Profitability Analysis of Strategic Business Segments

1. 13 C hapter Profitability Analysis of Strategic Business Segments Prepared by Douglas Cloud Pepperdine University

2. Objectives 1. Recognize a strategic business segment. 2. Discuss centralized and decentralized organization structures. 3. Understand the development and use of segment reports. 4. Evaluate transfer pricing alternatives, including international transfers. 5. Discuss the issues that cause difficulty in evaluating decentralized operations. After studying this chapter, you should be able to:

3. Objectives 6. Calculate, explain, and compare return on investment, residual income and economic value-added residual income measures for divisional performance 7. Understand the concept of performance measurement when financial and nonfinancial concepts are integrated.

4. Strategic Business Segment • Astrategic business segmentis generally one that has its own mission and set of goals to be achieved. • Themission of the segment influences the decisions that its top managers make in both short-run and long-run situations.

5. The lower in the organization that authority is delegated, the greater the decentralization. Decentralization Decentralization is the delegation of decision-making authority to successively lower management levels in an organization.

6. Decentralization The advantages of decentralization include: • Firsthand decision making • Timely decisions • Specialization • Motivation • Focus • Frees up higher level management’s time

7. Decentralization The disadvantages of decentralization include: • Compatible performance measurements • Suboptimization • Duplication • Lack of competent personnel

8. Centralization Centralization exists when top management has a wide span of control, including direct control over all major functions of an organization.

9. Centralization The advantages of centralization include: • Economies of scale • Sophistication of applications • Improved control

10. Centralization The disadvantages of centralization include: • Span of control • Complexity • Diseconomies of scale

11. Manager Plant 1 Manager Plant 2 Division Controller Marketing Manager Other Staff Organization Chart with Decentralization President Executive Vice President V. P. Division B Other Corporate Staff V. P. Division A Corporate Controller Marketing V. P. Production and Service Departments Area Sales Representatives

12. Segment Reporting They are used were companies have distinct divisions of product lines, geographic territories, or organization units. Segment Reports are income statements for a portions or segments of a business.

13. Segment Reporting Three steps basic to the preparation of all segment reports: 1. Identification of the segments 2. Assignment of direct costs to the segments 3. Allocation of indirect costs to the segments

14. Segment Reporting In segment reports, costs are recorded in four categories. Variable costs Direct fixed costs Allocated common costs Unallocated common costs

15. Multi-Level Segment Reports First Level Segments (Divisions) National Accounts Regional Accounts Company Total Sales $100,000 $200,000 $300,000 Less variable costs -55,000 -95,000 -150,000 Contribution margin $ 45,000 $105,000 $150,000 Less direct fixed costs -20,000 -60,000 -80,000 Division margin $ 25,000 $ 45,000 $ 70,000 Less allocated common costs -10,000 -25,000 -35,000 Division income $ 15,000 $ 20,000 $ 30,000 Less unallocated common costs -12,000 Net income $ 23,000

16. Multi-Level Segment Reports Second Level Segments (Products) National Division Total Fiber Optic Twisted Pair Sales $30,000 $70,000 $100,000 Less variable costs -15,000 -40,000 -55,000 Contribution margin $15,000 $30,000 $ 45,000 Less direct fixed costs -9,000 -6,000 -15,000 Product margin $ 6,000 $24,000 $ 30,000 Less allocated division costs -5,000 -5,000 -10,000 Product income $ 1,000 $19,000 $ 20,000 Less unallocated common costs -5,000 National Accounts Division income $ 15,000

17. Multi-Level Segment Reports Second Level Segments (Products) National Division Total Fiber Optic Twisted Pair Sales $30,000 $70,000 $100,000 Less variable costs -15,000 -40,000 -55,000 Contribution margin $15,000 $30,000 $ 45,000 Less direct fixed costs -9,000 -6,000 -15,000 Product margin $ 6,000 $24,000 $ 30,000 Less allocated division costs -5,000 -5,000 -10,000 Product income $ 1,000 $19,000 $ 20,000 Less unallocated common costs -5,000 National Accounts Division income $ 15,000

18. Multi-Level Segment Reports Third Level Fiber Optic Total Segments (Territories) Atlantic Pacific Sales $20,000 $10,000 $30,000 Less variable costs -11,000 -4,000 -15,000 Contribution margin $ 9,000 $ 6,000 $15,000 Less direct fixed costs -3,000 -4,000 -7,000 Territory margin $ 6,000 $ 2,000 $ 8,000 Less allocated division costs -2,000 -3,000 -5,000 Territory income $ 4,000 -$ 1,000 $ 3,000 Less unallocated common costs -2,000 Fiber Optic income $ 1,000

19. Direct Versus CommonSegment Costs The segment margin represents the amount that a segment contributes toward the common costs of the organization and toward profits. Direct segment costs are costs that would not be incurred if the segment being evaluated were to be discontinued. Common segment costs are related to more than one segment and are not directly traceable to a particular segment.

20. Transfer Pricing • A transfer priceis the internal value assigned a product or service that one division provides to another. • Transfer pricing transactionsnormally occur between profit or investment centers. • Theobjective of transfer pricingis to transmit financial data between departments or divisions of a company. • Transfer pricing systemsare normally used in decentralized operations to determine whether organizational objectives are being achieved in each division.

21. Transfer Pricing OmniTech, Inc. has five divisions, some of which transfer products and product components to other OmniTech divisions. The BioTech Division manufactures two products, Alpha and Beta. Alpha is sold externally for $50 per unit, and Beta is transferred to the GenTech Division for $60 per unit.

22. Transfer Pricing The costs associated with the two products are shown below: Product AlphaBeta Variable costs: Direct materials $15 $14 Direct labor 5 10 Variable manufacturing overhead 5 16 Selling 4 0 Fixed costs: Fixed manufacturing overhead 6 15 Total $35 $55

23. Buy $52 Make: Direct materials $14 Direct labor 10 Variable manufacturing overhead 16-40 Difference favors making $12 Transfer Pricing A proposal has been received from an external company to supply the GenTech Division with a substitute product similar to Beta at a price of $52. Relevant Costs

24. Transfer Pricing Opportunity Cost The BioTech Division can sell all the Alpha that it can produce (it is operating at capacity) and there is no external market for Beta. The outlay cost for Beta is $40 ($14 + $10 + $16)

25. Transfer Pricing Opportunity Cost If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s opportunity cost is the net benefit forgone. Buy Make

26. Selling price of Alpha $50 Outlay costs of Alpha: Direct materials $15 Direct labor 5 Variable manufacturing overhead 5 Variable selling 4-29 Opportunity cost of making Beta $21 Make: Outlay costs of Beta $40 Opportunity cost of Beta 21 $61 Buy: $52 Transfer Pricing Opportunity Cost If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s opportunity cost is the net benefit forgone. The company should buy from the outside supplier.

27. Determining Transfer Price • Market Price • Variable Costs • Variable Costs plus Opportunity Costs • Absorption Cost plus Markup • Negotiated Prices • Dual Prices

28. Determining Transfer Price Market Price Product Alpha of the BioTech Division can be sold competitively at $50 per unit or transferred to a third division, the Quantum Division for additional processing. The BioTech Division will never sell Alpha for less than $50, and the Quantum Division will never pay more than $50 for it. However, because variable selling expenses of $4 per unit can be eliminated in interdepartment transfers, the price probably will be between $46 and $50.

29. Direct materials $14 Direct labor 10 Variable manufacturing overhead 16 Total variable costs $40 Determining Transfer Price Variable Costs If Beta could be sold externally for $60, the BioTech Division would not want to transfer Beta to GenTech Division for a $40 transfer price based on the following variable costs:

30. Selling price of Beta $60 Variable costs -40 Contribution margin $20 Determining Transfer Price Variable Costs The BioTech Division would much rather sell outside the company for $60, which covers variable costs and provide for a profit contribution margin of $20.

31. Determining Transfer Price Variable Costs Plus Opportunity Costs If the BioTech Division had excess capacity, the transfer price of Beta would be set at Beta’s variable costs of $40 per unit. If BioTech Division cannot sell Beta externally, but can sell all the Alpha it can produce, and it is operating at capacity, the transfer price per unit would be set at $61, the sum of Beta’s variable and opportunity cost ($40 + $21).

32. Determining Transfer Price Absorption Cost Plus Markup Absorption cost plus markup provides the supplying division with a contribution toward unallocated costs. In “cost-plus” transfer pricing, “cost” should be defined as standard cost rather than as actual cost.

33. Determining Transfer Price Negotiated Price Negotiated transfer prices are used when the supplying and buying divisions independently agree on a price. Negotiated transfer prices are believed to preserve divisional autonomy.

34. Determining Transfer Price Dual Prices Dual prices exists when a company allows a difference in the supplier’s and receiver’s transfer prices for the same product.

35. Suboptimization Suboptimizationis a transfer pricing problem that exists when divisions, acting in their own best interest, set transfer prices or make decisions based on transfer prices that are not in the best interest of the organization as a whole

36. Suboptimization A potential transfer pricing problem exists when divisions exchange goods or services when there is no established market. In the interest of maintaining a strong profit center philosophy, top management may decide to suboptimize by allowing profit centers to profit services of themselves.

37. International Transfer Pricing Using Transfer Price Based on Variable CostFull CostMarket Price (000’s) (000’s) (000’s) Taxable income of the Mercedes Division, excluding the transfer $200,000 $200,000 $200,000 Cost of emission components to Mercedes Division Variable cost ($20 x 300,000) -6,000 Full cost ($25 x 300,000) -7,500 Market price ($40 x 300,000) -12,000 Taxable income $194,000 $192,500 $188,000 Mercedes Division income taxes (50%) $97,000 $96,250 $94,000 Continued

38. International Transfer Pricing Using Transfer Price Based on Variable CostFull CostMarket Price (000’s) (000’s) (000’s) Taxable income of the Chrysler Division, excluding the transfer $200,000 $200,000 $200,000 Cost of emission components to Mercedes Division Variable cost ($20 x 300,000) 6,000 Full cost ($25 x 300,000) 7,500 Market price ($40 x 300,000) 12,000 Taxable income $206,000 $207,500 $212,000 Chrysler Division Income Taxes (35%) $72,100 $72,625 $74,200 Continued

39. International Transfer Pricing Using Transfer Price Based on Variable CostFull CostMarket Price (000’s) (000’s) (000’s) • Total Daimler-Chrysler • Income Taxes • ($97,000 + $72,100) $169,100 • ($96,250 + $72,625) $168,875 • ($94,000 + $74,200) $168,200

40. or Investment turnover x Return-on-sales ratio ROI = Return on Investment (ROI) Investment center income Investment center asset base ROI =

41. Investment center income Sales Return-on-sales ratio = Return on Investment (ROI) Sales Investment center asset base Investment Turnover =

42. Sales Investment center income Investment center Sales asset base x ROI = Investment center income Investment center asset base ROI = Return on Investment (ROI)

43. North American Steel PERFORMANCE MEASURES Investment Return-on-Sales Turnover Ratio ROI x = Operating units: Maine Division 1.50 0.12 0.18 Alberta Division 2.00 0.12 0.24 Missouri Division 0.67 0.33 0.22 Tijuana Division 1.50 0.18 0.27 Company performance criteria: Projected minimums 1.20 0.15 0.18

44. Sales Investment center income Investment center Sales asset base x ROI = $1,600,000 $160,000 $800,000 $1,600,000 x ROI = 0.20 x 20 percent ROI = North American Steel Maine Division

45. $2,000,000 -1,800,000 $ 200,000 Division income Less minimum return (12%) Equals residual income Minimum rate of return set by management $15,000,000 x 0.12 Residual Income

46. Residual Income The primary disadvantage of the residual income method is that it measures performance in dollars. It cannot be used to compare the performance of divisions of different sizes

47. Division income after taxes ($2,000,000 x 0.70) $1,400,000 Cost of capital employed ($15,000,000 - $1,800,000) x 0.10 -1,320,000 Economic value-added residual income $ 80,000 Economic Value Added A firm has a cost of capital of 10 percent, $1,800,000 in current liabilities and a 30 percent tax rate.

48. Why Not Just Use Financial Measures? 1. There is no single financial measure that captures all performance aspects of an organization. 2. Financial measures have reporting time lags that may hinder timely decision making. 3. The financial measures may not accurately capture information needed for current decision making.

49. What is the Balanced Scorecard? It is a performance measurement system that includes financial and operational measures which are related to the organizational goals. Generally it relates resulting performance to the reward system within each organizational unit.

50. Balanced Scorecard Linked to Organizational Performance • Financial Perspective • Customer Perspective • Internal Perspective • Innovation and Learning Perspective The most commonly used key performance indicators found in a survey are--