Segment Reporting, Decentralization,
and the Balanced Scorecard
Chapter 12
McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
introduction
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.
12-2
Cost Center
A segment whose manager has control over costs,
but not over revenues 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 10 and 11, are often
used to evaluate cost center performance
12-3
Profit Center
A segment whose manager
has control over both costs
and revenues, Revenues
but no control over Sales
investment funds. Interest
The manager of a profit center has control Other
over both costs and revenue. Profit
center managers are often evaluated by
Costs
comparing actual profit to targeted or Mfg. costs
budgeted profit. An example of a profit Commissions
center is a companys cafeteria
Salaries
Other
12-4
Investment Center
A segment whose manager Corporate Headquarters
has control over costs,
revenues, and investments in
operating assets.
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
12-5
Decentralization and Segment Reporting
A segment is any part or activity An Individual Store
Quick Mart
of an organization about which a
manager seeks cost, revenue,
or profit data. A Sales Territory
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, A Service Center
individual stores, service centers,
manufacturing plants, marketing
departments, individual customers,
and product lines.
12-6
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.
12-7
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. 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.
No computer No computer
division means ... division manager.
12-8
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.
Examples of common fixed costs include the following:
The salary of the CEO of General Motors is a common fixed cost of the
various divisions of General Motors.
The cost of heating a Safeway or Kroger grocery store is a common fixed
cost of the various departments groceries, produce, and bakery.
We still have a
No computer
company president.
division but . ..
12-9
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.
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Segment Margin
The segment margin, which 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.
Profits
Time
12-11
Traceable and Common Costs
Fixed Dont allocate
Costs common costs to
segments.
Traceable Common
12-12
Traceable and Common Costs
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
12-13
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.
Pipe Products
9-inch 12-inch 18-inch Total
Warehouse sq. ft. 1,000 4,000 5,000 10,000
Lease price per sq. ft. $ 4 $ 4 $ 4 $ 4
Total lease cost $ 4,000 $ 16,000 $ 20,000 $ 40,000
12-14
Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
Net operating income
ROI =
Average operating assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.
12-15
Return on Investment (ROI) Formula
An investment centers 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).
12-16
Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating assets
ROI = Margin Turnover
12-17
Return on Investment (ROI) Formula
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
managers responsibility the investment in operating assets.
Excessive funds tied up in operating assets depress turnover and
lower ROI.
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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.
12-19
Calculating Residual Income
Residual
income
=
Net
operating -
income
( Average
operating
assets
Minimum
required rate of
return
)
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.
12-20
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
It motivates managers to pursue investments where the ROI associated
with those investments exceeds the companys minimum required return
but is less than the ROI being earned by the managers.
12-21
The Balanced Scorecard
A balanced scorecard is a system or procedure that is used for
checking or testing something.
A balanced scorecard consists of an integrated set of performance
measures that are derived from and support a companys strategy.
Importantly, the measures included in a companys 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.
12-22
The Balanced Scorecard
Management translates its strategy into
performance measures that employees
understand and influence.
Financial Customers
Performance
measures
Internal Learning
business and growth
processes
12-23
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 (slower) 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.
12-24
The 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
12-25
The Balanced Scorecard
A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.
If we improve Another desired
Then
one performance performance measure
measure . . . will improve.
The balanced scorecard lays out concrete
actions to attain desired outcomes.
12-26
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.
12-27
Three Primary Approaches
There are three primary
approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.
12-28
Negotiated Transfer Prices
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
12-29
Negotiated Transfer Prices
A negotiated transfer price results from discussions
between the selling and buying divisions.
Range of Acceptable
Transfer Prices
Advantages of negotiated transfer prices:
Upper limit is
1. They preserve the autonomy of the determined by the
buying division.
divisions, which is consistent with
the spirit of decentralization.
2. 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. Lower limit is
determined by the
selling division.
12-30
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:
1. Using full cost as a transfer price
can lead to suboptimization.
2. The selling division will never
show a profit on any internal
transfer.
3. Cost-based transfer prices do not
provide incentives to control
costs.
12-31
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.
1. 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. With no idle capacity the
real cost of the transfer from the
companys perspective is the
opportunity cost of the lost revenue
on the outside sale.
12-32
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.
2. A market price approach 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.
12-33
Reasons for Charging Service Department
Costs
Service department costs are charged to operating
departments for a variety of reasons including:
To provide operating
To encourage
departments with
operating departments
more complete cost
to wisely use service
data for making
department resources.
decisions.
To help measure the To create an incentive
profitability of for service
operating departments to
departments. operate efficiently.
12-34
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.
12-35
End of Chapter 12
12-36
