Segment Reporting and

Decentralization
UAA ACCT 202
Principles of Managerial
Accounting
Dr. Fred
Barbee

The Work of Management

Planning
Planning

Evaluating
Evaluating

Decision
Decision
Making
Making

Controlling
Controlling

Organizing
Organizing
&
& Directing
Directing

Controlling Operations
Management by exception
Responsibility Accounting
Delegation of authority
Management by walking

around

Responsibility Accounting
. . . is a reporting system in which

a cost is charged to the lowest

level of management that has
responsibility for it.
P r e s id e n t
and C E O
V ic e P r e s id e n t
M a r k e t in g

V ic e P r e s id e n t
P r o d u c t io n

V ic e P r e s id e n t
C o n t r o lle r

Installing Responsibility
Accounting
Create a set of financial

performance goals (budgets).

Measure and report actual

performance.
Evaluate based on comparison

of actual with budget.

Responsibility Accounting
Evaluation of responsibility centers

depends on . . .
The extent of delegation of authority;
and
A managers preference

Decentralization . . .
. . . the delegation of authority to

the lowest level of management

responsibility that can make
decisions.

Centralization . . .
. . . A centralized organization is

one in which little authority is

delegated to lower level managers.

Decentralization
The more decentralized the firm,

the greater the need for control.

Monitor employees
Motivate employees

Advantages of
Decentralization
Top level managers are relieved of

making routine decisions.

Higher employee morale
Training
Decisions are made where the

action is taking place.

Disadvantages of
Decentralization
Upper level management loses

some control.
Lack of goal congruence.
Duplication of effort.

Decentralization and Segment

Reporting
An Individual Store
Quick Mart

A segment is any
part or activity of
an organization
about which a
manager seeks
cost, revenue, or
profit data. A
segment can be

A Sales Territory

A Service Center

Cost, Profit, and Investments

Centers
Responsibility
Responsibility
Centers
Centers

Cost
Cost
Center
Center

Profit
Profit
Center
Center

Investment
Investment
Center
Center

Responsibility
Responsibility Centers:
Centers: AA Systems
Systems Perspective
Perspective

Data
(Inputs)

Resources used . . .
DM
DM
DL
DL
MOH
MOH

Processing
Processing Steps
Steps
Within
Within
Information
Information Systems
Systems
Capital . . .
Working
Working
Capital
Capital
Equipment
Equipment
Etc.
Etc.

Information
(Outputs)

Output . . .
Goods,
Goods,
Services,
Services,
Ideas
Ideas

Cost, Profit, and Investments

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

Responsibility
Responsibility Centers:
Centers:
A
A Systems
Systems Perspective
Perspective

Input
Input

Process
Process

Output
Output

Cost Center
Control only
this

Evaluation . . .
A cost center is evaluated by

means of performance reports (i.e.,

comparison of actual with
standard).

Segments Classified as Cost,

Profit and Investment Centers

Responsibility
Responsibility Centers:
Centers:
A
A Systems
Systems Perspective
Perspective

Input
Input

Process
Process

Profit Center
Control these

Output
Output

Cost, Profit, and Investments

Centers
Profit Center
A segment
whose manager
has control over
both costs and
revenues,
but no control
over investment
funds.

Revenues
Sales
Interest
Other

Costs

Mfg. costs
Commissions
Salaries
Other

A Profit Center . . .
A profit center is evaluated by

means of contribution margin

income statements.

Segments Classified as Cost,

Profit and Investment Centers

Cost, Profit, and Investments

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

Corporate Headquarters

Responsibility
Responsibility Centers:
Centers:
A
A Systems
Systems Perspective
Perspective

Input
Input

Process
Process

Output
Output

Investment Center
Control these

Investment Center
An investment center is evaluated

by means of the Return on

Investment (ROI) or the Residual
Income (RI) it is able to generate.

Segments Classified as Cost,

Profit and Investment Centers
Responsibility Centers

Profit Center Vs. Investment

Center
A profit center is focused on profits

as measured by the difference

between revenues and expenses.
An investment center is compared

with the assets employed in

earning revenues.

Levels of Segmented
Statements

Levels of Segmented
Statements

Levels of Segmented
Statements

Webber, Inc. has two divisions.

W e b b e r , In c .

C o m p u te r D iv is io n

T e le v is io n D iv is io n

Lets
Lets look
look more
more closely
closely at
at the
the Television
Television
Divisions
Divisions income
income statement.
statement.

Our approach to segment reporting uses

the contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales
$ 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

Cost
Cost of
of goods
goods
sold
sold consists
consists of
of
variable
variable
manufacturing
manufacturing
costs.
costs.
Fixed
Fixed and
and
variable
variable costs
costs
are
are listed
listed in
in
separate
separate
sections.
sections.

Our approach to segment reporting uses

the contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales
$ 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

Division Segment Margin

Segment
Segment margin
margin
is
is Televisions
Televisions
contribution
contribution
to
to profits.
profits.

Traceable and Common

Costs
Fixed
Costs

Dont allocate
common costs.

Traceable

Common

Costs arise because

of the existence of
a particular segment

A cost that supports more than one

segment but that would not go
away if any particular segment
were eliminated.

Identifying Traceable Fixed

Costs
Traceable costs would disappear over
time if the segment itself disappeared.
No computer
division means . . .

No computer
division manager.

Identifying Common Fixed

Costs
Common costs arise because of overall
operation of the company and are not due to
the existence of a particular segment.
No computer
division but . . .

We still have a
company president.

Levels of Segmented
Statements
Income Statement
Sales
Variable costs
CM
Traceable FC
Division margin
Common costs
Net operating
income

Company
$ 500,000
230,000
270,000
170,000
100,000
25,000
$

Television
$ 300,000
150,000
150,000
90,000
$ 60,000

Computer
$ 200,000
80,000
120,000
80,000
$ 40,000

Common
Common costs
costs should
should not
not
be
allocated
to
the
be
allocated
to
the
75,000
divisions.
divisions. These
These costs
costs
would
would remain
remain even
even ifif one
one
of
of the
the divisions
divisions were
were
eliminated.
eliminated.

Traceable Costs Can Become

Common Costs
Fixed costs that are traceable on one
segmented statement can become
common if the company is divided
into smaller segments.

Lets see how this works!

Traceable Costs Can Become

Common Costs
Webbers Television Division

Product
Lines

T e le v is io n
D iv is io n

R e g u la r

U .S . S a le s

B ig S c r e e n

F o r e ig n S a le s

U .S . S a le s

Sales
Territories

F o r e ig n S a le s

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
150,000
95,000
CM
150,000
105,000
Traceable FC
80,000
45,000
Product line margin
70,000
$ 60,000
Common costs
10,000
Divisional margin
$ 60,000

Big Screen
$ 100,000
55,000
45,000
35,000
$ 10,000

Fixed
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
150,000
95,000
CM
150,000
105,000
Traceable FC
80,000
45,000
Product line margin
70,000
$ 60,000
Common costs
10,000
Divisional margin
$ 60,000

Big Screen
$ 100,000
55,000
45,000
35,000
$ 10,000

Of the $90,000 cost directly traced to the Television

Division, $45,000 is traceable to Regular and $35,000
traceable to Big Screen product lines.

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
150,000
95,000
CM
150,000
105,000
Traceable FC
80,000
45,000
Product line margin
70,000
$ 60,000
Common costs
10,000
Divisional margin
$ 60,000

Big Screen
$ 100,000
55,000
45,000
35,000
$ 10,000

The remaining $10,000 cannot be traced to

either the Regular or Big Screen product lines.

Segment Margin

Profits

The segment margin is the best gauge of

the long-run profitability of a segment.

Time

Responsibility and
Controllability

Controllability is . . .
The degree of influence that a

specific manager has over costs,

revenues, or other items in
question.

Controllability
Few costs are

clearly under
the sole
influence of one
manager.

Controllability
With a long

enough time
span, all costs
will come
under
someones
control.

The Controllability Principle

Management
Management
Actions
Actions

Costs
Costs
Uncontrollable
Uncontrollable
Environmental
Environmental
Effects
Effects

Managers
Managers only
only
partially
partially control
control
costs.
costs.

The Controllability Principle

.. ....lead
leadto
tomore
morepredictable
predictable
rewards
rewardsfor
formanagers.
managers.

Management
Management
Actions
Actions

Costs
Costs
Uncontrollable
Uncontrollable
Environmental
Environmental
Effects
Effects

Performance
Performance
Measures
Measures

Rewards
Rewards

Performance
Performancemeasurement
measurement
systems
systemsthat
thatare
arebased
based on
on
controllable
controllable costs
costs .. .. ..

The Controllability Principle

The
Theperformance
performancemeasures
measuresand
and rewards
rewards
will
willinfluence
influencemanagement
management to
tofocus
focuson
onthe
the
controllable
controllablecosts.
costs.
Management
Management
Actions
Actions

Costs
Costs

Performance
Performance
Measures
Measures

Rewards
Rewards

The Controllability Principle

Management
Management
Actions
Actions

Costs
Costs
Uncontrollable
Uncontrollable
Environmental
Environmental
Effects
Effects

Performance
Performance
Measures
Measures

Rewards
Rewards

When
When performance
performancemeasures
measures
are
areaffected
affectedby
byuncontrollable
uncontrollable
environmental
environmentaleffects
effects.... ..

The Controllability Principle

Management
Management
Actions
Actions

Costs
Costs
Uncontrollable
Uncontrollable
Environmental
Environmental
Effects
Effects

Performance
Performance
Measures
Measures

Rewards
Rewards

.... ..management
management may
maytry
tryto
to control
control
the
theperformance
performancemeasure
measurerather
ratherthan
than
the
theunderlying
underlyingcost.
cost.

Hindrances to Proper Cost

Assignment
The Problems
Omission of some
costs in the
assignment process.

Assignment of costs
to segments that are
really common costs of
the entire organization.

The use of inappropriate

methods for allocating
costs among segments.

Omission of Costs
Costs assigned to a segment should include
all costs attributable to that segment from
the companys entire value chain.
chain
Business Functions
Making Up The
Value Chain
R&D

Product
Design

Customer
Manufacturing Marketing Distribution Service

Inappropriate Methods of
Allocating Costs Among
Segments
Arbitrarily dividing
common costs
among segments

Inappropriate
allocation base

Failure to trace
costs directly

Segment
1

Segment
2

Segment
3

Segment
4

Return on Investment
The ROI formula is expressed as:

Return on Investment
Where . . .

Income
Margin = -------------------Sales

Return on Investment
Where . . .

Sales
Turnover = -----------------------------Invested Capital

Return on Investment
Income
------------------------------

Sales
The ratio of
operating
income to sales

Sales
------------------------------

Invested Capital
The efficiency
of asset
utilization.

Return on Investment
Income
-----------------------------Sales

The ratio of
operating
income to sales

Sales
-----------------------------Invested Capital

The efficiency
of asset
utilization.

Return on Investment

Income
-----------------------------Invested Capital

ROI

Sales

Cost of
Goods Sold

Sales - OE

Selling
Expense

Operating
Expenses

Admin.
Expense

Net Oper.
Income

NOI / Sales

Margin

Sales

Margin is a measure of managements

ability to control operating expenses in
relation to sales.

Turnover is a measure of the amount of

sales that can be generated in an
investment center for each dollar invested
in operating assets.
Cash
Accounts
Receivable

Sales
Current
Assets

Inventory

CA + NCA
PP&E
Other
Assets

Noncurr.
Assets

Sales / AOA
Ave Oper
Assets

Turnover

Sales

Cost of
Goods Sold

Sales - OE

Selling
Expense

Operating
Expenses

Admin.
Expense

Net Oper.
Income

NOI / Sales

Margin

Sales

MxT
Cash
Accounts
Receivable

Sales
Current
Assets

Inventory

CA + NCA
PP&E
Other
Assets

Noncurr.
Assets

Sales / AOA
Ave Oper
Assets

Turnover

ROI

Measuring Income and

Invested Capital

Income
-----------------------------Sales

Sales
-----------------------------Invested Capital

Measuring Income
Variety of possibilities
Text uses EBIT (Net Operating

Income)
Earnings Before Interest and
Taxes

Measuring Invested
Capital
Variety of possibilities
Text uses Net Book Value
Consistent with how PP&E is listed on
the Balance Sheet.
Consistent with the computation of
operating income.

Return on Investment (ROI)

Formula
Income
Incomebefore
before interest
interest
and
andtaxes
taxes(EBIT)
(EBIT)

Net operating income

ROI =
Average operating assets
Cash,
Cash,accounts
accountsreceivable,
receivable, inventory,
inventory,
plant
plantand
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.

Improving the ROI

Increase
Sales

Reduce
Expenses

Reduce
Assets

XYZ Company

Income (EBIT)

$30,000

Sales

$500,000

Invested Capital

$200,000

Return on Investment
$30,000
-------------$500,000

$500,000
-------------$200,000

6%

2.5

15%

Approach #1:
Increase Sales

Increase Sales . . .
Assume that XYZ is able to increase

sales to $600,000.
Net Operating Income increases to

$42,000.
Average Operating Assets remain

unchanged.
What is the impact on ROI?

Return on Investment
$42,000
-------------$600,000

$600,000
-------------$200,000

7%

3.0

21%

Reduce Expenses . . .
Assume that XYZ is able to reduce

expenses by $10,000
Net Operating Income increases to

$40,000.
Average Operating Assets and sales

remain unchanged.
What is the impact on ROI?

Return on Investment
$40,000
-------------$500,000

$500,000
-------------$200,000

8%

2.5

20%

Reduce Assets . . .
Assume that XYZ is able to

reduce its operating assets

from $200,000 to $125,000.
Sales and Net Operating

Income remain unchanged.

What is the impact on ROI?

Return on Investment
$30,000
-------------$500,000
6%

x
x
24%

$500,000
-------------$125,000
2.4

Advantages of ROI . . .
It encourages managers to focus

on the relationship among sales,

expenses, and investment.
It encourages managers to focus

on cost efficiency.
It encourages managers to focus

on operating asset efficiency.

Disadvantages of ROI
It can produce a narrow focus on

divisional profitability at the

expense of profitability for the
overall firm.
It encourages managers to focus

on the short run at the expense of

the long run.

Overinvestment
Evaluation in terms of profit can

lead to overinvestment.

Overinvestment
Increases in

Assets
Manager

Compan
y

Increases in

Profits

Underinvestment
Evaluation in terms of ROI can

lead to underinvestment.

Overinvestment
Decreases in

Assets
Manager

Compan
y

Increases in

ROI

Criticisms of ROI . . .
ROI tends to emphasize short-run

performance over long-run

profitability.
ROI may not be completely

controllable by the division

manager due to committed costs.

Multiple Criteria . . .
Growth in market share
Increases in productivity
Dollar profits
Receivables turnover
Inventory turnover
Product innovation

Residual Income . . .
. . . is the net operating income

that an investment center is

able to earn above some
minimum rate of return on its
operating assets.

Residual Income = EBIT Required Profit

= EBIT Cost of Capital x Investment

Residual Income Example

Division A

Division B

$1,000,000

$3,000,000

EBIT Last Year

200,000

450,000

*Min. Required R of R

120,000

360,000

Residual Income

$80,000

$90,000

Invested Capital

*Minimum Required Rate of Return = 12%

Problem with RI . . .
RI cannot be used to compare

performance of divisions of
different sizes.

Advantage of RI . . .
RI encourages managers to make

profitable investments that would

be rejected under the ROI
approach.

Example . . .
Assume that ABC Companys

Division A has an opportunity to

make an investment of $250,000
that would generate a 16% return.
The Divisions current ROI is 20%.

Should the investment be made?

Marsh Company
Return on Investment
Present

Invested Capital (1)

New

Overall

$1,000,000

$250,000

$1,250,000

NOPAT (2)

200,000

*40,000

240,000

ROI (1)/(2)

20%

16%

19.2%

*$250,000 x 16% = $40,000

Marsh Company
Return on Investment

Reject - Reduces overall ROI!!!

Present

Invested Capital (1)

New

Overall

$1,000,000

$250,000

$1,250,000

NOPAT (2)

200,000

*40,000

240,000

ROI (1)/(2)

20%

16%

19.2%

*$250,000 x 16% = $40,000

Marsh Company
Residual Income

Accept - Positive Residual Income!!!

Present
Invested Capital (1)
NOPAT (2)
Minimum RofR*
Residual Income

New

Overall

$1,000,000

$250,000

$1,250,000

200,000

40,000

240,000

$120,000

$30,000

$150,000

$80,000

$10,000

$90,000

*Minimum Required Rate of Return = 12% x Invested Capital

Economic Value Added

Economic Value Added (EVA) is

after-tax operating profit minus the

total annual cost of capital
If EVA is positive, the company is
creating wealth.
If EVA is negative, the company is
destroying capital.

Calculating EVA . . .
EVA = After-tax operating income

minus (the weighted-average cost

of capital times total capital
employed)
Determine weighted average cost of
capital
Determine total dollar amount of
capital employed