Segment Reporting and Decentralization

1. Segment Reportingand Decentralization ACC 2203 Review Workshop Professor Huang

2. Responsibility Accounting, Performance Measurement Segment Reporting, and Transfer Pricing Large companies are comprised of many business units or segments. A segment may be a division, department, product line, sales territory, or a service center. Effective management of large companies requires delegating much of the decision making authority from corporate top management to segment managers. Segment managers are, in turn, held responsible for improving the segment performance as it relates to the overall corporate performance.

3. Responsibility Accounting, Performance Measurement Segment Reposting, and Transfer Pricing Responsibility Accounting is a management system that aims to develop performance measures by which segment managers are evaluated. Under responsibility accounting segments are broadly categorized as: • Cost centers – segments whose managers are held responsible only for costs but not for revenue or investments • Profit centers – segments whose managers are held responsible for both costs and revenues but not for investments • Investment centers – segments whose managers are held responsible for the capital invested as well as the profits made in the segment

4. Segment Reporting Obviously, in each segment category managerial responsibilities are different. The performance measures for evaluating managers should also be different so as to be consistent with the responsibilities. For example, assigning revenue or sales targets to a cost center manager would not be sensible. What are the advantages and disadvantages of decentralization – that is dividing the company into cost, profit, and investment centers and hiring managers to run each center rather than requiring the corporate top management to run all of them?

5. Segment Reporting Segment reports provide information about each segment’s financial performance and are important for assessing a segment’s success in attaining its goals as set mainly by upper level management. Segmented income statements reveal the profits earned by individual segments and hence the contribution of each segment to the overall corporate profitability. Income statements of segments are usually prepared in the contribution format which requires identifying the fixed costs attributable to segments. Traceable fixed costs – are caused by a particular segment and would go away if the segment is discontinued Common fixed costs – costs that are incurred to support more than one segment and hence are not directly identified with a particular segment. Common fixed costs would not go away if any particular segment is discontinued. Only traceable fixed costs are included in the income statements of segments; common fixed costs are excluded.

6. Traceable and Common Costs Classify the following fixed costs as traceable or common (Note: NBC is a subsidiary of GE): • The salary of GE’s CEO • The salary of the president of GE’s Appliances business unit which comprises multiple divisions such as Refrigerators & Freezers; Washers & Dryers; Dishwashers & Disposers • The maintenance cost for the broadcasting studios of NBC • The depreciation cost on the GE headquarters building • The maintenance and depreciation cost on the cameras used by NBC’s sports division • The salaries paid to the news anchors at NBC • The cost of heating, lighting, and air conditioning the NBC offices in Burbank, California and in New York

7. Concept check 1. Managers in which of the following responsibility centers are held responsible for profits? (You may select more than one answer.) a. Revenue centers b. Cost centers c. Profit centers d. Investment centers 2. Which of the following statements is false? (You may select more than one answer.) a. The same cost can be traceable or common depending on how the segment is defined. b. In general, common fixed costs should be assigned to segments. c. If a company eliminates a segment of its business, the costs that were traceable to that segment should disappear. d. If four segments share $1 million in common fixed costs and one segment is eliminated, the common fixed costs will decrease by $250,000.

8. Segment Reporting - Example • The Coldex Company has two divisions: Refrigerators Division and Deep-Freezers Division. The following financial information pertains to the operations of the divisions: (in thousands) RefrigeratorsDeep-Freezers Sales revenue $600,000 $330,000 Var. Man. $180,000 $120,000 Variable S&A $100,000 $80,000 Traceable FC $140,000 $100,000 • The common fixed costs in the company totaled $93,000

9. Segment Reporting - Example • Prepare an income statement for the Coldex company segmented by the divisions. (in thousands) CompanyRefrigeratorsDeep-Freezers Sales revenue $ Variable costs $ Cont. margin $ Traceable FC $ Division margin $ Common FC $ Net Op income $

10. Measuring Segment Performance A major purpose of segment reporting is to determine how well segments have performed and how well they are being run by the segment managers. In many companies, segment performance directly affects managerial compensation, managerial promotion, and amount of investment funds allocated to each segment by the headquarters. We will study two popular metrics that are primarily used in profit and investment centers for judging segment performance: Return on investment (ROI) and Residual income. Return on investment (ROI) measures the net operating income generated per dollar of investment in operating assets Net operating income – income before interest and taxes (or earnings before interest and taxes – EBIT) Operating assets – include accounts receivable, inventory, plant and equipment and other productive assets; excludes land held for future use, investments in other companies Average operating assets – average value of the operating assets between the beginning and end of a period

11. ROI - Definition The ROI formula can also be expressed as follows: Sales margin – measures a segment’s ability to control its operating costs and to make money on its sales Capital turnover – measures a segment’s ability to generate revenue for each dollar invested in operating assets Sales margin and capital turnover constitute the components of ROI and point attention to areas that present improvement opportunities such as increasing sales without increasing operating assets (increases capital turnover) and reducing costs without impairing sales (increases sales margin).

12. Net operating income Sales Sales Average operating assets ROI = × Margin  Turnover ROI = Increasing ROI – An Example Regal Company reports the following: Net operating income $ 30,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000

13. Net operating income Sales Sales Average operating assets ROI = × Margin  Turnover ROI = Increasing ROI – An Example Regal Company reports the following: Net operating income $ 30,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000 What is Regal Company’s ROI?

14. Net operating income Sales Sales Average operating assets ROI = × Margin  Turnover ROI = Increasing ROI – An Example

15. Increasing Sales Without anIncrease in Operating Assets • Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000. • Regal’s net operating income increased to $42,000. • There was no change in the average operating assets of the segment. What is the new ROI?

16. Net operating income Sales Sales Average operating assets ROI = × Margin  Turnover ROI = Increasing Sales Without anIncrease in Operating Assets ROI = ??

17. Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regal’s manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets. This would increase net operating income to $40,000. Regal Company reports the following: Net operating income $ 40,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 460,000

18. Decreasing Operating Assets with no Change in Sales or Operating Expenses Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time techniques without affecting sales or operating expenses. Regal Company reports the following: Net operating income $ 30,000 Average operating assets $ 180,000 Sales $ 500,000 Operating expenses $ 470,000 Let’s calculate the new ROI.

19. Investing in Operating Assets to Increase Sales Assume that Regal’s manager invests in a $30,000 piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Regal Company reports the following: Net operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000 Let’s calculate the new ROI.

20. Residual Income - Definition Residual Income (RI) measures the net operating income earned in excess of a required return on operating assets. RI = Net operating income – Required return on operating assets Decision rule: Accept a project if its residual income >0 Residual income recognizes that funds invested in operating assets impose a cost on the firm. For example, if a firm borrowed bank loans to acquire the operating assets, it has to pay interest. To improve the value of the firm, those assets must generate an income greater than the interest payments. Otherwise, value will be destroyed.

21. Residual Income - Example A division of Epsilon Corp. has average operating assets of $200,000. The required rate of return for the division is 20%. The division recently reported a net operating income of $50,000. Calculate the division’s residual income and indicate whether Epsilon should keep or discontinue the division. • Required return on assets = • RI =

22. ROI Vs. Residual Income The residual income approach emphasizes maximizing the overall firm value by encouraging managers to invest in projects that earn more than the firm’s cost of capital. The ROI approach, on the other hand, emphasizes maximizing the segment ROI, leading managers to sometimes forego projects that would otherwise improve overall firm value but reduce segment ROI. Problem: Sussex Magnet, a division of Sussex International Corp., has a net operating income of $150,000 and average operating assets of $500,000. The required annual rate of return for the company is 20%. Sussex Magnet identified a new project that would require an investment of $180,000 and earn an additional net operating income of $40,000 per year. • What is the division’s current ROI? • If the manager of Sussex Magnet is compensated based on the division’s ROI, would the manager undertake the new project? Why or why not?

23. ROI Vs. Residual Income • Would the Sussex International Corp. want the Sussex Magnet division to undertake the new project? Why or why not? • What is Sussex Magnet’s current residualincome? • If the manager of Sussex Magnet is compensated based on the division’s residual income, would the manager undertake the new project? Why or why not?

24. Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20%

25. Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

26. Quick Check  The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

27. Quick Check  Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000

28. Quick Check  If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No