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Questions and Answers
What is a major drawback of using full cost as a transfer price?
What is a major drawback of using full cost as a transfer price?
A market price approach works best when the selling division has idle capacity.
A market price approach works best when the selling division has idle capacity.
False
What are prevention costs?
What are prevention costs?
Costs incurred to reduce the number of defects.
Internal failure costs are incurred when __________ defects before they are shipped.
Internal failure costs are incurred when __________ defects before they are shipped.
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Match the following types of costs with their definitions:
Match the following types of costs with their definitions:
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What is a primary advantage of decentralization in organizations?
What is a primary advantage of decentralization in organizations?
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Traceable fixed costs can be attributed directly to a specific segment.
Traceable fixed costs can be attributed directly to a specific segment.
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What is a segmented income statement?
What is a segmented income statement?
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The ____ method of cost allocation allows for some costs to be allocated to multiple departments sequentially.
The ____ method of cost allocation allows for some costs to be allocated to multiple departments sequentially.
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Match the following terms to their definitions:
Match the following terms to their definitions:
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Which of the following is NOT a type of quality cost?
Which of the following is NOT a type of quality cost?
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Empowering lower-level managers is a disadvantage of decentralization.
Empowering lower-level managers is a disadvantage of decentralization.
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What does the contribution margin analysis help to assess?
What does the contribution margin analysis help to assess?
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Which of the following best defines a segment in an organization?
Which of the following best defines a segment in an organization?
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Decentralization allows for easier sharing of innovative ideas within an organization.
Decentralization allows for easier sharing of innovative ideas within an organization.
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What is the primary purpose of segment reporting in financial accounting?
What is the primary purpose of segment reporting in financial accounting?
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A _____ format should be used for segmented statements as it separates fixed from variable costs.
A _____ format should be used for segmented statements as it separates fixed from variable costs.
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What is a potential challenge of lower-level managers making independent decisions?
What is a potential challenge of lower-level managers making independent decisions?
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Match the type of segment with its example:
Match the type of segment with its example:
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Lower-level managers' objectives always align with the overall organization objectives.
Lower-level managers' objectives always align with the overall organization objectives.
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What is the role of an operating segment in an enterprise?
What is the role of an operating segment in an enterprise?
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What is the contribution margin for the current situation?
What is the contribution margin for the current situation?
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Only relevant costs should be considered when making financial decisions.
Only relevant costs should be considered when making financial decisions.
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What is the net annual cost saving from renting the new machine?
What is the net annual cost saving from renting the new machine?
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The total variable expenses in the new machine scenario are __________.
The total variable expenses in the new machine scenario are __________.
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Match the following expenses with their recognition:
Match the following expenses with their recognition:
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What is the contribution margin in the comparative income statement showing 'Keep Digital Watches'?
What is the contribution margin in the comparative income statement showing 'Keep Digital Watches'?
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What is the impact on operating income from renting the new machine?
What is the impact on operating income from renting the new machine?
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All fixed expenses are considered relevant when analyzing whether to keep or drop a product line.
All fixed expenses are considered relevant when analyzing whether to keep or drop a product line.
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The new machine results in higher variable expenses compared to the current situation.
The new machine results in higher variable expenses compared to the current situation.
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What is the net operating loss incurred when keeping digital watches?
What is the net operating loss incurred when keeping digital watches?
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What are the total fixed expenses when renting the new machine?
What are the total fixed expenses when renting the new machine?
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The total variable expenses for keeping digital watches amount to __________.
The total variable expenses for keeping digital watches amount to __________.
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Which of the following expenses would still exist if the digital watches line is dropped?
Which of the following expenses would still exist if the digital watches line is dropped?
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Match the following components with their respective classifications:
Match the following components with their respective classifications:
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A product line with a positive contribution margin should always be retained, regardless of fixed costs.
A product line with a positive contribution margin should always be retained, regardless of fixed costs.
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Identify one implication of having a net operating loss in the context of decision-making.
Identify one implication of having a net operating loss in the context of decision-making.
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What is the total contribution margin lost if digital watches are dropped?
What is the total contribution margin lost if digital watches are dropped?
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Avoidable fixed costs include expenses such as rent and salaries of line managers.
Avoidable fixed costs include expenses such as rent and salaries of line managers.
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What is the net disadvantage of dropping the digital watch segment?
What is the net disadvantage of dropping the digital watch segment?
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The total fixed expenses for the digital watches are __________.
The total fixed expenses for the digital watches are __________.
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Match the following expenses to their type:
Match the following expenses to their type:
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What would be the effect on the net operating loss if the digital watches are kept?
What would be the effect on the net operating loss if the digital watches are kept?
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Comparative income statements can help determine the financial impact of keeping or dropping a product segment.
Comparative income statements can help determine the financial impact of keeping or dropping a product segment.
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What is the primary purpose of contribution margin analysis?
What is the primary purpose of contribution margin analysis?
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Study Notes
Chapter 11: Reporting for Control
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Learning Objectives 1:
- Prepare segmented income statements using the contribution format, and explain the difference between traceable fixed costs and common fixed costs.
- Differentiate among responsibility centers (cost, profit, and investment centers) and explain how performance is measured in each.
- Analyze return on investment (ROI).
- Compute residual income and describe the strengths and weaknesses of this method of measuring performance.
- Explain the use of a balanced scorecard to assess performance.
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Learning Objectives 2:
- (Appendix 11A) Determine the range, if any, within which a negotiated transfer price should fall, and explain approaches to setting the transfer price.
- (Appendix 11A) Identify the four types of quality costs (prevention, appraisal, internal failure, and external failure), explain their interaction, and prepare a quality cost report.
- (Appendix 11A) Allocate service department costs to operating departments using the direct method.
- (Appendix 11A) Allocate service department costs to operating departments using the step-down method.
Decentralization in Organizations - Advantages
- Delegating daily problem-solving to lower-level managers allows top management to focus on overall strategy.
- Empowering lower-level managers gives decision-making authority to those with the most up-to-date information about daily operations.
- Eliminating layers of decision-making allows organizations to respond to customers and changes in the environment more efficiently.
- Granting decision-making authority helps train lower-level managers for higher-level positions.
- Empowering lower-level managers can increase motivation.
Decentralization in Organizations - Disadvantages
- Lower-level managers may make decisions without a full understanding of the company's overall strategy.
- Independent decision-making by lower-level managers can lead to coordination problems.
- Spreading innovative ideas can be challenging in decentralized organizations.
- Objectives of lower-level managers may clash with those of the entire organization (e.g., a manager focusing on department size over effectiveness).
Decentralization and Segment Reporting
- A segment is any part or activity of an organization for which a manager seeks cost, revenue, or profit data.
- Segments can include individual stores, sales territories, and service centers.
- Corporations often segment their business by customer channels, geographic regions, or product lines.
Segment Reporting (Financial Accounting Purposes)
- An operating segment is a component of an enterprise that engages in business activities, earns revenue, and incurs expenses.
- Its operating results are regularly reviewed by the chief operating officer to make decisions about resource allocation and performance assessment.
- Distinct financial information is available for each segment.
Different Levels of Segmented Statements
- Segmented statements can be prepared for different levels of activity in an organization and in different formats.
- A contribution format is beneficial because it distinguishes variable from fixed costs, allowing the calculation of a contribution margin.
Levels of Segmented Statements - Examples
- Data presented illustrates segmented statements using a contribution margin format for a company with two divisions (Computer and Television).
- Example reports include sales, variable costs, contribution margin, traceable fixed costs, and segment margins.
Assigning Costs to Segments
- Costs should be assigned to segments based on cost behavior patterns (variable or fixed) and direct traceability to the segments.
- Traceable fixed costs should be separated from common fixed costs for segment margin calculations.
Traceable Fixed Costs vs. Common Fixed Costs
- Traceable costs arise from the existence of a particular segment, disappearing if the segment is eliminated.
- Common costs arise from the overall operation of the company and would not vanish if a segment is eliminated; these costs are not allocated to segments.
Activity-Based Costing
- Activity-based costing identifies how costs shared by multiple segments are traceable to individual segments.
- An example demonstrates how warehousing costs can be traced to different pipe products based on their respective space usage.
Traceable Costs Can Become Common Costs
- Traceable fixed costs of one segment can sometimes become common fixed costs for another.
- For example, an airport landing fee is traceable to a specific flight but not to the passengers on that flight (first, business, or economy).
Segment Margin
- Segment margin equals contribution margin less traceable fixed costs, and is a key indicator of a segment's long-run profitability.
Segment Reporting for Financial Accounting
- IFRS 8 requires segmented reports for external users to follow consistent methods and definitions.
- However, the contribution approach does not necessarily comply with GAAP.
Hindrances to Proper Cost Assignment
- Cost omission, inappropriate methods for allocating traceable costs, failing to trace costs directly, improper allocation bases, and arbitrary distribution of common costs are all potential obstacles to proper cost assignment.
Omission of Costs
- Costs assigned to a segment should include all costs directly attributable from the entire company value chain, covering R&D, design, manufacturing, marketing, distribution, and customer service activities.
Inappropriate Methods for Assigning Traceable Costs Among Segments
- Companies may fail to trace fixed expenses to segments, or use inappropriate allocation bases when feasible allocation is necessary.
Arbitrarily Dividing Common Costs Among Segments
- Common costs shouldn't be allocated arbitrarily; this can make a profitable business segment appear unprofitable.
- This system also forces managers to take responsibility for costs outside their direct control.
Quick Check: Haglund's Lakeshore
- Data is presented for a segmented income statement (Bar and Restaurant).
- Common costs are allocated based on a specific allocation base.
- A question concerning eliminating a segment is posed (e.g., "Should the bar be eliminated?").
- Answers emphasize that some common fixed costs are unavoidable even if a segment is removed.
- Questions on calculating allocated amounts of common costs are presented using a particular allocation base (e.g., square footage).
Responsibility Centers
- Responsibility centers categorize segments by management control over costs, revenues, or investments. This categorization guides performance measurements.
- Cost centers: Control over costs only.
- Profit centers: Control over both costs and revenues.
- Investment centers: Control over costs, revenues, and investments in operating assets.
Return on Investment (ROI) Formula
- ROI = (Operating income) / (Average operating assets)
- Operating income represents earnings before interest and taxes.
- Average operating assets encompass cash, accounts receivable, inventory, plant and equipment, and other productive assets.
Operating Income and Operating Assets
- Operating income refers to income before considering interest and taxes.
- Operating assets encompass all assets used for the core operations of a business or investment center (e.g. cash, accounts receivable, inventory).
Net Book Value vs. Gross Cost
- Arguments for using net book value (NBV) of assets in ROI calculation emphasize consistency with balance sheet reporting and operating income calculations (which include depreciation).
- Using gross cost eliminates the age of equipment and depreciation method considerations and does not discourage replacement of worn-out equipment.
- Most companies often use net book value for calculating average operating assets.
Understanding ROI
- ROI can be broken down into Margin and Turnover.
- Margin calculates the proportion of sales resulting in profit.
- Turnover measures how efficiently assets generate revenue.
- ROI = Margin × Turnover
Increasing ROI
- Strategies to improve ROI include increasing sales, reducing operating expenses, and reducing operating assets, in a variety of situations.
Elements of ROI
- Detailed diagram showing various components of ROI calculations (sales, operating incomes, costs, assets).
Increasing ROI - Example
- Regal Company data is provided, showcasing the application of the ROI formula to calculate and analyze profitability improvements in various scenarios involving sales increases, reduced expenses, and adjusted assets.
Increasing Sales Without an Increase in Operating Assets
- Increase in sales, without increasing operating assets, shows the impact on overall ROI without increasing the resources used.
Decreasing Operating Expenses with No Change in Sales or Operating Assets
- Reduced operating expenses impact overall ROI positively without altering sales or assets.
Investing in Operating Assets to Increase Sales
- Example demonstrates that strategically investing in operating assets can impact the total revenue and ultimately increase the ROI when sales, expenses and operating assets all change.
Criticisms of ROI
- Organizations use balanced scorecards to improve the understanding of what areas in an organization to make adjustments to boost the total ROI for the organization.
- Managers may inherit committed costs and have limited control over them.
- Managers evaluating themselves based only on ROI may decline profitable investments.
Residual Income -- Another Measure of Performance
- Residual income measures operating income above a minimum required return on operating assets.
Calculating Residual Income
- Residual Income = Operating income – (Average operating assets x Minimum required rate of return)
Residual Income — Example
- Using example data of a Retail Division, the calculation of residual income is demonstrated, comparing the actual income with the required return on the assets.
Motivation and Residual Income
- Residual income, rather than ROI, encourages managers to make profitable investments that might be foregone under ROI evaluation (which measures assets vs. earnings, where residual income measures above and beyond target return).
Quick Check: ROI and Residual Income
- Example questions are presented relating to the calculation of ROI and residual income.
Divisional Comparisons and Residual Income
- Residual income, unlike ROI, is not always suitable for comparison of operations as the level of company size matters, and can be hard to compare divisions of different sizes.
Zephyr, Inc.
- Example demonstrating different levels of divisions in Zephyr, Inc. highlighting the varying performances of the wholesale versus the retail divisions, emphasizing the limitations in comparing based on residual income.
Criticisms of Residual Income
- Historically-based accounting data can inflate income, hindering effective evaluation, particularly with rising prices.
- A lack of comparison for earnings benchmarks in external markets might cause an inaccurate assessment of income levels.
- Non-financial factors and indicators are omitted (like employee motivation), so a fuller picture of true performance is missing.
The Balanced Scorecard
- A balanced scorecard integrates various non-financial measures and financial figures to more holistically monitor and evaluate organizational performance.
- Measures the financial effects of activities to determine if strategies improve financial performance.
- Establishes clear links between performance measures and how strategies might improve performance across multiple aspects of business.
- Explains how balanced scorecards track organizational strategy and its impacts.
Appendix 11A—Additional Control Topics
- Appendix 11A covers transfer pricing, cost of quality, and service department cost allocation.
- Transfer Pricing: Price charged when one segment provides goods/services to another.
- Cost of Quality: Prevention costs support reducing defects; appraisal costs identify defects before shipment; internal failure costs involve identifying defects pre-shipment; external failure costs result from defective products reaching customers.
- Service Department Cost Allocations: Methods for dividing service department costs among operating departments via a "direct method", "step-down method", and "reciprocal method".
Transfer Pricing
- A transfer price reflects the price charged when a segment of a company provides goods or services to another segment.
- The goal is to motivate managers to act in the best interest of the overall company.
- Three Approaches
- Negotiated transfer prices.
- Transfers to the selling division at cost.
- Transfers at market price.
Negotiated Transfer Prices
- The transfer price is determined through negotiation between the selling and buying divisions.
- An upper price limit is set by the buying division and a lower limit by the selling division to reach agreement.
- The method advantages preserve autonomy and better decision making.
Harrison Ltd—Examples
- Example cases demonstrates the calculation procedures for determining the lowest and highest transfer prices (and the applicable range), presented under three different scenarios.
- These examples illustrate when idle capacity exists, is absent, or when an alternative external supplier exists/doesn't exist.
Quality Costs
- Quality cost is the total cost of maintaining or improving quality within an organization.
- Quality of Conformance: Products consistent with design specifications and free of defects.
- Prevention Costs: Activities that reduce the number of defects.
- Appraisal Costs: Activities in which defective products are identified before shipment.
- Internal Failure Costs: Costs incurred by discovering defects before shipment.
- External Failure Costs: Costs stemming from delivering defective products to customers. Examples of quality costs are given.
Quality Cost Report
- Quality cost reports provide a financial estimation of the impact of current defect rates for a company
- The report is a crucial first step towards quality improvements.
Allocation Methods
- Allocation methods for service department costs to operating departments include direct, step-down, and reciprocal. This is useful to determine how costs from various sections of the organization impact the overall performance.
Direct Method
- This approach ignores interactions between service departments to allocate costs to operating departments.
- Involves allocating costs directly to the operating departments based on some allocation baseline like employee count or square footage.
Step-Down Method
- First, one service department's costs are allocated to operating departments.
- Costs of any further service departments are passed along to remaining operating departments. It prioritizes service departments in terms of the amount of services provided.
Reciprocal Method
- Fully recognizes interdepartmental services.
- Considered more accurate.
- In practice, rare due to the complexity, usually similar to step-down method.
Quick Check: Direct and Step Methods
- Quick Check questions cover cost allocation from Service Departments (ADMIN and BACS) to Operating Departments (Accounting, Others) employing both direct and step methods, using relevant allocation bases.
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Test your knowledge on cost accounting concepts such as transfer pricing, cost allocation methods, decentralization advantages, and various types of costs. This quiz covers essential definitions and principles that are crucial for understanding the financial operations within organizations. Perfect for students in accounting courses!
