segment reporting

Segment Reporting & Decentralization(Go through the reference books for details)

Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

A decentralized organization is one in which decision making is not confined to a few top executives but rather is spread throughout the organization with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity.

Advantages of Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

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 of decentralization are as follows:

1. Top management freed to concentrate on strategy.2. Decision-making authority leads to job satisfaction.3. Lower level managers can respond quickly to customers.4. Lower-level managers gain experience in decision-making.5. Lower-level decision often based on better information.

Disadvantages of Decentralization (Managerial Accounting, Garrison, 10th edition, p. 526)

1. May be a lack of coordination among autonomous managers.2. Lower-level managers may make decisions without seeing the “big picture.”3. Lower-level manager’s objectives may not be those of the organization.4. May be difficult to spread innovative ideas in the organization.

Segment (Managerial Accounting, Garrison, 10th edition, p. 527)

A segment is a part or activity of an organization about which managers would like cost, revenue, or profit data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers, and product lines. A company’s operations can be segmented in many ways. For example, segment the business by geographic region, by individual store, by the nature of the merchandise, by brand name and so on.

Segment Reporting and Decentralization of 12

Responsibility Center (Managerial Accounting, Garrison, 10th edition, p. 529)

Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions. Responsibility center is broadly defined as any part of an organization whose manager has control over, and is accountable for cost, profit, or investment funds. The three primary types of responsibility centers are cost centers, profit centers, and investment centers. Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

Cost Center (Managerial Accounting, Garrison, 10th edition, p. 527)

A cost center is a business segment whose manager has control over costs, but not over revenue or investment funds. Service departments such as accounting, general administration, legal and personnel are usually considered to be cost centers. In addition, manufacturing facilities are often considered to be cost center. The manager of the cost center are expected to minimize cost while providing the level of services or the amount of products demanded by the other parts of the organization. Standard cost variances and flexible budget variances are often used to evaluate cost center performance.

Profit Center (Managerial Accounting, Garrison, 10th edition, p. 528)

In contrast to a cost center, a profit center is any business segment whose manager has control over both costs and revenue. Like a cost center, however, a profit center generally does not nave control over investment funds. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. An example of a profit center is a company’s cafeteria.

Investment Center (Managerial Accounting, Garrison, 10th edition, p. 528)

An investment center is any segment of an organization whose manager has control over cost, revenue, and investments in operating assets. Investment center managers are usually evaluated using return on investment (ROI) or residual income. An example of an investment center would be the corporate headquarters.


Salty SnacksProduct M anger

Bottling P lantM anager

W arehouseM anager

DistributionM anager

BeveragesProduct M anager

ConfectionsProduct M anager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Profit Centers

Cost Centers

Investment Centers

Segment Margin (Managerial Accounting, Garrison, 10th edition, p. 536)

To prepare an income statement for a particular segment, variable expenses are deducted from sales to yield the contribution margin for the segment. The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin. It represents the margin available after a segment has covered all of its own costs. The segment margin is the best gauge of the long-run profitability of a segment. There are two keys to building segmented income statements:

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

2. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Income StatementContribution Margin Format

Television DivisionSales $300,000 Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Traceable Fixed Cost (Managerial Accounting, Garrison, 10th edition, p. 533)

A Traceable costs or a segment is a fixed cost that is incurred because of the existence of a particular segment and would disappear over time if the segment itself disappeared. Only the traceable fixed costs are charged to a segment in the segmented income statements in the report. 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.

Common Fixed Cost (Managerial Accounting, Garrison, 10th edition, p. 534)

A common 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. Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. Common costs are not allocated to segments.

Income StatementCompany Television Computer

Sales $ 500,000 $ 300,000 $ 200,000 Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 $ 60,000 $ 40,000 Common costs 25,000 Net operating income $ 75,000

Return on Investment (ROI) (Managerial Accounting, Garrison, 10th edition, p. 542)


Rate of return is an approach for measuring managerial performance of a segment. The return on investment (ROI) is defined as net operating income divided by average operating assets. The higher the ROI of a business segment, the greater the profit generated in a segment operating assets. ROI measures net operating income earned relative to the investment in average operating assets.

Return on Investment (ROI) = Net Operating IncomeAverage Operating Assets

Net operating income, rather than net income, is used in the ROI formula. Net operating income is income before interest and taxes and is sometimes referred to as earning before interest and taxes (EBIT). Operating assets include cash, account receivable, inventory, plant and equipment, and all other assets held for productive use in the organization. Most companies use the net book value of depreciable assets to calculate average operating assets.

We can modify this formula slightly by introducing sales as follows

Return on Investment (ROI) = Net Operating Income X SalesSales Average Operating Assets

The first term on the right-hand side of the equation is the margin. Margin is a measure of management’s ability to control operating expenses in relation to sales. The lower the operating expenses per taka of sales, the higher the margin earned.

Margin = Net Operating IncomeSales

The second term of the right-hand side of the equation is turnover. Turnover is a measure of the sales that are generated for each taka invested in operating assets.

Turnover = SalesAverage Operating Assets

The following alternative form of the ROI formula, which will be used most frequently, combines margin and turnover:

Return on Investment (ROI) = Margin X Turnover

Improve or Increase the ROI (Managerial Accounting, Garrison, 10th edition, p. 544)

There are three ways to increase ROI;

1. Increase Sales: With the help of increase in sales we can be able to increase ROI

2. Reduce Expenses: If we can be able to reduce expense, operating income will be increased. Due to the increase in operating income ROI will be increase

3. Reduce Assets: If we can be able to reduce average operating assets, ROI will be increased. By using JIT inventory as an operating asset can be reduced.


Criticisms of ROI (Managerial Accounting, Garrison, 10th edition, p. 547)

1. In the absence of the balanced scorecard, management may not know how to increase ROI. They may increase ROI in a way that is inconsistent with the company’s strategy or they may take actions that increase ROI in the short run but harm the company in the long run. Example, cutting back on research and development cost.

2. Managers often inherit many committed costs over which they have no control. These committed costs may be relevant in assessing the performance of the business segment.

3. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but that would have negative impact on the manager’s performance evaluation.

Residual Income (Managerial Accounting, Garrison, 10th edition, p. 548)

Another approach to measuring an investment center’s performance is residual income. Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. That means, Residual income measures net operating income earned less the minimum required return on average operating assets. Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

Transfer Pricing (Managerial Accounting, Garrison, 10th edition, p. 554)

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. There are three primary approaches to setting transfer prices:

1. Negotiated Transfer Prices2. Transfer at Cost Prices at the selling division

a. Variable Costb. Full (Absorption Cost) Cost

3. Transfer at Market Prices

Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions. Advantages of negotiated transfer prices:

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.


Transfer at Cost Prices

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.

Transfer at Market Prices

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. 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. 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.

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.


Problem 1

Caltec, Inc., produces and sells recordable CD and DVD packs. Revenue and cost information relating to the products follows:

ProductCD DVD

Sales Tk. 8 Tk. 25Variable expenses per pack 3.20 17.50Traceable fixed expenses per year 138,000 45,000

Common fixed expenses in the company total Tk. 105000 annually. Last year the company produced and sold 37500 CD and 18000 DVD packs.

RequiredPrepare an income statement for the year segmented by product lines. Show both amount and percent columns for the company as a whole and for each of the products.

Problem 2

The Magnetic Imaging Division of Medical Diagnostics, Inc., has reported the following results for last year’s operations

Sales Tk. 25 millionNet operating income Tk. 3 millionAverage operating assets Tk. 10 million

Required

1. Compute the margin, turnover, and ROI for the Magnetic Imaging Division2. Top management of has set a minimum required rate of return on average operating assets of

25%, What is the residual income for the year?

Problem 3

Regal Company reports the following: Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000

Required

1. What is Regal Company’s ROI?2. Regal’s manager was able to increase sales to $600,000 while operating expenses increased to

$558,000. What will be the new ROI?3. Assume that Regal’s manager was able to reduce operating expenses by $10,000 without affecting

sales or operating assets. What will be the new ROI?4. Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time

techniques without affecting sales or operating expenses. What will be the new ROI?


Problem 4

Collyer Products, Inc., has a Valve Division that manufactures and sells a standard valve as follows:

Capacity in units 100,000Selling price to outside customers Tk. 30Variable cost per unit Tk. 16Fixed cost per unit based on capacity Tk. 9

The company has a pump division that could use this valve in one of its pumps. The Pump Division is currently purchasing 10,000 valves per year from an overseas supplier at a cost of Tk. 29 per valve.

Required

1. Assume that the Valve Division has ample idle capacity to handle all of the Pump Division’s needs. What is the acceptable range, if any, for the transfer price between the two divisions?

2. Assume that the Valve Division is selling all of the valve that it can produce to outside customers. What is the acceptable range, if any, for the transfer price between the two divisions?

3. Assume again that the Valve Division is selling all of the valves that it can produce to outside customers. Also assume that Tk. 3 in variable expenses can be avoided on transfers within the company, due to reduce selling cost. What is the acceptable range, if any, for the transfer price between the two divisions?

4. Assume that the Pump Division needs 20,000 special high-pressure valves per year. The Valve Division variable costs to manufactures and ship the special valve would be Tk. 20 per unit. To produce these special valve, the Valve Division would gave to reduce its production and sales of regular valves from 100,000 units per year to 70,000 units per year. What is the lowest acceptable transfer price?

Problem 5

Marple Associates is a consulting firm that specializes in information systems for construction companies. A segmented income statement for the company’s most recent year is given below:

Company SegmentHouston Dallas

Sales 750,000 150,000 600,000Variable expenses 405,000 45,000 360,000Contribution Margin 345,000 105,000 240,000Traceable Fixed expenses 168,000 78,000 90,000Segment Margin 177,000 27,000 150,000Common Fixed expenses 120,000Net Operating income 57,000

Required1. By how much would the company’s net operating income increase if Dallas increased its sales

by Tk. 75,000 per year? Assume no change in cost behavior patterns.2. Assume that sales in Houston increase by Tk. 50,000 next year and that sales in Dallas remain

unchanged. Prepare a new segmented income statement for the company showing both amount and percentages.


Problem 6

A company has two segments, A and B. A segmented income statement for the company’s most recent year is given below:

Company SegmentA B

Sales 600,000 400,000 200,000Variable expenses 360,000 260,000 100,000Contribution Margin 240,000 140,000 100,000Traceable Fixed expenses 72,000 20,000 52,000Segment Margin 168,000 120,000 48,000Common Fixed expenses 18,000Net Operating income 150,000

The company would like to initiate an intensive advertising campaign in one of the two markets during the next month. The campaign cost Tk. 8000. Market studies indicate that such a campaign would increase sales in the A market by Tk. 70,000 or increase sales in the B market by 60,000

Required

In which of the market would you recommend that the company focus its advertising campaign? Show computations to support your answer.

Problem 7

Bovine Company, a wholesale distributor of DVDs, has been experiencing losses for some time, as shown by its most recent monthly income statement below:

TakaSales 1,500,000Variable expenses 588,000Contribution Margin 912,000Fixed expenses 945,000Net Operating income (33,000)

In an effort to isolate the problem, the president has asked for an income statement segmented by geographic market. Accordingly, the Accounting Department has developed the following data:

Geographic MarketSouth Central North

Sales Tk. 400,000 Tk. 600,000 Tk. 500,000Variable expenses 230000 320000 130000Traceable Fixed expenses Tk. 240,000 Tk. 330,000 Tk. 200,000

Required1. Prepare an income statement segmented by geographic market, as desired by the president. 2. The company’s sales manager believes that sales in the Central geographic market could be

increased by 15% if advertising were increased by Tk. 25000 each month. Would you recommend the increased advertising? Show computations to support your answer.

Problem 8


Provide the missing data in the following tabulation:

DivisionX Y Z

Sales Tk. 800,000 Tk. ? Tk. ?Net operating income 72,000 ? 40,000Average operating assets ? 130,000 ?Margin ? 4% 8%Turnover ? 5 ?ROI 18% ? 20%

Problem 9

Rains Nickless Ltd. has two divisions that operate in Rajshahi and Dhaka. Selected data on the two divisions follows:

DivisionRajshahi Dhaka

Sales Tk. 9,000,000 Tk. 20,000,000Net operating income 630,000 1,800,000Average operating assets 3,000,000 10,000,000

Required

1. Compute the ROI for each division2. Assume that the company evaluates performance by use of residual income and that the

minimum required return for any division is 16%. Compute the residual income for each division3. Is the Dhaka Division’s greater residual income an indication that it is better managed? Explain.

Problem 10

Selected sales and operating data fo9r three divisions of three different companies are given below:

DivisionA B C

Sales 6,000,000 10,000,000 8,000,000Net operating income 300,000 900,000 180,000Average operating assets 1,500,000 5,000,000 2,000,000Minimum required rate of return 15% 18% 12%

Required

1. Compute the ROI for each division, using the formula stated in terms of margin and turnover.2. Compute the residual income for each division


Problem 11

Nelcro Company’s Electrical Division produces a high-quality transformer. Sales and cost data on the transformer follows:

Selling price per unit on the outside market Tk. 40Variable cost per unit Tk. 21Fixed cost per unit based on capacity Tk. 9Capacity in units 60,000

Nelcro Company has a Motor Division that would like to begin purchasing this transformer from the Electrical Division. The Motor Division is currently purchasing 10,000 transformers each year from another company at a cost of Tk. 38 per transformer. Nelcro Company evaluates its division managers on the basis of divisional profits.

Required

1. Assume that the Electrical Division is now selling only 50,000 transformer each year to outside customers.

a. From the standpoint of Electrical Division, what is the lowest acceptable transfer price for transformers sold to the Motor Division?

b. From the standpoint of Motor Division, what is the highest acceptable transfer price for transformers acquired from the Electrical Division?

c. If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 10,000 transformers from the Electrical Division to the Motor Division? Why or why not?

d. From the standpoint of the entire company, should a transfer take place? Why or why not?1. Assume that the Electrical Division is now selling all of the transformers it can produce to outside

customersa. From the standpoint of Electrical Division, what is the lowest acceptable transfer price for

transformers sold to the Motor Division?b. From the standpoint of Motor Division, what is the highest acceptable transfer price for

transformers acquired from the Electrical Division?c. If left free to negotiate without interference, would you expect the division managers to

voluntarily agree to the transfer of 10,000 transformers from the Electrical Division to the Motor Division? Why or why not?

d. From the standpoint of the entire company, should a transfer take place? Why or why not?


Problem 12

In each of the case below, assume that Division X has a product that can be sold either to outside customers or to Division Y of the same company for use in its production process. The managers of the divisions are evaluated based on their divisional profit.

CaseA B

Division XCapacity in units 100,000 100,000Number of units being sold to outside customers 100,000 80,000Selling price per unit to outside customers Tk. 50 Tk. 35Variable cost per unit Tk. 30 Tk. 20Fixed cost per unit based on capacity Tk. 8 Tk. 6

Division YNumber of units needed for production 20,000 20,000Purchase price paid to outside customer Tk. 47 Tk. 34

Required

1. Refer to the data in case of A above, assume that Tk. 2 per unit in variable selling costs can be avoided on intracompany sales. If the managers are free to negotiate and make decisions on their own, will a transfer take place? If so, within what range will the transfer price fall? Explain

2. Refer to the data in case of B above, assume that there is on reduction in variable selling costs on intracompany sales. If the managers are free to negotiate and make decisions on their own, will a transfer take place? If so, within what range will the transfer price fall? Explain


segment reporting

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