Segment ReportingSegment Reportingand Decentralizationand Decentralization

ACC 2203 Review WorkshopProfessor Huang

Responsibility Accounting, Performance Responsibility Accounting, Performance Measurement Segment Reporting, and Measurement Segment Reporting, and Transfer PricingTransfer Pricing

Large companies are comprised of many business units or segments. A segment may be a division, department, product line, sales territory, or a service center. Effective management of large companies requires delegating much of the decision making authority from corporate top management to segment managers. Segment managers are, in turn, held responsible for improving the segment performance as it relates to the overall corporate performance.

Responsibility Accounting, Performance Responsibility Accounting, Performance Measurement Segment Reposting, and Measurement Segment Reposting, and Transfer PricingTransfer Pricing

Responsibility Accounting is a management system that aims to develop performance measures by which segment managers are evaluated. Under responsibility accounting segments are broadly categorized as:

Cost centers – segments whose managers are held responsible only for costs but not for revenue or investments

Profit centers – segments whose managers are held responsible for both costs and revenues but not for investments

Investment centers – segments whose managers are held responsible for the capital invested as well as the profits made in the segment

Segment ReportingSegment ReportingObviously, in each segment category managerial

responsibilities are different. The performance measures for evaluating managers should also be different so as to be consistent with the responsibilities. For example, assigning revenue or sales targets to a cost center manager would not be sensible.

What are the advantages and disadvantages of decentralization – that is dividing the company into cost, profit, and investment centers and hiring managers to run each center rather than requiring the corporate top management to run all of them?

Segment ReportingSegment ReportingSegment reports provide information about each segment’s

financial performance and are important for assessing a segment’s success in attaining its goals as set mainly by upper level management.

Segmented income statements reveal the profits earned by individual segments and hence the contribution of each segment to the overall corporate profitability. Income statements of segments are usually prepared in the contribution format which requires identifying the fixed costs attributable to segments.

Traceable fixed costs – are caused by a particular segment and would go away if the segment is discontinued

Common fixed costs – costs that are incurred to support more than one segment and hence are not directly identified with a particular segment. Common fixed costs would not go away if any particular segment is discontinued.

Only traceable fixed costs are included in the income statements of segments; common fixed costs are excluded.

Traceable and Common Traceable and Common CostsCosts

Classify the following fixed costs as traceable or common (Note: NBC is a subsidiary of GE): The salary of GE’s CEO

The salary of the president of GE’s Appliances business unit which comprises multiple divisions such as Refrigerators & Freezers; Washers & Dryers; Dishwashers & Disposers

The maintenance cost for the broadcasting studios of NBC

The depreciation cost on the GE headquarters building

The maintenance and depreciation cost on the cameras used by NBC’s sports division

The salaries paid to the news anchors at NBC

The cost of heating, lighting, and air conditioning the NBC offices in Burbank, California and in New York

Concept checkConcept check1. Managers in which of the following responsibility centers are

held responsible for profits? (You may select more than one answer.) a. Revenue centers b. Cost centers c. Profit centers d. Investment centers

2. Which of the following statements is false? (You may select more than one answer.) a. The same cost can be traceable or common depending on

how the segment is defined. b. In general, common fixed costs should be assigned to

segments. c. If a company eliminates a segment of its business, the costs

that were traceable to that segment should disappear. d. If four segments share $1 million in common fixed costs and

one segment is eliminated, the common fixed costs will decrease by $250,000.

Segment Reporting - Segment Reporting - ExampleExample

The Coldex Company has two divisions: Refrigerators Division and Deep-Freezers Division. The following financial information pertains to the operations of the divisions:

(in thousands) Refrigerators Deep-Freezers

Sales revenue $600,000 $330,000Var. Man. $180,000 $120,000Variable S&A $100,000 $80,000Traceable FC $140,000 $100,000The common fixed costs in the company totaled

$93,000

Segment Reporting - Segment Reporting - ExampleExamplePrepare an income statement for

the Coldex company segmented by the divisions.

(in thousands) Company Refrigerators Deep-Freezers

Sales revenue $

Variable costs $Cont. margin $Traceable FC $Division margin $Common FC $Net Op income $

Measuring Segment Measuring Segment PerformancePerformance

A major purpose of segment reporting is to determine how well segments have performed and how well they are being run by the segment managers. In many companies, segment performance directly affects managerial compensation, managerial promotion, and amount of investment funds allocated to each segment by the headquarters. We will study two popular metrics that are primarily used in profit and investment centers for judging segment performance: Return on investment (ROI) and Residual income.

Return on investment (ROI) measures the net operating income generated per dollar of investment in operating assets

assets operating Averageincome operatingNet investment on Return

Net operating income – income before interest and taxes (or earnings before interest and taxes – EBIT)Operating assets – include accounts receivable, inventory, plant and equipment and other productive assets; excludes land held for future use, investments in other companiesAverage operating assets – average value of the operating assets between the beginning and end of a period

ROI - DefinitionROI - DefinitionThe ROI formula can also be expressed as follows:

ROI = Sales

income operatingNet x assets operating Average

Sales

Sales Margin Capital Turnover

Sales margin – measures a segment’s ability to control its operating costs and to make money on its salesCapital turnover – measures a segment’s ability to generate revenue for each dollar invested in operating assetsSales margin and capital turnover constitute the components of ROI and point attention to areas that present improvement opportunities such as increasing sales without increasing operating assets (increases capital turnover) and reducing costs without impairing sales (increases sales margin).

Increasing ROI – An Increasing ROI – An ExampleExample

Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000 Average operating assets $ 200,000Average operating assets $ 200,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 470,000Operating expenses $ 470,000

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

Increasing ROI – An Increasing ROI – An ExampleExample

Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000 Average operating assets $ 200,000Average operating assets $ 200,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 470,000Operating expenses $ 470,000

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

What is Regal Company’s ROI?

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

Increasing ROI – An Increasing ROI – An ExampleExample

Increasing Sales Without anIncreasing Sales Without anIncrease in Operating AssetsIncrease in Operating Assets

Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000.

Regal’s net operating income increased to $42,000.

There was no change in the average operating assets of the segment.

What is the new ROI?What is the new ROI?

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

Increasing Sales Without anIncreasing Sales Without anIncrease in Operating AssetsIncrease in Operating Assets

ROI = ??

Decreasing Operating Expenses Decreasing Operating Expenses with no Change in Sales or with no Change in Sales or Operating AssetsOperating Assets

Assume that Regal’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:Regal Company reports the following: Net operating income $ 40,000Net operating income $ 40,000 Average operating assets $ 200,000Average operating assets $ 200,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 460,000Operating expenses $ 460,000

Decreasing Operating Assets with Decreasing Operating Assets with no Change in Sales or Operating no Change in Sales or Operating ExpensesExpenses

Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time

techniques without affecting sales or operating expenses.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000 Average operating assets $ 180,000Average operating assets $ 180,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 470,000Operating expenses $ 470,000

Investing in Operating Assets to Investing in Operating Assets to Increase SalesIncrease SalesAssume 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.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Regal Company reports the following:Regal Company reports the following: Net operating income $ 50,000Net operating income $ 50,000 Average operating assets $ 230,000Average operating assets $ 230,000 Sales $ 535,000Sales $ 535,000 Operating expenses $ 485,000Operating expenses $ 485,000

Residual Income - Residual Income - DefinitionDefinition

Residual Income (RI) measures the net operating income earned in excess of a required return on operating assets.

RI = Net operating income – Required return on operating assets

Decision rule: Accept a project if its residual income >0

Residual income recognizes that funds invested in operating assets impose a cost on the firm. For example, if a firm borrowed bank loans to acquire the operating assets, it has to pay interest. To improve the value of the firm, those assets must generate an income greater than the interest payments. Otherwise, value will be destroyed.

Residual Income - Residual Income - ExampleExample

A division of Epsilon Corp. has average operating assets of $200,000. The required rate of return for the division is 20%. The division recently reported a net operating income of $50,000. Calculate the division’s residual income and indicate whether Epsilon should keep or discontinue the division.

Required return on assets =

RI =

ROI Vs. Residual IncomeROI Vs. Residual IncomeThe residual income approach emphasizes maximizing the overall

firm value by encouraging managers to invest in projects that earn more than the firm’s cost of capital. The ROI approach, on the other hand, emphasizes maximizing the segment ROI, leading managers to sometimes forego projects that would otherwise improve overall firm value but reduce segment ROI.

Problem: Sussex Magnet, a division of Sussex International Corp., has a net operating income of $150,000 and average operating assets of $500,000. The required annual rate of return for the company is 20%. Sussex Magnet identified a new project that would require an investment of $180,000 and earn an additional net operating income of $40,000 per year.

1. What is the division’s current ROI?

2. If the manager of Sussex Magnet is compensated based on the division’s ROI, would the manager undertake the new project? Why or why not?

ROI Vs. Residual IncomeROI Vs. Residual Income3. Would the Sussex International Corp. want

the Sussex Magnet division to undertake the new project? Why or why not?

4. What is Sussex Magnet’s current residualincome?

5. If the manager of Sussex Magnet is compensated based on the division’s residual income, would the manager undertake the new project? Why or why not?

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?a. 25%b. 5%c. 15%d. 20%

Quick Check

Quick Check Quick Check Redmond Awnings, a division of Wrapup

Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check Quick Check The company’s required rate of return is

15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check Quick Check Redmond Awnings, a division of Wrapup

Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?a. $240,000b. $ 45,000c. $ 15,000d. $ 51,000

Quick Check Quick Check If the manager of the Redmond Awnings

division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No