this example, if the warehouse was owned rather than leased, perhaps the

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warehousing costs assigned to a given segment would not disappear if the segment was discontinued.

“In Business Insights”Activity-based costing can be used by companies to more accurately trace costs to business segments. For example:

“Using ABC to Assign Data Center Costs” (page 549) Harris Corporation consolidated its division-level

data centers into a centralized data center called the Computing and Communication Services (CCS) Department.

CCS is a cost center that recovers its operating costs by charging other divisions within Harris for the use of its resources.

To facilitate the “chargeback” process, CCS developed an activity-based costing system. Activities such as “test systems,” “monitor network,” “schedule jobs,” “install software,” and “print reports” were used to ensure that internal customers were only charged for the dollar value of the resources that they consumed.

Helpful Hint: In several articles, Cooper and Kaplan, the leading architects of activity-based costing, have proposed that costs be sorted into a hierarchy of unit-level, batch-level, product-level, and facility-level costs. This hierarchy can be viewed as a pyramid with facility-level costs at the top and unit-level costs at the bottom. Cooper and Kaplan basically view costs at each level of the pyramid as common costs of the

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activities carried out at the lower levels. They strongly recommend that these common costs should not be allocated downwards in the pyramid. This

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conceptualization is highly consistent with the segmented reports discussed in this chapter.

B. Segmented income statements – an example

i. Assume that Webber, Inc. has two divisions – the Computer Division and the Television Division.

1. The contribution format income statement for the Television Division is as shown. Notice:

a. Cost of goods sold consists of variable manufacturing costs.

b. Fixed and variable costs are listed in separate sections.

c. Contribution margin is computed by taking sales minus variable costs.

d. The divisional segment margin represents the Television Division’s contribution to overall company profits.

2. The Television Division’s results can be rolled into Webber, Inc.’s overall results as shown. Notice:

a. The results of the Television and Computer Divisions sum to the results shown for the whole company.

b. The common costs for the company as a whole ($25,000) are not allocated to the divisions.

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3. The Television Division’s results can also be broken down into smaller segments. This

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enables us to see how traceable fixed costs of the Television Division can become common costs of smaller segments.

a. Assume that the Television Division can be broken down into two major product lines – Regular and Big Screen.

b. Assume that the segment margins for these two product lines are as shown.

c. Of the $90,000 of fixed costs that were previously traceable to the Television Division, $80,000 ($45,000 + $35,000) is traceable to the two product lines and $10,000 is a common cost.

“In Business Insights”Segmental income statements have the potential to be useful to front-line employees. For example:

“Daily Segment Feedback Fuels Innovation” (page 551)

Steve Briley, the department manager of Cracking Plant 3B at Texas Eastman Company’s chemical plant in Longview, Texas, created an innovative daily performance report to help guide his department.

Briley issued an income statement to his employees at the beginning of each day. The daily income statement assigned revenues to the output of the previous day and costs to the inputs used.

Briley found that giving his employees the responsibility for their own income statement

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provided three key benefits. First, it gave employees rapid feedback regarding what actions

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increased or decreased profits. Second, it empowered workers to make decisions quickly in response to changes in the operating environment. Third, the daily income statement helped employees make trade-offs and set priorities.

C. Segmented financial information on external reports

i. The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports. This ruling has implications for internal segment reporting because:

1. It mandates that companies 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.

a. The absorption approach hinders internal decision making because it does not distinguish between fixed and variable costs or common and traceable costs.

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IV. Hindrances to proper cost assignment

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A. Omission of costs

i. The costs assigned to a segment should include all the costs attributable to that segment from the company’s entire value chain. The value chain consists of all major business functions that add value to a company’s products and services.

1. Since only manufacturing costs are included in product costs under absorption costing, those companies that choose to use absorption costing for segment reporting purposes will omit from their profitability analysis all “upstream” and “downstream” costs.

a. “Upstream” costs include research and development and product design costs.

b. “Downstream” costs include marketing, distribution, and customer service costs.

c. Although these “upstream” and “downstream” costs are nonmanufacturing costs, they are just as essential to determining product profitability as are manufacturing costs. Omitting them from profitability analysis will result in the undercosting of products.

Helpful Hint: An example of a company with a very high amount of upstream and downstream costs is a

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pharmaceutical company such as Merck. A great deal of its costs are comprised of research and development and marketing.

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B. Inappropriate methods for assigning traceable costs to segments

i. Failure to trace costs directly

1. Costs that can be traced directly to specific segments of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example:

a. The rent for a branch office of an insurance company should be charged directly against the branch office rather than included in a companywide overhead pool and then spread throughout the company.

ii. Inappropriate allocation base

1. Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments for internal decision making purposes only when the allocation base actually drives the cost being allocated. For example:

a. Sales is frequently used to allocate S, G, & A expenses to segments. This should only be done if sales drive S, G & A expenses.

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C. Arbitrarily dividing common costs among segments

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i. 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. First, this practice may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided.

2. Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control.

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Quick Check – common costs


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Arbitrarily allocating common costs to business segments generally leads to unnecessary bickering among segment managers. For example:

“Stopping the Bickering” (page 554) At AT&T Power Systems profit center managers

were spending more time debating overhead allocation schemes than they were spending on creating strategies to increase contribution margins.

Since no cause-and-effect relationship existed between the overhead expenses being allocated and the activity of any particular segment, these endless debates were completely unproductive.

Consequently, a change was made to evaluate the segments on the basis of contribution margin and controllable expenses – eliminating arbitrary allocations of overhead from the performance measure.

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V. Evaluating investment center performance – return on investment

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i. Investment center performance is often evaluating using a measure called return on investment (ROI), which is defined as follows:

ii. Net operating income is income before taxes and is sometimes referred to as EBIT (earnings before interest and taxes). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.

1. Net operating income is used in the numerator because the denominator consists only of operating assets.

2. The operating asset base used in the formula is typically computed as the average of the assets between the beginning and the end of the year.

iii. Net book value versus gross cost

1. Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets.

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a. With this approach, ROI mechanically increases over time as the accumulated depreciation

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increases. Replacing a fully-depreciated asset with a new asset will decrease ROI.

2. An alternative to net book value is the gross cost of the asset, which ignores accumulated depreciation.

a. With this approach, ROI does not grow automatically over time, rather it stays constant. Replacing a fully-depreciated asset does not adversely affect ROI.

B. Understanding ROI – the DuPont perspective

i. DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover.

1. Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned.

2. Turnover is computed as shown. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI.

Helpful Hint: Emphasize that both margin and turnover affect profitability. As an example, ask students to

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compare the margins and turnovers of grocery stores to jewelry stores. In equilibrium, every industry should have roughly the same ROI. Groceries, because of their

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short shelf life, have high turnovers relative to fine jewelry. If the ROIs are to be comparable in grocery stores and in jewelry stores, the margins would have to be higher in jewelry stores.

ii. Any increase in ROI must involve at least one of the following – increased sales, reduced operating expenses, or reduced operating assets. The following example shows four different ways to increase ROI:

1. Assume that Regal Company reports the results as shown.

a. Given this information, its current ROI is 15%.

2. The first way to increase ROI is to increase sales without any increase in operating assets.

a. Assume that: (1) Regal’s manager was able to increase sales to $600,000 (an increase of 20%), (2) operating expenses increased to $558,000 (an increase of 18.7%), (3) net income increased to $42,000, and (4) average operating assets remained unchanged.

b. In this case, the ROI increases from 15% to 21%. Notice, for ROI to increase, the percentage increase in sales must exceed the percentage increase in operating expenses.

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3. The second way to increase ROI is to decrease operating expenses with no change in sales or operating assets.

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a. Assume that Regal’s manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets.

b. In this case, the ROI increases from 15% to 20%.

“In Business Insights”Research shows that JIT systems can improve ROI. For example:

“JIT and ROI Improvement” (page 560) A study of companies that adopted just-in-time

(JIT) in comparison to a control group that did not adopt JIT, found that the JIT adopters improved their ROI’s more.

The JIT adopters’ success resulted from improvements in both profit margins and asset turnover.

The elimination of inventories in JIT reduces total assets, but more importantly, it leads to process improvements as production problems are exposed. When production problems and non-value-added activities are eliminated, costs go down.

4. The third way to increase ROI is to decrease operating assets with no change in sales or operating expenses.

a. Assume that Regal’s manager was able to reduce inventories by $20,000 by

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using just-in-time techniques without affecting sales or operating expenses.

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b. In this case, the ROI increases from 15% to 16.7%.

5. The fourth way to increase ROI is to invest in operating assets to increase sales.

a. 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.

b. In this case, the ROI increases from 15% to 21.8%.

“In Business Insights”Investing in operating assets can increase ROI. For example:

“McDonald Chic” (page 560) McDonald’s France has been spending lavishly to

remodel its restaurants in an effort to defuse the negative feelings many of the French people feel toward McDonald’s as a symbol of American culture.

Beyond overcoming cultural barriers, McDonald’s hopes that its remodeling efforts will entice customers to linger over their meals and spend more.

The investment in operating assets has apparently been successful – even though a Big Mac costs about the same in Paris as in New York, the average French customer spends about $9 per visit versus only about $4 in the U.S.

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C. ROI and the balanced scorecard

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i. It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well-constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI. A scorecard can answer questions such as:

1. Which internal business processes should be improved?

2. Which customers should be targeted and how will they be attracted and retained at a profit?

D. Criticisms of ROI

i. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI in a manner that is consistent with the company’s strategy.

1. This is why ROI is best used as part of a

balanced scorecard.

ii. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. This may make it difficult to assess this manager relative to other managers.

ii. A manager who is evaluated based on ROI may reject investment opportunities that are

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profitable for the whole company but that would have a negative impact on the manager’s performance evaluation.

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Helpful Hint: When discussing the criticisms of ROI and other measures of profitability, ask students to play the role of a manager who anticipates a short tenure. This manager will want to increase ROI as quickly as possible. Ask students to list the activities that could be undertaken to increase ROI that, in reality, would hurt the company as a whole.

VI. Residual income

A. Defining residual income

i. Residual income is the net operating income that an investment center earns above the minimum required return on its assets.

1. Economic Value Added (EVA®) is an adaptation of residual income. We will not distinguish between the two terms in this class.

B. Calculating residual income

i. The equation for computing residual income is as shown. Notice:

1. This computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the

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minimum required return on average operating assets.

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ii. Zepher, Inc. - an example

1. Assume the information as given for a division of Zepher, Inc.

2. The residual income ($10,000) is computed by subtracting the minimum required return ($20,000) from the actual income ($30,000).

C. Motivation and residual income

i. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula. More specifically:

1. This occurs when the ROI associated with an investment opportunity exceeds the company’s minimum required return but is less than the ROI being earned by the division manager contemplating the investment.

Quick Check – ROI versus residual income

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D. Divisional comparison and residual income

i. The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.

ii. Zepher, Inc. – continued

1. Recall that the Retail Division of Zepher had average operating assets of $100,000, a minimum required rate of return of 20%, net operating income of $30,000, and residual income of $10,000.

2. Assume that the Wholesale Division of Zepher had average operating assets of $1,000,000, a minimum required rate of return of 20%, net operating income of $220,000, and residual income of $20,000.

3. The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However,

a. The Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division.

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Some companies have stopped using residual income performance measures after trying them. For example:

“Heads I Win, Tails You Lose” (page 564) A number of companies including AT&T,

Armstrong Holdings, and Baldwin Technology, have stopped using residual income as a performance measure.

Why? Reasons differ, but “bonus evaporation is often seen as the Achilles heel of value-based metrics [like residual income and EVA] – and a major cause of plans being dropped.

Managers love residual income and EVA when their bonuses are big, but clamor for changes in performance measures when bonuses shrink.

VII. Appendix 12A: transfer pricing (Slide #77 is a title slide)


i. A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic transfer prices have no direct effect on the entire company’s reported profit, they can have a dramatic effect on the reported profitability of a division.

ii. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. Suboptimization occurs when managers do not act in the best interests of the overall company or even their own divisions.

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Helpful Hint: Emphasize that a good transfer price is one that induces division managers to do whatever is in the best interest of the entire company. Students often take for granted that divisions should make all purchases internally whenever possible – which of course is not the case. They also sometimes lose sight of the purpose of transfer pricing in their zeal to be “fair” to the various divisions.

iii. There are three primary approaches to setting transfer prices, namely negotiated transfer prices, transfers at the cost to the selling division, and transfers at market price.

B. Negotiated transfer prices

i. A negotiated transfer price results from discussions between the selling and buying divisions.

1. Negotiated transfer prices have two advantages:

a. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.

b. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

2. The range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase.

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a. The lower limit is determined by the selling division.

b. The upper limit is determined by the buying division.

ii. Harris and Louder – an example

1. Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder).

a. The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as shown.

b. The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as shown. If Pizza Maven had no outside

supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses.

c. Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

2. If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Maven’s demands (2,000 barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices are computed as follows:

a. The lowest acceptable transfer price, as determined by the seller, is £8.

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b. The highest acceptable transfer price, as determined by the buyer, is £18.

c. Therefore, the range of acceptable transfer prices is £8-£18.

3. If Imperial Beverages has no idle capacity and must sacrifice other customer orders (2,000 barrels) to meet the demands of Pizza Maven (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows:



c. Therefore, there is no range of acceptable transfer prices.

d. This is a desirable outcome for Harris Louder because it would be illogical to give up sales of £20 to save costs of £18.

4. If Imperial Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet the demands of Pizza Maven (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows:



c. Therefore, the range of acceptable transfer prices is £14-£18.

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iii. Evaluation of negotiated transfer prices

1. If a transfer within the company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer.

2. Nonetheless, if managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative atmosphere is almost guaranteed. Thus, negotiations often break down even though it would be in both parties’ best interests to agree to a transfer price.

3. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices.

“In Business Insights”Activity-based costing can be used for transfer pricing purposes. For example:

“ABC-Based Transfer Prices” (page 572) Teva Pharmaceutical Industries Ltd. of Israel

rejected the negotiated transfer price approach because senior executives believed that it would lead to endless arguments.

Instead, the company used activity-based costing to set its transfer prices. Marketing divisions are charged for unit-level costs based on the actual quantities of each product they acquire.

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In addition, they are charged batch-level costs based on the actual number of batches their orders require. Product-level and facility-level costs are charged to the marketing divisions annually in lump sums.

Essentially, Teva is setting its transfer prices at carefully computed variable costs. As long as Teva has unused capacity, this system sends the marketing managers the correct signals about how much it really costs the company to produce each product.

C. Transfers at the cost to the selling division

i. Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. The drawbacks of this approach include:

1. Using full cost as a transfer price can lead to suboptimization because it does not distinguish between variable costs, which may be relevant to the transfer pricing decision, and fixed costs, which may be irrelevant.

2. If cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sale to an outside party.

3. Cost-based transfer prices do not provide incentives to control costs. If the actual costs of one division are passed on to the next, there is little incentive for anyone to work on reducing costs.

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D. Transfers at market price

i. A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.

1. It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.

a. With no idle capacity the real cost of the transfer from the company’s perspective is the opportunity cost of the lost revenue on the outside sale.

2. It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole.

E. Divisional autonomy and suboptimization

i. The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally.

iii. While subordinate managers may occasionally make suboptimal decisions, top managers should allow their subordinates to control their own destiny – even to the extent of

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granting subordinate managers the right to make mistakes.

F. International aspects of transfer pricing

i. The objectives of domestic transfer pricing include:

1. Creating greater divisional autonomy.2. Providing greater motivation for managers.3. Enabling better performance evaluation.4. Establishing better goal congruence.

ii. The objectives of international transfer pricing include:

1. Lessen taxes, duties and tariffs.2. Lessen foreign exchange risks.3. Improve competitive position.4. Improve relations with foreign governments.

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Chapter 12Transparency Masters

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TM 12-1

AGENDA: SEGMENT REPORTING AND DECENTRALIZATION

A. Segment reporting.1. Cost, profit, and investment centers.2. Traceable and common costs.3. Dangers in allocating common costs.

B. Measures of performance in investment centers.1. Return on investment (ROI).2. Residual income.

C. Transfer pricing.

© The McGraw-Hill Companies, Inc., 2006. All rights reserved.

TM 12-2

Segments Classified as Cost, Profit, And Investment Centers

(Exhibit 12-1)


TM 12-3

SEGMENT REPORTING

Managers need more than a single, company-wide income statement; they need statements that focus on the various segments of a company.DEFINITION OF A SEGMENT

A segment is any part or activity of an organization about which a manager seeks cost or revenue data. Examples of segments include: sales territories, products, divisions of a company, individual salespersons, individual customers, etc.ASSIGNMENT GUIDELINES

Two guidelines should be followed in assigning costs to the various segments of a company:

1. According to cost behavior patterns (i.e., fixed or variable).2. According to whether the costs are directly traceable to

the segments involved.TRACEABLE AND COMMON COSTS

A cost is either traceable or common with respect to a particular segment.

Traceable costs arise because of the existence of the particular segment. Traceable costs would disappear if the segment itself disappeared.

Common costs support more than one business segment but are not traceable, in whole or in part, to any one of those segments.


TM 12-4

SEGMENT REPORTING EXAMPLEEXAMPLE:

Mary Fischer, the owner of Mary’s Market, would like information concerning the performance of the Market’s two main segments—the meat and produce departments.

The following partial list of costs was provided to help identify fixed and variable and traceable and common costs:

Meat Department Produce Department• Variable

costs• Wholesale cost of

meats• Wholesale cost of

produce• Packaging materials • Plastic bags and ties

• Traceable fixed costs

• Meat department manager’s salary

• Produce department manager’s salary

• Butchers’ wages * • Workers’ wages *• Meat department

depreciation *• Produce department

depreciation *• Rent on meat

department spaces**• Rent on produce

department spaces**

• Common fixed costs

• Rent on space occupied by general offices, checkout counters, etc.

• General manager’s salary• Accountant’s salary• Checkout clerks’ wages• Liability insurance premiums

* Depending on circumstances, all or part of the indicated costs

could be variable.** This assumes that the rent costs would be avoided if the

department were eliminated.


TM 12-5

SEGMENT REPORTING EXAMPLETotal Departments

Company Meats Produce

Sales.......................................$1,500,00

0$900,00

0 $600,000

Less variable expenses.......... 810,00

0 460,000 350,000 Contribution margin............... 690,000 440,000 250,000Less traceable fixed

expenses.............................. 400,00

0 230,000 170,000

*

Divisional segment margin..... 290,000$210,00

0 $ 80,000 Less common fixed expenses

not traceable to departments........................

240,00 0

Net operating income.............$

50,000

Product LinesFresh Packaged

Produce Produce Produce

Sales...................................... $600,000$400,00

0 $ 200,000Less variable expenses.......... 350,000 200,000 150,000 Contribution margin............... 250,000 200,000 50,000Less traceable fixed

expenses............................. 100,000 40,000 60,000

Product line segment margin. 150,000$160,00

0 $ (10,000 )Less common fixed expenses

not traceable to product lines..................................... 70,000

Divisional segment margin..... $ 80,000 *The $170,000 in traceable fixed expenses for the Produce Department changes to $100,000 traceable and $70,000 common expenses when the Produce Department is further segmented by product lines.


TM 12-6

Graphic Presentation of Segment Reporting

(Exhibit 12-2)


TM 12-7

DANGERS IN ALLOCATING COMMON COSTSCommon costs should not be allocated among segments. If

common costs are allocated, then the results can be misleading to management.EXAMPLE: Suppose the common costs of Mary’s Market were allocated on the basis of sales (a frequently used allocation basis).

Total Product LinesCompany Meats Produce

Sales........................................$1,500,00

0 $900,000$600,00

0

Less variable costs................... 810,00

0 460,000 350,000 Contribution margin................. 690,000 440,000 250,000

Less traceable fixed costs........ 400,00

0 230,000 170,000 Divisional segment margin....... 290,000 210,000 80,000 Less allocated common fixed

costs...................................... 240,00

0 144,000 96,000

Net operating income...............$ 50,00

0 $ 66,000 $(16,000

)If the Produce Department were closed down because of its apparent loss, the following would be expected to occur:

Total Product LinesCompany Meats Produce

Sales........................................ $900,000 $900,000 —Less variable costs................... 460,000 460,000 —Contribution margin................. 440,000 440,000 —Less traceable fixed costs........ 230,000 230,000 —Divisional segment margin....... 210,000 210,000 —Less allocated common fixed

costs...................................... 240,000 240,000 —Net operating income............... $(30,000) $(30,000) —


TM 12-8

RETURN ON INVESTMENT

Investment centers are often evaluated based on their return on investment (ROI), which is computed as follows:

orROI = Margin × Turnover

where:

EXAMPLE: Regal Company reports the following data for last year’s operations:

Net operating income...... $30,000

Sales...............................$500,00

0Average operating

assets...........................$200,00

0

To increase ROI, at least one of the following must occur:1. Increase sales.2. Reduce expenses.3. Reduce operating assets.


TM 12-9

RETURN ON INVESTMENT (cont’d)

Example 1—Increase sales:Assume that Regal Company is able to increase sales to

$600,000. Net operating income increases to $42,000, and the operating assets remain unchanged.

(compared to 15% before)

Example 2—Reduce expenses:Assume that Regal Company is able to reduce expenses by

$10,000 per year, so that net operating income increases from $30,000 to $40,000. Sales and operating assets remain unchanged.


Example 3—Reduce assets:Assume that Regal Company is able to reduce its average

operating assets from $200,000 to $125,000. Sales and net operating income remain unchanged.



TM 12-10

RESIDUAL INCOME

Residual income is the net operating income that an investment center earns above the minimum rate of return on its operating assets.EXAMPLE: Marsh Company has two divisions, A and B. Division A has $1,000,000 and Division B has $3,000,000 in average operating assets. Each division is required to earn a minimum return of 12% on its investment in operating assets.

Division A Division B

Average operating assets...................$1,000,00

0$3,000,00

0Net operating income......................... $ 200,000 $ 450,000Minimum required return:

12% × average operating assets..... 120,000 360,000 Residual income................................. $ 80,000 $ 90,000

Economic value added (EVA) is a concept similar to residual income. EVA has been adopted by many companies in recent years.


TM 12-11

RESIDUAL INCOME (cont’d)

The residual income approach encourages managers to make profitable investments that would be rejected under the ROI approach.

EXAMPLE: Marsh Company’s Division A has an opportunity to make an investment of $250,000 that would generate a return of 16% on invested assets (i.e., $40,000 per year). This investment would be in the best interests of the company since the rate of return of 16% exceeds the minimum required rate of return. However, this investment would reduce the division’s ROI:

PresentNew

Project OverallAverage operating assets

(a)$1,000,0

00$250,00

0$1,250,0

00Net operating income (b).... $200,000 $40,000 $240,000ROI (b) ÷ (a)....................... 20.0% 16.0% 19.2%

On the other hand, this investment would increase the division’s residual income:

Average operating assets (a)

$1,000,000

$250,000

$1,250,000

Net operating income (b)....$ 200,00

0$ 40,00

0$ 240,00

0Minimum required return:

12% × (a)........................ 120,00

0 30,000 150,000

Residual income..................$ 80,00

0$ 10,00

0 $ 90,000


TM 12-12

TRANSFER PRICING

A transfer price is the price charged when one segment (for example, a division) provides goods or services to another segment of the same company.

• Transfer prices are necessary to calculate costs in a cost, profit, or investment center.

• The buying division will naturally want a low transfer price and the selling division will want a high transfer price.

• From the standpoint of the company as a whole, transfer prices involve taking money out of one pocket and putting it into the other.

• An optimal transfer price is one that leads division managers to make decisions that are in the best interests of the company as a whole.

Three general approaches are used in practice to set transfer prices:

1. Negotiated price.2. Cost-based price.

a. Variable cost.b. Full (absorption) cost.

3. Market price.


TM 12-13

NEGOTIATED TRANSFER PRICESWhen division managers work well together and understand

their businesses, a negotiated transfer price is an excellent solution to the transfer pricing problem. If a transfer is in the best interests of the entire company, division managers bargaining in good faith should be able to find a transfer price that increases the profits of both the divisions.

The lowest acceptable price from the viewpoint of the selling division:

The highest acceptable price from the viewpoint of the buying division when the unit can be purchased from an outside supplier:


TM 12-14

TRANSFER PRICING EXAMPLES

EXAMPLE: The Battery Division of Barker Company makes a standard 12-volt battery.

Production capacity (number of batteries).............................................. 300,000

Selling price per battery to outsiders...... $40Variable costs per battery....................... $18Fixed costs per battery (based on

capacity)............................................... $7Barker Company has a Vehicle Division that could use this battery in its forklift trucks. The Vehicle Division would like to buy 50,000 batteries per year. It is presently buying these batteries from an outside supplier for $39 per battery.

BatteryDivision Selling price: $40

Purchase price: $39

Transfer Price: ?

VehicleDivision

OutsideMarket

forVehicle

Batteries

ForkliftTrucks


TM 12-15

TRANSFER PRICING EXAMPLES (cont’d)

Situation 1:Suppose the Battery Division is operating at capacity.What is the lowest acceptable transfer price from the viewpoint

of the selling division?

But, the buying division will not pay more than $39, the cost from buying the batteries from the outside. So the two managers will not be able to agree to a transfer price and no transfer will voluntarily take place.

From the standpoint of the entire company, no transfer should take place since the company gives up $40 in revenues, but saves only $39 in costs.


TM 12-16


Situation 2:Assume again that the Battery Division is operating at capacity,

but suppose that the division can avoid $4 in variable costs, such as selling commissions, on transfers within the company.

What is the lowest acceptable transfer price from the viewpoint of the selling division?

Once again, the buying division will not pay more than $39, the cost from buying the batteries from the outside.

In this case an agreement is possible. Any transfer price within the range

$36 Transfer price $39will increase the profits of both of the divisions.

From the standpoint of the entire company, this transfer should take place since the cost of the transfer is $36 and the company saves $39, for a net gain of $3.


TM 12-17


Situation 3:Refer to the original data. Assume that the Battery Division has

enough idle capacity to supply the Vehicle Division’s needs without diverting batteries from the outside market, but there is no savings in variable costs on the transfer inside the company.

What is the lowest acceptable transfer price from the viewpoint of the selling division? In this case there are no lost sales.

Once again, the buying division will not pay more than $39, the cost from buying the batteries from the outside.

And again in this case an agreement is possible. Any transfer price within the range

$18 Transfer price $39will increase the profits of both of the divisions.

From the standpoint of the entire company, this transfer should take place since the cost of the transfer is $18 and the company saves $39, for a net gain of $11.


TM 12-18


Situation 4:The Vehicle Division wants the Battery Division to supply it with

20,000 special heavy-duty batteries.• The variable cost for each heavy-duty battery would be $27.• The Battery Division has no idle capacity.• Heavy-duty batteries require more processing time than

regular batteries; they would displace 22,000 regular batteries from the production line.

What is the lowest acceptable transfer price from the viewpoint of the selling division?

In this case, the opportunity cost of producing one of the special batteries is $24.20, the average amount of lost contribution margin.


TM 12-19

TRANSFER PRICING EXERCISE

Case 1 Case 2 Case 3 Case 4

Division A capacity.................100,00

0500,00

0250,00

0400,00

0

Division A outside sales..........100,00

0500,00

0200,00

0300,00

0

Division B needs..................... 30,000 80,000 50,000100,00

0Division A:

Normal variable cost............ $40 $ 60 $30 $50Variable costs avoided on

internal sales..................... $0 $10 $0 $2Fixed cost per unit based

on capacity........................ $10 $25 $8 $12Outside selling price............ $70 $100 $45 $80

Division B:Purchase price from outside

supplier.............................. $68 $96 $43 $75Range of acceptable

transfer prices................... ? ? ? ?

Answers:Case 1: No Transfer will take placeCase 2, $90 Transfer price $96Case 3, $30 Transfer price $43Case 4, $48 Transfer price $75


TM 12-20

COST-BASED TRANSFER PRICESTransfer prices based on cost are easily understood and

convenient to use and do not require negotiation. Unfortunately, cost-based transfer prices have several disadvantages:

• Cost-based transfer prices can lead to bad decisions. (For example, they don’t include opportunity costs from lost sales.)

• The only division that will show any profit on the transaction is the one that makes the final sale to an outside party.

• Cost-based transfer prices provide no incentive for control of costs unless transfers are made at standard cost.

MARKET-BASED TRANSFER PRICESWhen item being transferred has an active outside market, the

market price may be a suitable transfer price. However, when the selling division has idle capacity, the market price will overstate the real cost to the company of the transfer and may lead the buying division manager to make bad decisions.


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