Segment Reporting and Decentralization

1. Segment Reporting and Decentralization Chapter Eleven

2. Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. Lower-level decisions often based on better information. Lower level managers can respond quickly to customers.

3. Decentralization in Organizations May be a lack of coordination among autonomous managers. Lower-level managers may make decisions without seeing the “big picture.” Disadvantages of Decentralization Lower-level manager’s objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization.

4. Cost, Profit, and Investments Centers Cost Center Profit Center Investment Center Cost, profit, and investment centers areall known as responsibility centers. Responsibility Center

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

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

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

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

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

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

11. Learning Objective 1 Prepare a segmented income statement using the contribution margin format, and explain the difference between traceable fixed costs and common fixed costs.

12. 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 . . .

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

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

15. 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.

16. 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.

17. 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.

18. 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.

19. 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

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

21. Activity-Based Costing Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments. 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. If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then ABC can be used to trace the warehousing costs to the three products as shown.

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

23. 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.

24. 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.

25. Levels of Segmented Statements

26. 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.

27. 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!

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

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

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

31. 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.

32. Product Customer R&D Design Manufacturing Marketing Distribution Service Omission of Costs Costs assigned to a segment should include all costs attributable to that segment from the company’s entirevalue chain. Business Functions Making Up The Value Chain

33. Inappropriate allocation base Failure to trace costs directly Segment 1 Inappropriate Methods of Allocating Costs Among Segments Segment 2 Segment 3 Segment 4

34. 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

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

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

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

38. Learning Objective 2 Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI.

39. 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.

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

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

42. Increasing ROI There are three ways to increase ROI . . . • Reduce • Expenses • Increase • Sales • Reduce • Assets

43. 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?

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

45. Increasing Sales Without an Increase in Operating Assets • Regale's manager was able to increase sales to $600,000, while operating expenses increased to $558,000. • Regale's net operating income increased to $42,000. • There was no change in the average operating assets of the segment. Let’s calculate the new ROI.

46. Net operating income Sales Sales Average operating assets ROI = × $42,000 $600,000 $600,000 $200,000 ROI = × ROI = 7%  3.0 = 21% Margin  Turnover ROI = Increasing Sales Without an Increase in Operating Assets ROI increased from 15% to 21%.

47. Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regale'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 Let’s calculate the new ROI.

48. Net operating income Sales Sales Average operating assets ROI = × $40,000 $500,000 $500,000 $200,000 ROI = × ROI = 8%  2.5 = 20% Margin  Turnover ROI = Decreasing Operating Expenses with no Change in Sales or Operating Assets ROI increased from 15% to 20%.

49. Decreasing Operating Assets with no Change in Sales or Operating Expenses Assume that Regale'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.

50. Net operating income Sales Sales Average operating assets ROI = × $30,000 $500,000 $500,000 $180,000 ROI = × ROI = 6%  2.78 = 16.7% Margin  Turnover ROI = Decreasing Operating Assets with no Change in Sales or Operating Expenses ROI increased from 15% to 16.7%.