Chapter 12

Segment Reporting
and Decentralization
5/03/04

Decentralization in
Organizations
Benefits of
Decentralization

Top
Top management
management
freed
freed to
to concentrate
concentrate
on
on strategy.
strategy.

Lower-level
Lower-level managers
managers
gain
gain experience
experience in
in
decision-making.
decision-making.
Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
Lower-level
decision
Lower-level decision
often
often based
based on
on
better
better information.
information.
Improves
Improves ability
ability to
to
evaluate
evaluate managers.
managers.
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Decentralization in
Organizations
Lower-level
Lower-level managers
managers
may
may make
make decisions
decisions
without
without seeing
seeing the
the
big
big picture.
picture.
Lower-level
Lower-level managers
managers
objectives
objectives may
may not
not
be
be those
those of
of the
the
organization.
organization.

McGraw-Hill/Irwin

May
May be
be aa lack
lack of
of
coordination
coordination among
among
autonomous
autonomous
managers.
managers.

Disadvantages of
Decentralization

May
May be
be difficult
difficult to
to
spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.

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Decentralization and Segment

Reporting
A segment is any part or
activity of an
organization about
which a manager seeks
cost, revenue, or profit
data. A segment can
also be divisions,
manufacturing plants,
customers, product
lines, departments, etc.
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An Individual Store
Quick Mart

A Sales Territory

A Service Center

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Cost, Profit, and Investments

Centers
Cost Center
A segment whose
manager has control
over costs,
but not over revenues
or investment funds.
Accounting, personnel,
R & D,legal, admin.,
Manufacturing, etc.
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Cost, Profit, and Investments

Centers
Profit Center
A business segment
whose manager has
control over both
costs and revenues,
but no control over
investment funds.
ie., operations, product
lines
McGraw-Hill/Irwin

Revenues
Sales
Interest
Other

Costs
Mfg. costs
Commissions
Salaries
Other

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Cost, Profit, and Investments

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

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Corporate Headquarters

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Segmenting Costs
Variable costs are easily traceable to
their respective segments
Fixed costs must be divided up into
those costs that are traceable to
segments and those that are not
Only those costs that are traceable to a
segment will be assigned to a segment
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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.

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Identifying Traceable Fixed

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

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No computer
division manager.

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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 . . .

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We still have a
company president.

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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.
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Levels of Segmented
Statements
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
McGraw-Hill/Irwin

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

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Levels of Segmented
Statements
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
Segment Margin
$ 60,000
McGraw-Hill/Irwin

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

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Levels of Segmented
Statements

Lets see how the Television

Division/Segment fits into
Webber, Inc.

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Levels of Segmented
Statements
Income Statement
Company
Television
Sales
$ 500,000
$ 300,000
Variable costs
230,000
150,000
CM
270,000
150,000
Traceable FC
170,000
90,000
Segment Margin
100,000
$ 60,000
Common costs
Net operating
income

McGraw-Hill/Irwin

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

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Levels of Segmented
Statements
Income Statement
Company
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
Segment Margin
100,000
$ 60,000
$ 40,000
Common costs
25,000
Common
Common costs
costs should
should not
not
Net operating
be
allocated
to
the
be
allocated
to
the
income
$ 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.

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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!

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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

McGraw-Hill/Irwin

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

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Traceable Costs Can Become

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

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

We obtained the following information from

the Regular and Big Screen segments.
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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

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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.
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Segment Margin

Profits

The segment margin is the best gauge of

the long-run profitability of a segment.

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Time

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Hindrances to Proper Cost

Assignment
The Problems
Omission of some
Value-chain costs in the
assignment process,
Upstream & downstream

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

The use of inappropriate

methods for allocating
costs among segments,
ie, Sales, or DL in automated plant
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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

McGraw-Hill/Irwin

Customer
Manufacturing Marketing Distribution Service

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Inappropriate Methods of Allocating

Costs Among Segments
Arbitrarily dividing
common costs
among segments

Inappropriate
allocation base

Failure to trace
costs directly

Segment
1

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Segment
2

Segment
3

Segment
4

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Allocations of Common Costs

Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit

McGraw-Hill/Irwin

Income Statement
Haglund's
Lakeshore
Bar
$ 800,000
$ 100,000
310,000
60,000
490,000
40,000
246,000
26,000
244,000
$ 14,000
200,000
$ 44,000

Restaurant
$ 700,000
250,000
450,000
220,000
$ 230,000

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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.

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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.
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Allocations of Common Costs

Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit

Income Statement
Haglund's
Lakeshore
Bar
$ 800,000
$ 100,000
310,000
60,000
490,000
40,000
246,000
26,000
244,000
14,000
200,000
25,000
$ 44,000
$ (11,000)

Restaurant
$ 700,000
250,000
450,000
220,000
230,000
175,000
$ 55,000

Allocated on the basis of sales.

Hurray, now everything adds up!!!

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Allocations of Common Costs

Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit

Income Statement
Haglund's
Lakeshore
Bar
$ 800,000
$ 100,000
310,000
60,000
490,000
40,000
246,000
26,000
244,000
14,000
200,000
25,000
$ 44,000
$ (11,000)

Restaurant
$ 700,000
250,000
450,000
220,000
230,000
175,000
$ 55,000

Whoops, what about the bar???

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

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

Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
McGraw-Hill/Irwin

the bar,
profit drops to $30,000!
Income
Statement
Haglund's
Lakeshore
Bar
Restaurant
$ 700,000
$ 700,000
250,000
250,000
450,000
450,000
220,000
220,000
230,000
230,000
200,000
200,000
$ 30,000
$ 30,000

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Teaching Note
Allocating common fixed costs to the
segments those fixed costs support is a
recipe for disaster

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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.
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Return on Investment (ROI)

Formula
Regal Company reports the
following:
Net operating income
Average operating assets
Sales

$ 30,000
$ 200,000
$ 500,000

$30,000
= 15%
ROI =
$200,000
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Return on Investment (ROI)

Formula
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales

Sales
Turnover =
Average operating assets
Turnover
ROI Margin
=
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Return on Investment (ROI)

Formula
Turnover
ROI Margin
=

Sales
ROI = Net operating income
Sales
Average operating assets

ROI = $30,000 $500,000

$500,000
$200,000
ROI =6% 2.5 = 15%

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Controlling the Rate of Return

Three ways to improve ROI . . .
Increase
Sales

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Reduce
Expenses

Reduce
Assets

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Controlling the Rate of Return

Regals manager was able to increase
sales to $600,000 which increased net
operating income to $42,000.
There was no change in the average
operating assets of the segment.

Lets calculate the new ROI.

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Return on Investment (ROI)

Formula
Turnover
ROI Margin
=

Sales
ROI = Net operating income
Sales
Average operating assets

ROI = $42,000 $600,000

$600,000
$200,000
ROI =7% 3.0 = 21%
ROI
ROI increased
increased from
from 15%
15% to
to 21%
21%
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Criticisms of ROI
Management may not know
how to increase ROI.
Managers often inherit many
committed costs over which
they have no control.
Managers evaluated on ROI
may reject profitable
investment opportunities
for the company (because
its bad for their ROI).
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Criticisms of ROI
As division manager at Winston, Inc., your
compensation package includes a salary plus bonus
based on your divisions ROI -- the higher your ROI,
the bigger your bonus.
The company requires an ROI of 15% on all new
investments -- your division has been producing an
ROI of 30%.
You have an opportunity to invest in a new project
that will produce an ROI of 25%.

As division manager would you

invest in this project?
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Criticisms of ROI
Gee . . .
I thought we were
supposed to do what
was best for the
company!

McGraw-Hill/Irwin

As division manager,
I wouldnt invest in
that project because
it would lower my pay!

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Criticisms of ROI
So to fix this problem, change the
incentive plan to reward the manager
for any ROI over and above the firms
ROI.
Duh!

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Review Problem 1
Redo report eliminate common cost
allocation
Advise on whether to spend advertising
money to increase Family Law practice.
Answer on Page 552-553

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End of Chapter 12

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