Performance Measurement in Decentralized Organizations

1. Performance Measurement in Decentralized Organizations Chapter 11

2. Cost, Profit, and Investments Centers Cost Center Profit Center Investment Center Cost, profit, and investment centers are all known as responsibility centers. Responsibility Center

3. Cost Center A segment whose manager has control over costs, but not over revenues or investment funds.

4. A segment whose manager has control overbothcosts and revenues, but no control over investment funds. Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other Profit Center

5. A segment whose manager has control over costs, revenues, and investments in operating assets. Investment Center Corporate Headquarters

6. Investment Centers Cost Centers Responsibility Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

7. Responsibility Centers Profit Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

8. Cost Centers Responsibility Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

9. An Individual Store Quick Mart A Sales Territory A Service Center Decentralization and Segment Reporting Asegmentis any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be . . .

10. Superior Foods: Geographic Regions Superior Foods Corporation could segment its business by geographic regions.

11. Superior Foods: Customer Channel Superior Foods Corporation could segment its business by customer channel.

12. Keys to Segmented Income Statements There are two keys to building segmented income statements: A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

13. No computer division means . . . No computer division manager. Identifying Traceable Fixed Costs Traceable costsarise because of the existence of a particular segment and would disappear over time if the segment itself disappeared.

14. No computer division but . . . We still have a company president. Identifying Common Fixed Costs Common costsarise because of the overall operation of the company and would not disappear if any particular segment were eliminated.

15. Traceable Costs Can Become Common Costs It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

16. Segment Margin Thesegment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is thebest gaugeof the long-run profitability of a segment. Profits Time

17. Don’t allocate common costs to segments. Traceable Common Traceable and Common Costs Fixed Costs

18. Let’s look more closely at the Television Division’s income statement. Levels of Segmented Statements Webber, Inc. has two divisions.

19. Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate sections. Levels of Segmented Statements Our approach to segment reporting uses the contribution format.

20. Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Contribution margin is computed by taking sales minus variable costs. Segment margin is Television’s contribution to profits.

21. Levels of Segmented Statements

22. Levels of Segmented Statements Common costs should not be allocated to the divisions. These costs would remain even if one of the divisions were eliminated.

23. Traceable Costs Can Become Common Costs As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided intosmaller segments. Let’s see how this works using the Webber, Inc. example!

24. Television Division Regular Big Screen Traceable Costs Can Become Common Costs Webber’s Television Division Product Lines

25. Traceable Costs Can Become Common Costs We obtained the following information from the Regular and Big Screen segments.

26. Traceable Costs Can Become Common Costs Fixed costs directly traced to the Television Division $80,000 + $10,000 = $90,000

27. External Reports The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports. • Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. • 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.

28. Segment 1 Common Costs and Segments • Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: • This practice may make a profitable business segment appear to be unprofitable. • Allocating common fixed costs forces managers to be held accountable for costs they cannot control. Segment 2 Segment 3 Segment 4

29. Quick Check  Assume that Hoagland's Lakeshore prepared its segmented income statement as shown.

30. Quick Check  How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it.

31. Quick Check  How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it. A common fixed cost cannot be eliminated by dropping one of the segments.

32. Quick Check  Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000

33. Quick Check  Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000 The bar would be allocated 1/10 of the cost or $20,000.

34. Quick Check  If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment?

35. Hurray, now everything adds up!!! Allocations of Common Costs

36. Quick Check  Should the bar be eliminated? a. Yes b. No

37. The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000! Quick Check  Should the bar be eliminated? a. Yes b. No

38. Net operating income Average operating assets ROI = Return on Investment (ROI) Formula Income before interest and taxes (EBIT) Cash, accounts receivable, inventory, plant and equipment, and other productive assets.

39. Net Book Value versus Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets.

40. Net operating income Average operating assets ROI = Net operating income Sales Margin = Sales Average operating assets Turnover = Margin  Turnover ROI = Understanding ROI

41. Net operating income Sales Sales Average operating assets ROI = × ROI = Margin  Turnover 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?

42. Sales Average operating assets Net operating income Sales ROI = × $30,000 $500,000 $500,000 $200,000 ROI = × ROI = 6%  2.5 = 15% ROI = Margin  Turnover Increasing ROI – An Example

43. 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.

44. Net operating income Sales Sales Average operating assets ROI = × $50,000 $535,000 $535,000 $230,000 ROI = × ROI = 9.35%  2.33 = 21.8% ROI = Margin  Turnover Investing in Operating Assets to Increase Sales ROI increased from 15% to 21.8%.

45. Managers evaluated on ROI may reject profitable investment opportunities. Major Criticism of ROI

46. Residual Income - Another Measure of Performance Net operating income above some minimum return on operating assets

47. Calculating Residual Income ( ) 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 minimum required return on average operating assets.

48. Residual Income – An Example • The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. • In the current period, the division earns $30,000. Let’s calculate residual income.

49. Residual Income – An Example

50. Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.