chap013_[管理成本会计]_CGA_MA1_Managerial_Accounting__management_accounting_课件

chap013_[管理成本会计]_CGA_MA1_Managerial_Accounting__management_accounting_课件 chap013_[管理成本会 计]_CGA_MA1_Managerial_Accounting__management_accou nting_课件 Segment Reporting, Decentralization, and the Balanced Scorecard Chapter 13 Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy1>. 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. Decentralization in Organizations Disadvantages of Decentralization Lower-level managers may make decisions without seeing the “big picture.” May be a lack of coordination among autonomous managers. Lower-level manager’s objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization. Cost, Profit, and Investments Centers Responsibility Center Cost Center Profit Center Investment Center Cost, profit, and investment centers are all known as responsibility centers. Cost Center A segment whose manager has control over costs, but not over revenues or investment funds. 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 Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. Corporate Headquarters Responsibility Centers Cost Centers Investment Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. Responsibility Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. Profit Centers Responsibility Centers Cost Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. Learning Objective 1 Prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed costs. Decentralization and Segment Reporting A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Popular Foods An Individual Store A Sales Territory A Service Center Superior Foods: Geographic Regions Superior Foods Corporation could segment its business by geographic region. Superior Foods: Customer Channel Superior Foods Corporation could segment its business by customer channel. 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. Identifying Traceable Fixed Costs Traceable costs arise because of the existence of a particular segment and 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 the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but . . . We still have a company president. 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. Segment Margin The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Time Profits Traceable and Common Costs Fixed Costs Traceable Common Don’t allocate common costs to segments. 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. Levels of Segmented Statements Webber, Inc. has two divisions. Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate sections. Levels of Segmented Statements Segment margin is Television’s contribution to profits. Contribution margin is computed by taking sales minus variable costs. Our approach to segment reporting uses the contribution format. Levels of Segmented Statements 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. 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 into smaller segments. Let’s see how this works using the Webber, Inc. example! Traceable Costs Can Become Common Costs Product Lines Regular Big Screen Television Division Webber’s Television Division Traceable Costs Can Become Common Costs We obtained the following information from the Regular and Big Screen segments. Traceable Costs Can Become Common Costs Fixed costs directly traced to the Television Division $80,000 + $10,000 = $90,000 External Reports The International Financial Reporting Standards (IFRS) and US GAAP require companies to include segmented financial data in their annual reports. In addition to some compulsory disclosure, companies must report segmented results to shareholders using the same measures to be used by the Chief Operating Decision Maker (CODM) to make decisions Since the contribution approach to segment reporting does not comply with financial reporting standards, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP. Omission of Costs Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain. Product Customer R&D Design Manufacturing Marketing Distribution Service Business Functions Making Up The Value Chain Inappropriate Methods of Allocating Costs Among Segments Segment 1 Segment 3 Segment 4 Inappropriate allocation base Segment 2 Failure to trace costs directly Common Costs and Segments Segment 1 Segment 3 Segment 4 Segment 2 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. Quick Check ?? Assume that Hoagland's Lakeshore prepared its segmented income statement as shown. 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. 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. Quick Check ?? Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000 Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000 Quick Check ?? The bar would be allocated 1/10 of the cost or $20,000. Quick Check ?? If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? Allocations of Common Costs Hurray, now everything adds up!!! Quick Check ?? Should the bar be eliminated? a. Yes b. No Should the bar be eliminated? a. Yes b. No Quick Check ?? The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000! Learning Objective 2 Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI. Return on Investment (ROI) Formula ROI = Net operating income Average operating assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. Income before interest and taxes (EBIT) Net Book Value vs. Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets. Understanding ROI ROI = Net operating income Average operating assets Margin = Net operating income Sales Turnover = Sales Average operating assets ROI = Margin ?? Turnover Increasing ROI There are three ways to increase ROI . . . Increase Sales Reduce Expenses Reduce Assets 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 ROI = Margin ?? Turnover Net operating income Sales Sales Average operating assets × ROI = What is Regal Company’s ROI? Increasing ROI – An Example $30,000 $500,000 × $500,000 $200,000 ROI = 6% ?? 2.5 = 15% ROI = ROI = Margin ?? Turnover Net operating income Sales Sales Average operating assets × ROI = Investing in Operating Assets to Increase Sales Assume 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. Regal Company reports the following: Net operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000 Investing in Operating Assets to Increase Sales $50,000 $535,000 × $535,000 $230,000 ROI = 9.35% ?? 2.33 = 21.8% ROI = ROI increased from 15% to 21.8%. ROI = Margin ?? Turnover Net operating income Sales Sales Average operating assets × ROI = Criticisms of ROI In the absence of the balanced scorecard, 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. Learning Objective 3 Compute residual income and understand its strengths and weaknesses. Residual Income - Another Measure of Performance Net operating income above some minimum return on operating assets Calculating Residual Income ( ) This computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets. Residual Income – An Example The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period, the division earns $30,000. Let’s calculate residual income. Residual Income – An Example Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. Quick Check ?? Redmond Awnings, a division of Wrap-up 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 ?? Redmond Awnings, a division of Wrap-up 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% ROI = NOI/Average operating assets = $60,000/$300,000 = 20% Quick Check ?? Redmond Awnings, a division of Wrap-up 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. Yes b. No Quick Check ?? Redmond Awnings, a division of Wrap-up 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. Yes b. No ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%. 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. Yes b. No 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. Yes b. No ROI = $18,000/$100,000 = 18% The return on the investment exceeds the minimum required rate of return. Quick Check ?? Redmond Awnings, a division of Wrap-up 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. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Quick Check ?? Redmond Awnings, a division of Wrap-up 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. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Net operating income $60,000 Required return (15% of $300,000) (45,000) Residual income $15,000 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. Yes b. No 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. Yes b. No Net operating income $78,000 Required return (15% of $400,000) (60,000) Residual income $18,000 Yields an increase of $3,000 in the residual income. Divisional Comparisons and Residual Income The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. Zephyr, Inc. - Continued Recall the following information for the Retail Division of Zephyr, Inc. Assume the following information for the Wholesale Division of Zephyr, Inc. Zephyr, Inc. - Continued The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division. Learning Objective 4 Understand how to construct and use a balanced scorecard. The Balanced Scorecard Management translates its strategy into performance measures that employees understand and influence. Performance measures Customers Learning and growth Internal business processes Financial The Balanced Scorecard: From Strategy to Performance Measures Financial Has our financial performance improved? Customer Do customers recognize that we are delivering more value? Internal Business Processes Have we improved key business processes so that we can deliver more value to customers? Learning and Growth Are we maintaining our ability to change and improve? Performance Measures What are our financial goals? What customers do we want to serve and how are we going to win and retain them? What internal busi- ness processes are critical to providing value to customers? Vision and Strategy The Balanced Scorecard: Non-financial Measures The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons: Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance. Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers. The Balanced Scorecard for Individuals A personal scorecard should contain measures that can be influenced by the individual being evaluated and that support the measures in the overall balanced scorecard. The entire organization should have an overall balanced scorecard. Each individual should have a personal balanced scorecard. The balanced scorecard lays out concrete actions to attain desired outcomes. A balanced scorecard should have measures that are linked together on a cause-and-effect basis. If we improve one performance measure . . . Another desired performance measure will improve. The Balanced Scorecard Then The Balanced Scorecard and Compensation Incentive compensation should be linked to balanced scorecard performance measures. Employee skills in installing options Number of options available Time to install option Customer satisfaction with options Number of cars sold Contribution per car Profit Learning and Growth Internal Business Processes Customer Financial The Balanced Scorecard — Jaguar Example Employee skills in installing options Number of options available Time to install option Customer satisfaction with options Number of cars sold Contribution per car Profit Increase Options Time Decreases Strategies Satisfaction Increases Increase Skills Results The Balanced Scorecard — Jaguar Example Employee skills in installing options Number of options available Time to install option Customer satisfaction with options Number of cars sold Contribution per car Profit Satisfaction Increases Results Cars sold Increase The Balanced Scorecard — Jaguar Example Employee skills in installing options Number of options available Time to install option Customer satisfaction with options Number of cars sold Contribution per car Profit Results Time Decreases Contribution Increases Satisfaction Increases The Balanced Scorecard — Jaguar Example The Balanced Scorecard — Jaguar Example Employee skills in installing options Number of options available Time to install option Customer satisfaction with options Number of cars sold Contribution per car Profit Results Contribution Increases Profits Increase If number of cars sold and contribution per car increase, profits increase. Cars Sold Increases Key Performance Indicators for a Balanced Scorecard Key performance indicators (KPIs) should address Missions and Vision of the organization Management principles and objectives (i.e. Execution of strategy) Critical success factors of the organization and operations Key objectives of the subsidiary/division/department/employee Balance of lead and lag measures (i.e. measures that lead to future success and measures that reflect historical performance) Number of KPI s should be kept at a controllable number. Summary of the Measures and Their Purposes Transfer Pricing Appendix 13A Key Concepts/Definitions 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. Three Primary Approaches There are three primary approaches to setting transfer prices: Negotiated transfer prices; Transfers at the cost to the selling division; and Transfers at market price. Learning Objective 5 Determine the range, if any, within which a negotiated transfer price should fall. Negotiated Transfer Prices A negotiated transfer price results from discussions between the selling and buying divisions. Advantages of negotiated transfer prices: They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. 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. Upper limit is determined by the buying division. Lower limit is determined by the selling division. Range of Acceptable Transfer Prices Grocery Storehouse – An Example Assume the information as shown with respect to West Coast Plantations and Grocery Mart (both companies are owned by Grocery Storehouse). Grocery Storehouse – An Example The selling division’s (West Coast Plantations) lowest acceptable transfer price is calculated as: The buying division’s (Grocery Mart) highest acceptable transfer price is calculated as: Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. If an outside supplier does not exist, the highest acceptable transfer price is calculated as: Grocery Storehouse – An Example If West Coast Plantations has sufficient idle capacity (3,000 crates) to satisfy Grocery Mart’s demands (1,000 crates), without sacrificing sales to other customers, then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Buying division’s highest possible transfer price: Therefore, the range of acceptable transfer prices is $10 – $20. Grocery Storehouse – An Example If West Coast Plantations has no idle capacity (0 crates) and must sacrifice other customer orders (1,000 crates) to meet Grocery Mart’s demands (1,000 crates), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Buying division’s highest possible transfer price: Therefore, there is no range of acceptable transfer prices. Grocery Storehouse – An Example If West Coast Plantations has some idle capacity (500 crates) and must sacrifice other customer orders (500 crates) to meet Grocery Mart’s demands (1,000 crates), then the lowest and highest possible transfer prices are computed as follows: Buying division’s highest possible transfer price: Therefore, the range of acceptable transfer prices is $17.50 – $20.00. Selling division’s lowest possible transfer price: Evaluation of Negotiated Transfer Prices If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. If managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative atmosphere is almost guaranteed. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices. Transfers at the Cost to the Selling Division Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. Drawbacks of this approach include: Using full cost as a transfer price can lead to suboptimization. The selling division will never show a profit on any internal transfer. Cost-based transfer prices do not provide incentives to control costs. Transfers at Market Price 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. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. A market price approach does not work well when the selling division has idle capacity. Divisional Autonomy and Suboptimization The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally, even if this may occasionally result in suboptimal decisions. This way top management allows subordinates to control their own destiny. Chapter 13: Segment Reporting, Decentralization, and the Balanced Scorecard. Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, segmented income statements, and return on investment (ROI), residual income, and balanced scorecard measures are used to help control decentralized organizations. 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: It enables top management to concentrate on strategy, higher-level decision-making, and coordinating activities. It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions. It enables lower-level managers to quickly respond to customers. It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions. It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance. The disadvantages of decentralization are as follows: Lower-level managers may make decisions without fully understanding the “big picture.” There may be a lack of coordination among autonomous managers. The balanced scorecard can help reduce this problem by communicating a company’s strategy throughout the organization. Lower-level managers may have objectives that differ from those of the entire organization. This problem can be reduced by designing performance evaluation systems that motivate managers to make decisions which are in the best interests of the company. It may difficult to effectively spread innovative ideas in a strongly decentralized organization. This problem can be reduced through the effective use of intranet systems, which enable globally dispersed employees to electronically share ideas. Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions. The term responsibility center is used for any part of an organization whose manager has control over, and is accountable for cost, profit, or investments. The three primary types of responsibility centers are cost centers, profit centers, and investment centers. The manager of a cost center has control over costs, but not over revenue or investment funds. Service departments such as accounting, general administration, legal, and personnel are usually classified as cost centers, as are manufacturing facilities. Standard cost variances and flexible budget variances, such as those discussed in Chapters 11 and 12, are often used to evaluate cost center performance. The manager of a profit center has control over both costs and revenue. 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. The manager of an investment center has control over cost, revenue, and investments in operating assets. Investment center managers are often evaluated using return on investment (ROI) or residual income (discussed later in this chapter). An example of an investment center would be the corporate headquarters. Part I Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. Part II The President and CEO, as well as the Vice President of Operations, manage investment centers. Part III The Chief Financial Officer, General Counsel, and Vice President of Personnel all manage cost centers. Each of the three product managers that report to the Vice President of Operations (e.g., salty snacks, beverages, and confections) manages a profit center. The bottling plant manager, warehouse manager, and distribution manager all manage cost centers that report to the Beverages product manager. Learning objective number 1 is to prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed costs. 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. As this slide illustrates, Superior Foods could segment its business by geographic region. Or, Superior Foods could segment its business by customer channel. In Asia, a similar example of such operation is Diary Farm International which is listed on Hong Kong Exchange. Well known brands under Diary Farm include Cold Storage, Giant, Shop n Save, Market Place, Guardian, Mannings, 7-11, GNC, Wellcome, Ikea, Starmart. (//.dairyfarmgroup3>/companies/overview.htm) There are two keys to building segmented income statements. First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. If the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include the following: The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing. A common fixed 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. Examples of common fixed costs include the following: The salary of the CEO of Honda Motors is a common fixed cost of the various divisions of Honda Motors. The cost of heating a Carrefour or Giant Hypermarket is a common fixed cost of the various departments – groceries, produce, and bakery. 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 a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers. A segment margin is computed by subtracting the traceable fixed costs of a segment from its contribution margin. The segment margin is a valuable tool for assessing the long-run profitability of a segment. Part I Allocating common costs to segments reduces the value of the segment margin as a guide to long-run segment profitability. Part II As a result, common costs should not be allocated to segments. Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments. For example, assume that three products, a 9-inch, a 12-inch, and an 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 activity-based costing can be used to trace the warehousing costs to the three products as shown. When using activity-based costing to trace fixed costs to segments, managers must still ask themselves if the traceable costs that they have identified would disappear over time, if the segment disappeared. In this example, if the warehouse was owned rather than leased, perhaps the warehousing costs assigned to a given segment would not disappear if the segment was discontinued. Assume that Webber, Inc. has two divisions – the Computer Division and the Television Division. The contribution format income statement for the Television Division is as shown. Notice that: Cost of goods sold consists of variable manufacturing costs; and Fixed and variable costs are listed in separate sections. Also notice that: Contribution margin is computed by subtracting variable costs from sales; and The divisional segment margin represents the Television Division’s contribution to overall company profits. The Television Division’s results can be rolled into Webber, Inc.’s overall results as shown. Notice that the results of the Television and Computer Divisions sum to the results shown for the whole company. The common costs for the company as a whole ($25,000) are not allocated to the divisions. Common costs are not allocated to segments because these costs would remain even if one of the divisions were eliminated. The Television Division’s results can also be broken down into smaller segments. This enables us to see how traceable fixed costs of the Television Division can become common costs of smaller segments. Assume that the Television Division can be broken down into two major product lines – Regular and Big Screen. Assume that the segment margins for these two product lines are as shown. Of the $90,000 of fixed costs that were previously traceable to the Television Division, only $80,000 is traceable to the two product lines and $10,000 is a common cost. The International Financial Reporting Standards (IFRS) and US GAAP require companies to include segmented financial data in their annual reports. This ruling has implications for internal segment reporting because: In addition to some compulsory disclosure, it mandates that companies report segmented results to shareholders using the same measures to be used by the Chief Operating Decision Maker (CODM) to make decisions. Since the contribution approach to segment reporting does not comply with IFRS and GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with IFRS and GAAP. The absorption approach hinders internal decision making because it does not distinguish between fixed and variable costs or common and traceable costs. The costs assigned to a segment should include all the costs attributable to that segment from the company’s entire value chain. The value chain consists of all major business functions that add value to a company’s products and services. Since only manufacturing costs are included in product costs under absorption costing, those companies that choose to use absorption costing for segment reporting purposes will omit from their profitability analysis all “upstream” and “downstream” costs. “Upstream” costs include research and development and product design costs. “Downstream” costs include marketing, distribution, and customer service costs. Although these “upstream” and “downstream” costs are not manufacturing costs, they are just as essential to determining product profitability as are manufacturing costs. Omitting them from profitability analysis will result in the undercosting of products. Costs that can be traced directly to specific segments of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example, the rent for a branch office of an insurance company should be charged directly against the branch office rather than included in a companywide overhead pool and then spread throughout the company. Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments for internal decision making purposes only when the allocation base actually drives the cost being allocated. For example, sales is frequently used to allocate selling and administrative expenses to segments. This should only be done if sales drive these expenses. Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: First, this practice may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided. Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control. Assume that Hoagland's Lakeshore prepared the segmented income statement as shown. How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? None of it. A common fixed cost cannot be eliminated by dropping one of the segments. Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? The bar would be allocated one tenth of the cost or $20,000. If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? Take a minute and review this slide. Notice that the common costs of $200,000 are allocated to the bar and restaurant. Should the bar be eliminated? No. The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000! Learning objective number 2 is to compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI. An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as net operating income divided by average operating assets. Net operating income is income before taxes and is sometimes referred to as earnings before interest and taxes (EBIT). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Net operating income is used in the numerator because the denominator consists only of operating assets. The operating asset base used in the formula is typically computed as the average operating assets (beginning assets + ending assets/2). Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets. With this approach, ROI mechanically increases over time as the accumulated depreciation increases. Replacing a fully-depreciated asset with a new asset will decrease ROI. An alternative to using net book value is the use of the gross cost of the asset, which ignores accumulated depreciation. With this approach, ROI does not grow automatically over time, rather it stays constant; thus, replacing a fully-depreciated asset does not adversely affect ROI. DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover. Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned. Turnover is computed as shown. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI. Any increase in ROI must involve at least one of the following – increased sales, reduced operating expenses, or reduced operating assets. Assume that Regal Company reports net operating income of $30,000; average operating assets of $200,000; sales of $500,000; and operating expenses of $470,000. What is Regal Company’s ROI? Given this information, its current ROI is 15%. The fourth way to increase ROI is to invest in operating assets to increase sales. Assume that Regal's manager invests $30,000 in a piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Let’s calculate the new ROI. In this case, the ROI increases from 15% to 21.8%. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI in a manner that is consistent with the company’s strategy. This is why ROI is best used as part of a balanced scorecard. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. This may make it difficult to assess this manager relative to other managers. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager’s performance evaluation. Learning objective number 3 is to compute residual income and understand its strengths and weaknesses. Residual income is the net operating income that an investment center earns above the minimum required return on its assets. Economic Value Added (EVA) is an adaptation of residual income. We will not distinguish between the two terms in this class. The equation for computing residual income is as shown. Notice that this computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets. Assume the information for a division of Zephyr, Inc. is as follows. The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period, the division earns $30,000. Let’s calculate residual income. The residual income of $10,000 is computed by subtracting the minimum required return of $20,000 from the actual income of $30,000. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula. It motivates managers to pursue investments where the ROI associated with those investments exceeds the company’s minimum required return but is less than the ROI being earned by the managers. Redmond Awnings, a division of Wrap-up 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? The ROI is 20%. 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? No, she would not want to invest in this project because its return is 18%, which would reduce her division’s ROI from 20% to 19.5%. The company’s required rate of return is fifteen percent. 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? Yes, she would want to invest in this project because the return on the investment exceeds the minimum required rate of return. Review this question. What is the division’s residual income? The residual income is $15,000. 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? Yes, she would want to invest in this project because it will increase the residual income by $3,000. The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. Recall that the Retail Division of Zephyr had average operating assets of $100,000, a minimum required rate of return of 20%, net operating income of $30,000, and residual income of $10,000. Assume that the Wholesale Division of Zephyr had average operating assets of $1,000,000, a minimum required rate of return of 20%, net operating income of $220,000, and residual income of $20,000. The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division. Learning objective number 4 is to understand how to construct and use a balanced scorecard. A balanced scorecard consists of an integrated set of performance measures that are derived from and support a company’s strategy. Importantly, the measures included in a company’s balanced scorecard are unique to its specific strategy. The balanced scorecard enables top management to translate its strategy into four groups of performance measures – financial, customer, internal business processes, and learning and growth – that employees can understand and influence. The premise of these four groups of measures is that learning is necessary to improve internal business processes. This in turn improves the level of customer satisfaction, thereby improving financial results. Note the emphasis on improvement, not just attaining some specific objective. The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons: ?? Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance. Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers. While the entire organization has an overall balanced scorecard, each responsible individual should have his or her own personal scorecard as well. A personal scorecard should contain measures that can be influenced by the individual being evaluated and that support the measures in the overall balanced scorecard. A balanced scorecard, whether for an individual or the company as a whole, should have measures that are linked together on a cause-and-effect basis. Each link can be read as a hypothesis in the form “If we improve this performance measure, then this other performance measure should also improve.” In essence, the balanced scorecard lays out a theory of how a company can take concrete actions to attain desired outcomes. If the theory proves false or the company alters its strategy, the measures within the scorecard are subject to change. Incentive compensation for employees probably should be linked to balanced scorecard performance measures. However, this should only be done after the organization has been successfully managed with the scorecard for some time – perhaps a year or more. Managers must be confident that the measures are reliable, not easily manipulated, and understandable by those being evaluated with them. Assume that Jaguar pursues a strategy as shown on this slide. Examples of measures that Jaguar might select with their corresponding cause-and-effect linkages include those shown on the next four slides. If “employee skills in installing options” increases, then the “number of options available” should increase and the “time to install an option” should decrease. If the “number of options available” increases and the “time to install an option” decreases, then “customer satisfaction with options available” should increase. If the “customer satisfaction with options available” increases, then the “number of cars sold” should increase. If the “time to install an option” decreases and the “customer satisfaction with options available” increases, then the “contribution per car” should increase. If the “number of cars sold” and the “contribution per car” increases, then the “profit” should increase. To derive meaningful Key Performance Indicators for a Balanced Scorecard may take lots of experience, understanding of the business and continuous feedback to do so. The limited number of key performance indicators should address: Missions and Vision of the organization Management principles and objectives (i.e. Execution of strategy) Critical success factors of the organization and operations Key objectives of the subsidiary/division/department/employee Balance of lead and lag measures (i.e. measures that lead to future success and measures that reflect historical performance) Too many KPIs may backfire as employees cannot remember and cannot focus on the key issues. Summary of the Measures and Their Purposes provides a mapping opportunity in the tabulate format to help users to match and to ensure completeness of addressing issues. A balanced scorecard example for a business division of a media product manufacturer provides a practical format to be considered. Definition and Measures of the KPIs, agreed targets, review frequency and the objectives of such measures should be clearly spelt out to provide a transparent and clear communication device for the parties concerned in executing and evaluating. Appendix 13A: Transfer Pricing. A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic transfer prices have no direct effect on the entire company’s reported profit, they can have a dramatic effect on the reported profitability of a division. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. Suboptimization occurs when managers do not act in the best interests of the overall company or even their own divisions. There are three primary approaches to setting transfer prices, namely negotiated transfer prices, transfers at the cost to the selling division, and transfers at market price. Learning objective number 5 is to determine the range, if any, within which a negotiated transfer price should fall. A negotiated transfer price results from discussions between the selling and buying divisions. Negotiated transfer prices have two advantages. First, they preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. 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. Second, the range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase. The lower limit is determined by the selling division. The upper limit is determined by the buying division. Assume the information as shown with respect to West Coast Plantations and Grocery Mart (both companies are owned by Grocery Storehouse). The selling division’s (West Coast Plantations) lowest acceptable transfer price is calculated as shown. The buying division’s (Grocery Mart) highest acceptable transfer price is calculated as shown. If Grocery Mart had no outside supplier for naval oranges, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the naval oranges, net of its own expenses. Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. Part I If West Coast Plantations has sufficient idle capacity (3,000 crates) to satisfy Grocery Mart’s demands (1,000 crates) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as follows. Part II The lowest acceptable transfer price, as determined by the seller, is $10. Part III The highest acceptable transfer price, as determined by the buyer, is $20. Therefore, the range of acceptable transfer prices is $10 to $20. Part I If West Coast Plantations has no idle capacity and must sacrifice other customer orders (1,000 crates) to meet the demands of Grocery Mart (1,000 crates), then the lowest and highest possible transfer prices will be computed as follows. Part II The lowest acceptable transfer price, as determined by the seller, is $25. Part III The highest acceptable transfer price, as determined by the buyer, is $20. Therefore, there is no range of acceptable transfer prices. This is a desirable outcome for Grocery Storehouse because it would be illogical to give up sales of $25 to save costs of $20. Part I If West Coast Plantations has some idle capacity (500 crates) and must sacrifice other customer orders (500 crates) to meet the demands of Grocery Mart (1,000 crates), then the lowest and highest possible transfer prices will be computed as follows. Part II The lowest acceptable transfer price, as determined by the seller, is $17.50. Part III The highest acceptable transfer price, as determined by the buyer, is $20. Therefore, the range of acceptable transfer prices is $17.50 to $20.00. If a transfer within the company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. Nonetheless, if managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative atmosphere is almost guaranteed. Thus, negotiations often break down even though it would be in both parties’ best interests to agree to a transfer price. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer 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: 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. 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. 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. 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. The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally. While subordinate managers may occasionally make suboptimal decisions, top managers should allow their subordinates to control their own destiny – even to the extent of granting subordinate managers the right to make mistakes.