Managerial Accounting Chapter 11 Reporting for Control PDF

CHAPTER 11: Reporting for Control Prepared by Ruth Ann Strickland, CPA Western University © 2024 McGraw Hill Limited  Lear...

CHAPTER 11: Reporting for Control Prepared by Ruth Ann Strickland, CPA Western University © 2024 McGraw Hill Limited  Learning Objectives 1 1. Prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed costs. 2. Differentiate among responsibility centres such as cost centres, profit centres, and investment centres, and explain how performance is measured in each. 3. Analyze the return on investment. 4. Compute residual income, and describe the strengths and weaknesses of this method of measuring performance. 5. Explain the use of a balanced scorecard to assess performance. © 2024 McGraw Hill Limited 11-2  Learning Objectives 2 6. (Appendix 11A) Determine the range, if any, within which a negotiated transfer price should fall, and explain approaches to setting the transfer price. 7. (Appendix 11A) Identify the four types of quality costs, explain their interaction, and prepare a quality cost report. 8. (Appendix 11A) Allocate service department costs to operating departments using the direct method. 9. (Appendix 11A) Allocate service department costs to operating department costs using the step-down method. © 2024 McGraw Hill Limited 11-3 Decentralization in Organizations - Advantages 1. By delegating day-to-day problem solving to lower- level managers, top management can concentrate on bigger issues, such as overall strategy. 2. Empowering lower-level managers to make decisions puts the decision-making authority in the hands of those who tend to have the most detailed and up-to-date information about day-to-day operations. 3. By eliminating layers of decision making and approvals, organizations can respond more quickly to customers and to changes in the operating environment. 4. Granting decision-making authority helps train lower-level managers for higher-level positions. 5. Empowering lower-level managers to make © 2024 McGraw Hill Limited 11-4 decisions can increase their motivation and job Decentralization in Organizations – Disadvantages 1. Lower-level managers may make decisions without fully understanding the company’s overall strategy. 2. If lower-level managers make their own decisions independently of each other, coordination may be lacking. 3. Spreading innovative ideas may be difficult in a decentralized organization. Someone in one part of the organization may have a terrific idea that would benefit other parts of the organization, but without strong central direction the idea may not be shared with, and adopted by, other parts of the organization. 4. Lower-level managers may have objectives that clash with the objectives of the entire organization. For example, a manager may be more interested in increasing the size of his or her department, leading to more power and prestige, than in increasing the © 2024 McGraw Hill Limited 11-5  Decentralization and Segment Reporting A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be: An individual store A sales territory A service centre Corporations could segment their business by customer channel, by geographic regions, by product line, etc. © 2024 McGraw Hill Limited 11-6  Segment Reporting An operating segment for financial accounting purposes is a component of an enterprise: That engages in business activities from which it may earn revenues and incur expenses. Whose operating results are regularly reviewed by the enterprise’s chief operating officer to make decisions about resources to be allocated to the segment and assess its performance. For which discrete financial information is available. © 2024 McGraw Hill Limited 11-7  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 should be used because it separates fixed from variable costs, and it enables the calculation of a contribution margin. © 2024 McGraw-Hill Limited 11-8  Levels of Segmented Statements - Example Part 1 two divisions. Webber, Inc. has Webber, Inc. Computer Television Division Division A separate income statement can be prepared for each division. © 2024 McGraw Hill Limited 11-9  Levels of Segmented Statements - Example Part 2 Income Statement Cost of goods Contribution Margin Format sold consists of Television Division variable Sales $ 300,000 manufacturing Variable COGS 120,000 costs. Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Variable and Traceable fixed costs 90,000 fixed costs are Division segment margin $ 60,000 listed in separate sections. © 2024 McGraw Hill Limited 11-10  Levels of Segmented Statements - Example Part 3 Contribution Income Statement margin Contribution Margin Format is computed as Television Division sales minus all Sales $ 300,000 variable costs. Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Segment margin Contribution margin 150,000 is Television’s Traceable fixed costs 90,000 contribution Division segment margin $ 60,000 to company profits. © 2024 McGraw Hill Limited 11-11  Levels of Segmented Statements - Example Part 4 Income Statement Company Television Computer Sales $ 500,000 $ 300,000 $ 200,000 Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 $ 60,000 $ 40,000 Common costs Operating income © 2024 McGraw Hill Limited 11-12  Levels of Segmented Statements - Example Part 5 Income Statement Company Television Computer Sales $ 500,000 $ 300,000 $ 200,000 Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 $ 60,000 $ 40,000 Common costs 25,000 Operating Common costs should income $ 75,000 not be allocated to the divisions. These costs would remain with the company even if one of the divisions was eliminated. © 2024 McGraw Hill Limited 11-13  Assigning Costs to Segments Two guidelines are followed in assigning costs to the various segments under the contribution approach: 1. According to cost behaviour patterns (i.e., variable and fixed). 2. According to whether the costs are directly traceable to the segments involved. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. © 2024 McGraw Hill Limited 11-14 Traceable Fixed Costs vs. Common Fixed Costs Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself was eliminated. Common costs arise because of the overall operation of the company and would not disappear if any particular segment was eliminated. Common fixed costs are not allocated to segments. © 2024 McGraw Hill Limited 11-15  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 © 2024 McGraw Hill Limited 11-16  Traceable Costs Can Become Common Costs 1 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. This can be applied to the Webber, Inc. example. © 2024 McGraw Hill Limited 11-17  Traceable Costs Can Become Common Costs 2 Webber’s Television Division Television Division Regular TV Smart TV Product Lines © 2024 McGraw Hill Limited 11-18  Traceable Costs Can Become Common Costs 3 Regular TVs and Smart TVs can be separated into divisional segments. Income Statement Television Division Regular TV Smart TV Sales $ 200,000 $ 100,000 Variable costs 95,000 55,000 CM 105,000 45,000 Traceable FC 45,000 35,000 Product line margin $ 60,000 $ 10,000 Common costs Divisional margin © 2024 McGraw Hill Limited 11-19  Traceable Costs Can Become Common Costs 4 Income Statement Television Division Regular TV Smart TV Sales $ 300,000 $ 200,000 $ 100,000 Variable costs 150,000 95,000 55,000 CM 150,000 105,000 45,000 Traceable FC 80,000 45,000 35,000 Product line margin 70,000 $ 60,000 $ 10,000 Common costs 10,000 Divisional margin $ 60,000 Fixed costs directly traced to the Television Division $80,000 + $10,000 = $90,000 © 2024 McGraw Hill Limited 11-20  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. © 2024 McGraw Hill Limited 11-21  Segment Reporting for Financial Accounting International Financial Reporting Standard (IFRS) 8-Operating Segments, requires that segmented reports prepared for external users follow the same methods and definitions used for internal segmented reports that are prepared to aid in making operating decisions. Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP. © 2024 McGraw Hill Limited 11-22 Hindrances to Proper Cost Assignment Omission of some costs in the assignment process. Use of inappropriate methods for assigning traceable costs among segments. Failure to trace costs directly. Inappropriate allocation base. Arbitrarily dividing common costs among segments. © 2024 McGraw Hill Limited 11-23  Omission of Costs Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain. Produc Customer R& t Manufacturing Marketing Distribution Service D Design Typical business functions in a value chain. © 2024 McGraw Hill Limited 11-24  Inappropriate Methods for Assigning Traceable Costs Among Segments Many companies do not correctly handle traceable fixed expenses on segmented income statements. They may not trace fixed expenses to segments even when it is feasible to do so. They may use inappropriate allocation bases to allocate traceable fixed expenses to segments. © 2024 McGraw Hill Limited 11-25  Arbitrarily Dividing Common Costs and Common costs Segments 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. © 2024 McGraw Hill Limited 11-26  Quick Check  Income Statement Haglund's Lakeshore Bar Restaurant Sales $ 800,000 $ 100,000 $ 700,000 Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 Segment margin 244,000 $ 14,000 $ 230,000 Common costs 200,000 Profit $ 44,000 Assume that Haglund's Lakeshore location prepared its segmented income statement as shown. © 2024 McGraw Hill Limited 11-27  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. © 2024 McGraw Hill Limited 11-28  Quick Check  How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? Answer: a. None of it. A common fixed cost cannot be eliminated by dropping one of the segments. © 2024 McGraw Hill Limited 11-29  Quick Check  Suppose square meters 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 meters and the restaurant 9,000 square meters? a. $20,000 b. $30,000 c. $40,000 d. $50,000 © 2024 McGraw Hill Limited 11-30  Quick Check  Suppose square meters 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 meters and the restaurant 9,000 square meters? The bar would be Answer: allocated 1÷10 of the a. $20,000 cost or $20,000. © 2024 McGraw Hill Limited 11-31  Quick Check  If Haglund's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? © 2024 McGraw Hill Limited 11-32  Allocations of Common Costs Income Statement Haglund's Lakeshore Bar Restaurant Sales $ 800,000 $ 100,000 $ 700,000 Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 Segment margin 244,000 14,000 230,000 Common costs 200,000 20,000 180,000 Profit $ 44,000 $ (6,000) $ 50,000 © 2024 McGraw Hill Limited 11-33  Quick Check  Should the bar be eliminated? a. Yes b. No © 2024 McGraw Hill Limited 11-34  Quick Check  Should the bar be eliminated? Answer: The profit was $44,000 before b. No eliminating the bar. If the bar Income Statement is eliminated, profit drops to Haglund's $30,000! Lakeshore Bar Restaurant Sales $ 700,000 $ 700,000 Variable costs 250,000 250,000 CM 450,000 450,000 Traceable FC 220,000 220,000 Segment margin 230,000 230,000 Common costs 200,000 200,000 Profit $ 30,000 $ 30,000 © 2024 McGraw Hill Limited 11-35  Responsibility Centres 1 A responsibility centre is broadly defined as any part of an organization whose manager has control over and is accountable for cost, profit, or investment. The three primary types of responsibility centres are cost centres, profit centres, and investment centres. Organizations categorize responsibility centres into one of these three types based on the manager’s authority to control cost, revenue, and investment © 2024 McGraw Hill Limited 11-36  Responsibility Centres 2 Cost Centre: A segment whose manager has control over costs, but not over revenues or investment funds. Profit Centre: A segment whose manager has control over both costs and revenues, but no control over investment funds. Investment Centre: A segment whose manager has control over costs, revenues, and investments in operating © 2024 McGraw Hill Limited 11-37 Return on Investment (ROI) Formula Income before interest and taxes (EBIT) Operating income ROI = Average operating assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. © 2024 McGraw Hill Limited 11-38  Operating Income and Operating Assets Operating income is income before interest and taxes and is sometimes referred to as EBIT. Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization and/or the investment centre. © 2024 McGraw Hill Limited 11-39 Net Book Value vs. Gross Cost 1 Arguments for using NBV to measure operating assets in ROI calculation: It is consistent with how plant and equipment are reported on the balance sheet It is consistent with the calculation of operating income, which includes depreciation as an operating expense. © 2024 McGraw Hill Limited 11-40 Net Book Value vs. Gross Cost 2 Arguments for using gross cost to measure operating assets in ROI calculation: It eliminates both the age of equipment and the method of depreciation as factors in ROI calculations. It does not discourage replacement of old, worn-out equipment. © 2024 McGraw Hill Limited 11-41 Net Book Value vs. Gross Cost 3 Most companies use the net book value of depreciable assets to calculate average operating assets. Acquisition cost $3,000,000 Less: accumulated depreciation 900,000 Net book value $2,100,000 © 2024 McGraw Hill Limited 11-42  Understanding ROI Sales Turnover = Average operating assets © 2024 McGraw Hill Limited 11-43  Increasing ROI There are three ways to increase ROI... 1. Increase sales 2. Reduce operating expenses 3. Reduce operating assets © 2024 McGraw Hill Limited 11-44 Elements of ROI © 2024 McGraw Hill Limited 11-45  Increasing ROI – An Example Part 1 Regal Company reported the following: Operating income $ 30,000 Average operating assets $ 200,000 Sales $ What is Regal Company’s ROI? 500,000 Operating expenses $ ROI 470,000 = Margin  Turnover Operating income Sales ROI = ×Average operating Sales assets © 2024 McGraw Hill Limited 11-46  Increasing ROI – An Example Part 2 Margin  Turnover ROI = Operating income Sales ROI = ×Average operating Sales assets ROI = $30,000 × $500,000 $500,000 $200,000 ROI = 6%  2.5 = 15% © 2024 McGraw Hill Limited 11-47  Increasing Sales Without an Increase in Operating Assets 1 Regal's manager was able to increase sales to $600,000, while operating expenses increased to $558,000. Regal's operating income increased to $42,000. There was no change in the average operating assets of the segment. Calculate the new ROI. © 2024 McGraw Hill Limited 11-48  Increasing Sales Without an Increase in Operating Assets 2 ROI =Margin  Turnover Operating income Sales ROI = ×Average operating Sales assets ROI = $42,000 × $600,000 $600,000 $200,000 ROI =7%  3.0 = 21% ROI increased from 15% to 21%. © 2024 McGraw Hill Limited 11-49 Decreasing Operating Expenses with No Change in Sales or Operating Assets Assume that Regal's 1 was able to manager reduce operating expenses by $10,000, without affecting sales or operating assets. This increased operating income to $40,000. Regal Company reported the following: Operating income $ 40,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 460,000 Calculate the new ROI. © 2024 McGraw Hill Limited 11-50 Decreasing Operating Expenses with No Change in Sales or Operating Assets 2 Margin  Turnover ROI = Operating income Sales ROI = ×Average operating Sales assets ROI = $40,000 × $500,000 $500,000 $200,000 ROI =8%  2.5 = 20% ROI increased from 15% to 20%. © 2024 McGraw Hill Limited 11-51  Investing in Operating Assets to Increase Sales 1 Assume that Regal's manager invested in a $30,000 piece of equipment that increased sales by $35,000, while increasing operating expenses by $15,000. Regal Company reported the following: Operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000 Calculate the new ROI. © 2024 McGraw Hill Limited 11-52  Investing in Operating Assets to Increase Sales 2 ROI = Margin  Turnover Operating income Sales ROI = ×Average operating assets Sales ROI = $50,000 × $535,000 $535,000 $230,000 ROI = 9.35%  2.33 = 21.8% ROI increased from 15% to 21.8%. © 2024 McGraw Hill Limited 11-53  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. © 2024 McGraw Hill Limited 11-54 Residual Income - Another Measure of Performance Operating income above some minimum return on operating assets © 2024 McGraw Hill Limited 11-55  Calculating Residual Income ( ) Average Residual Operating Minimum required = – operating x income income rate of return assets This computation differs from ROI. ROI measures operating income earned relative to the investment in average operating assets. Residual income measures operating income earned less the minimum required return on average operating assets. © 2024 McGraw Hill Limited 11-56  Residual Income – An Example Part 1 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. Calculate residual income. © 2024 McGraw Hill Limited 11-57  Residual Income – An Example Part 2 Operating Operatingassets assets $$100,000 100,000 Required Requiredrate rateof ofreturn return ×× 20% 20% Minimum Minimumrequired requiredreturn return $$ 20,000 20,000 Actual Actualincome income $$ 30,000 30,000 Minimum Minimumrequired requiredreturn return (20,000) (20,000) Residual Residualincome income $$ 10,000 10,000 © 2024 McGraw Hill Limited 11-58  Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. © 2024 McGraw Hill Limited 11-59  Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an 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% © 2024 McGraw Hill Limited 11-60  Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an 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? Answer: d. 20% ROI = OI ÷ Average operating assets = $60,000 ÷ $300,000 = 20% © 2024 McGraw Hill Limited 11-61  Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an 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 operating income of $18,000 per year? a. Yes b. No © 2024 McGraw Hill Limited 11-62  Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an 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 operating income of $18,000 perROI year? = $78,000 ÷ $400,000 = 19.5% Answer: This investment has an 18% ROI. It lowers the division’s ROI b. No from 20.0% to 19.5%. © 2024 McGraw Hill Limited 11-63  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 operating income of $18,000 per year? a. Yes b. No © 2024 McGraw Hill Limited 11-64  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 operating income of $18,000 per year? ROI = $18,000 ÷ $100,000 = Answer: 18% a. Yes The 18% ROI for the investment exceeds the minimum required rate of © 2024 McGraw return. Hill Limited 11-65  Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an 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 © 2024 McGraw Hill Limited 11-66  Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an 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? Answer: c. $ 15,000 Operating income $60,000 Required return (15% of $300,000) (45,000) Residual income © 2024 McGraw Hill Limited 11-67  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 operating income of $18,000 per year? a. Yes b. No © 2024 McGraw Hill Limited 11-68  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 operating income of $18,000 per year? Answer: Operating income a. Yes $78,000 Required return (15% of $400,000) (60,000) Residual income $18,000 Residual income increased by $3,000. 11-69 © 2024 McGraw Hill Limited Divisional Comparisons and Residual Income The residual income approach has one major disadvantage  it cannot be used to compare performance of divisions of different sizes. © 2024 McGraw Hill Limited 11-70  Zephyr, Inc. 1 This information is for This information is the Retail Division of for the Wholesale Zephyr, Inc Division of Zephyr, Inc Retail Retail Wholesale Wholesale Operating Operatingassets assets $ $ 100,000 100,000 $ $ 1,000,000 1,000,000 Required Requiredrate rateof ofreturn return ×× 20% 20% 20% 20% M Minimum inimumrequired requiredreturn return $$ 20,000 20,000 $ $ 200,000 200,000 Retail Retail Wholesale Wholesale Actual Actualincome income $ $ 30,000 30,000 $ $ 220,000 220,000 M Minimum inimumrequired requiredreturn return (20,000) (20,000) (200,000) (200,000) Residual Residualincome income $ $ 10,000 10,000 $ $ 20,000 20,000 © 2024 McGraw Hill Limited 11-71  Zephyr, Inc. 2 The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply Retailbecause Retail Wholesale Wholesale it is a Operating assets $$ 100,000 100,000 $$ 1,000,000 bigger division. Operating assets Required rate of return × 20% 1,000,000 20% Required rate of return × 20% 20% M Minimum inimumrequired requiredreturn return $$ 20,000 20,000 $$ 200,000 200,000 Retail Retail Wholesale Wholesale Actual Actualincome income $$ 30,000 30,000 $$ 220,000 220,000 M Minimum inimumrequired requiredreturn return (20,000) (20,000) (200,000) (200,000) Residual income Residual income $ 10,000 $ 10,000 $ $ 20,000 20,000 © 2024 McGraw Hill Limited 11-72  Criticisms of Residual Income RI is based on historical accounting data which can lead to inflated amounts for residual income in periods of rising prices (such as values for capital assets). RI does not indicate what earnings should be (need comparison of external benchmark or trends). RI does not incorporate important leading non-financial indicators. © 2024 McGraw Hill Limited 11-73 The Balanced Scorecard 1 Management translates its strategy into performance measures that employees can understand and accept. Financial Customers Performance measures Internal Learning business and growth processes © 2024 McGraw Hill Limited 11-74  The Balanced Scorecard: From Strategy to Performance Exhibit 11-3 Measures © 2024 McGraw Hill Limited 11-75 The Balanced Scorecard 2 A balanced scorecard should have measures that are linked together on a cause-and-effect basis. another desired If one performance then performance measure measure improves, should improve. The balanced scorecard lays out concrete actions to attain desired outcomes. © 2024 McGraw Hill Limited 11-76 The Balanced Scorecard 3 The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons: 1. Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance. 2. 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. © 2024 McGraw Hill Limited 11-77 The Balanced Scorecard 4 The entire organization should have an overall balanced scorecard and each individual should have a personal balanced scorecard. 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. © 2024 McGraw Hill Limited 11-78 The Balanced Scorecard 5 Incentive compensation for employees should be linked to balanced scorecard performance measures. This should only be done after the organization has been successfully managed with the scorecard for a period of time. The emphasis of the balanced scorecard is on progress and improvement rather than on meeting a specific standard. © 2024 McGraw Hill Limited 11-79  A Possible Strategy map for a Regional Airline and the Balanced Exhibit 11-4 Scorecard © 2024 McGraw Hill Limited 11-80 Corporate Social Responsibility and the Balanced Scorecard Companies are responsible for creating strategies which produce financial results that satisfy shareholders. They also have a corporate social responsibility to serve other stakeholders whose interests are tied to the company’s performance. Corporate social responsibility (CSR) is a concept whereby organizations consider the needs of all stakeholders when making decisions. CSR extends beyond legal compliance to include voluntary actions © 2024 that satisfy McGraw Hill Limited 11-81 End of Chapter Summary 1 Segmented income statements provide information for evaluating the profitability and performance of divisions, product lines, sales territories, and other company segments. Under the contribution approach, variable costs and fixed costs are clearly distinguished from each other, and only those costs that are traceable to a segment are assigned to the segment. A responsibility centre is any segment of an organization whose manager has control over and is accountable for cost, profit, or investments. © 2024 McGraw Hill Limited 11-82 End of Chapter Summary 2 A cost centre is a business segment whose manager has control over costs only. A profit centre is a segment whose manager controls revenues and costs but not investments in operating assets. An investment centre manager controls profits and investments in operating assets. Return on investment (ROI) and residual income can be used to evaluate investment centre performance. © 2024 McGraw Hill Limited 11-83 End of Chapter Summary 3 The balanced scorecard consists of an integrated system of performance measures that are derived from and support the company’s strategy. It has four main categories of performance measures: financial, customer, internal business processes, and learning and growth. Different companies have different balanced scorecards because they have different strategies. Organizations are increasingly including social and environmental performance measures in their balanced scorecards. Some regularly report separate ‘sustainability’ scorecards. © 2024 McGraw Hill Limited 11-84  Appendix 11A Additional Control Topics Transfer Pricing Cost of Quality Service Department Cost Allocations © 2024 McGraw Hill Limited 11-85  Transfer Pricing 1 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. © 2024 McGraw Hill Limited 11-86  Transfer Pricing 2 There are three common approaches to setting transfer prices: 1. Negotiated transfer prices 2. Transfers to the selling division at cost 3. Transfers at market price The fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company. © 2024 McGraw Hill Limited 11-87 Negotiated Transfer Prices A negotiated transfer price results from discussions between the selling and buying divisions. Range of acceptable transfer prices: Upper limit is determined by the buying division. Lower limit is determined by the selling division. Advantages of negotiated transfer prices: 1. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. 2. The managers negotiating the transfer price are likely to have much © 2024 McGraw better Hill Limited information 11-88 Harrison Ltd – An Example Part 1 Assume the information as shown with respect to Cumberland Beverages and Pizza Place (both companies are owned by Harrison Ltd). Cumberland Beverages: Ginger beer production capactiy per month 10,000 barrels Variable cost per barrel of ginger beer $ 8 per barrel Fixed costs per month $ 70,000 Selling price of Cumberland Beverage's ginger beer on the outside market $ 20 per barrel Pizza Place: Purchase price of regular brand of ginger beer $ 18 per barrel Monthly comsumption of ginger beer 2,000 barrels © 2024 McGraw Hill Limited 11-89 Harrison Ltd – An Example Part 2 the highest acceptable Calculate the lowest and transfer prices under three scenarios. Selling division’s (Cumberland) lowest acceptable transfer Transfer Price ≥ Variable cost perprice: unit + total contribution margin on lost sales number of units transferred Buying division’s (Pizza Place) highest acceptable transfer price if there is an outside supplier: Transfer Price ≤ Cost of buying from outside supplier Buying division’s (Pizza Place) highest acceptable transfer price if no other outside supplier exists: Transfer Price ≤ Profit to be earned per unit sold (excluding transfer price) © 2024 McGraw Hill Limited 11-90 Harrison Ltd – An Example Part 3 idle capacity to provide If Cumberland has sufficient Pizza Place with 2,000 barrels, without sacrificing sales to other customers, then the lowest and highest acceptable transfer prices are computed as follows: Selling division’s lowest acceptable transfer price: $0 Transfer Price ³ $8 + = $8 2,000 Buying division’s highest acceptable transfer price: Transfer Price  Cost of buying from outside supplier = $18 Therefore, the range of acceptable transfer prices is $8 to $18. © 2024 McGraw Hill Limited 11-91 Harrison Ltd – An Example Part If Cumberland has no idle 4 capacity and must give up 2,000 barrels for other customer orders to meet Pizza Place’s requirements, then the lowest and highest acceptable transfer prices are computed as follows: Selling division’s lowest acceptable transfer price: ( $20 - $8) × 2,000 Transfer Price ³ $8 + = $20 2,000 Buying division’s highest acceptable transfer price: from outside supplier = $18 Transfer Price  Cost of buying Therefore, there is no range of acceptable transfer prices. © 2024 McGraw Hill Limited 11-92 Harrison Ltd – An Example Part 5 idle capacity to make Suppose Cumberland has enough 1,000 barrels for Pizza Place but must give up current customer orders for another 1,000 barrels to meet Pizza Place’s full requirements of 2,000 barrels. The lowest and highest acceptable transfer prices are computed as follows. Selling division’s lowest acceptable transfer price:  ( $20 - $8) × 1,000 = Transfer Price $8 + $14 2,000 Buying division’s highest acceptable transfer price: Transfer Price  Cost of buying from outside supplier = $18 Therefore, the range of acceptable transfer price is $14 to $18. © 2024 McGraw Hill Limited 11-93 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 non-cooperative atmosphere is almost guaranteed. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices. © 2024 McGraw Hill Limited 11-94 Transfers From the Selling Division at Cost 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. © 2024 McGraw Hill Limited 11-95 Transfers at Market Price A market price (the price charged for an item on the open market) is often regarded as the best approach to establishing transfer prices. 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. 2. A market price approach does not work well when the selling division has idle capacity. © 2024 McGraw Hill Limited 11-96  Divisional Autonomy 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 the results of their own segment of the business. © 2024 McGraw Hill Limited 11-97  Quality Costs Quality of Conformance: When the overwhelming majority of products produced conform to design specifications and are free from defects. © 2024 McGraw Hill Limited 11-98 Prevention and Appraisal Costs Prevention Costs  Support activities whose purpose is to reduce the number of defects. Appraisal Costs  Incurred to identify defective products before the products are shipped. © 2024 McGraw Hill Limited 11-99  Internal and External Failure Costs Internal Failure Costs  Incurred as a result of identifying defects before they are shipped. External Failure Costs  Incurred as a result of defective products being delivered to customers. © 2024 McGraw Hill Limited 11-100 Examples of Quality Costs 1 Prevention Costs Appraisal Costs Systems development Test and inspection of incoming Quality engineering materials Quality training Test and inspection of in-process Quality circles goods Statistical process control Final product testing and activities inspection Supervision of prevention Supplies used in testing and activities inspection Quality data gathering, analysis, Supervision of testing and and reporting inspection activities Quality improvement projects Depreciation of test equipment Technical support provided to Maintenance of test equipment suppliers Plant utilities in the inspection Audits of the effectiveness of the area quality system Field testing and appraisal at customer site © 2024 McGraw Hill Limited 11-101 Examples of Quality Costs 2 Internal Failure Costs External Failure Costs Net cost of scrap or spoilage Cost of field service calls and Rework materials, labour, and handling complaints overhead Warranty repairs and Reinspection of reworked replacements products Repairs and replacements Retesting of reworked products beyond the warranty period Downtime caused by quality Product recalls problems Liability arising from defective Disposal of defective products products Analysis of the cause of defects Returns and allowances arising in production from quality problems Re-entering data because of Lost sales arising from a keying errors reputation for poor quality Debugging software errors © 2024 McGraw Hill Limited 11-102  Distribution of Quality Costs When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure. Total quality costs drop rapidly as the quality of conformance increases. Companies reduce their total quality costs by focusing their efforts on prevention and appraisal because the cost savings from reduced defects usually far exceeds the costs of additional prevention and appraisal. Total quality costs are minimized when the quality of conformance is slightly less than 100%. © 2024 McGraw Hill Limited 11-103  Quality Cost Report As a first step in quality improvement programs, companies often construct a quality cost report that provides an estimate of the financial consequences of the company's current level of defects. Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate. © 2024 McGraw Hill Limited 11-104 Quality Costs in Graphic Form Exhibit 11A-4 © 2024 McGraw Hill Limited 11-105  Uses of Quality Cost Information Helps managers see the financial significance of defects. Helps managers identify the relative importance of the quality problems. Helps managers see whether their quality costs are poorly distributed. © 2024 McGraw Hill Limited 11-106 Limitations of Quality Cost Information Simply measuring quality cost problems does not solve quality problems. Results usually lag behind quality improvement programs. The most important quality cost, lost sales, is often omitted from quality cost reports. © 2024 McGraw Hill Limited 11-107  Operating Departments An operating department carries out the central purpose of the organization. Examples: Geography Department at your university. Assembly Department at Bombardier. © 2024 McGraw Hill Limited 11-108  Service Departments A service department does not directly engage in operating activities. Examples: The Accounting Department at Lowe’s. The Human Resources Department at Walmart. © 2024 McGraw Hill Limited 11-109 Interdepartmental Services Service Operating Department Department Costs of the service department become overhead costs to the operating department. © 2024 McGraw Hill Limited 11-110  Reciprocal Services Service Service Department 1 Department 2 When service departments provide services to each other they are called reciprocal services. © 2024 McGraw Hill Limited 11-111 Allocation Methods 1. Direct Method 2. Step-Down Method 3. Reciprocal Method © 2024 McGraw Hill Limited 11-112  Direct Method 1 Service Operating Interactions Department Department between service (Cafeteria) (Machining) departments are ignored and all Interactions costs are ignored allocated directly to operating Service Operating departments. Department Department (Custodial) (Assembly) © 2024 McGraw Hill Limited 11-113  Direct Method 2 Service Department Allocation Base Cafeteria Number of employees Custodial Square meters occupied © 2024 McGraw Hill Limited 11-114  Direct Method 3 How much of the Cafeteria and Custodial costs should be allocated to each operating department using the direct method of cost allocation? © 2024 McGraw Hill Limited 11-115  Direct Method 4 20 $360,000 20 + = $144,000 × 30 Allocation base: Number of employees © 2024 McGraw Hill Limited 11-116  Direct Method 5 30 $360,000 = $216,000 20 + × 30 Allocation base: Number of employees © 2024 McGraw Hill Limited 11-117  Direct Method 6 25,000 $90,000 = $30,000 25,000 + 50,000 × Allocation base: Square meters occupied © 2024 McGraw Hill Limited 11-118  Direct Method 7 50,000 $90,000 = $60,000 25,000 + 50,000 × Allocation base: Square meters occupied © 2024 McGraw Hill Limited 11-119  Step-Down Method 1 Service Operating Department Department Once a service (Cafeteria) (Machining) department’s costs are allocated, other service department costs are not allocated back to it. Service Operating Department Department (Custodial) (Assembly) © 2024 McGraw Hill Limited 11-120  Step-Down Method 2 There are three key points to understand regarding the step method: 1. In both the direct and step methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored. 2. Any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored. 3. Each service department assigns all its own costs to operating departments plus the costs that have been allocated to it from other service departments. © 2024 McGraw Hill Limited 11-121  Step-Down Method 3 Use the same data from the direct method example. Service Department Allocation Base Cafeteria Number of employees Custodial Square meters occupied © 2024 McGraw Hill Limited 11-122  Step-Down Method 4 Allocate Cafeteria costs first since it provides more service than Custodial. © 2024 McGraw Hill Limited 11-123 Step-Down Method 5 10 $360,000 10 + 20 + = $60,000 × 30 Allocation base: Number of employees © 2024 McGraw Hill Limited 11-124 Step-Down Method 6 20 $360,000 = $120,000 10 + 20 + × 30 Allocation base: Number of employees © 2024 McGraw Hill Limited 11-125 Step-Down Method 7 30 $360,000 = $180,000 10 + 20 + × 30 Allocation base: Number of employees © 2024 McGraw Hill Limited 11-126 Step-Down Method 8 New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria. © 2024 McGraw Hill Limited 11-127 Step-Down Method 9 25,000 $150,000 = $50,000 25,000 + 50,000 × Allocation base: Square meters occupied © 2024 McGraw Hill Limited 11-128 Step-Down Method 10 50,000 $150,000 = $100,000 25,000 + 50,000 × Allocation base: Square meters occupied © 2024 McGraw Hill Limited 11-129  Reciprocal Method Service Operating Department Department Interdepartmental (Cafeteria) (Machining) services are given full recognition rather than partial recognition as with the step method. Service Operating Department Department (Custodial) (Assembly) Because of its complexity and the fact that it yields similar results as the step-down method, the reciprocal method © 2024 is rarely used. 11-130 McGraw Hill Limited  Quick Check Data for Direct and Step Methods Service Departments Operating Departments ADMIN BACS Accounting Others Departmental costs before allocation $ 180,000 $ 90,000 $ 190,000 $ 900,000 Number of employees 15 5 20 80 Number of PCs 12 20 18 102 The direct method of allocation is used. Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers © 2024 McGraw Hill Limited 11-131  Quick Check  How much cost will be allocated from Administration to Accounting? a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000 © 2024 McGraw Hill Limited 11-132  Quick Check  How much cost will be allocated from Administration to Accounting? Answer: a. $ 36,000 Service Departments Operating Departments ADMIN BACS Accounting Others Departmental costs before allocation $ 180,000 $ 90,000 $ 190,000 $ 900,000 ADMIN allocation (180,000) 36,000 144,000 20 $180,000 = $36,000 20 + × 80 © 2024 McGraw Hill Limited 11-133  Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting department? a. $ 52,500 b. $135,000 c. $270,000 d. $ 49,500 © 2024 McGraw Hill Limited 11-136  Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department? Service Departments Operating Departments ADMIN BACS Accounting Others Departmental costs before allocation $ 180,000 $ 90,000 $ 190,000 $ 900,000 ADMIN allocation (180,000) 36,000 144,000 BACS allocation - (90,000) 13,500 76,500 Total after allocation $ - $ - $ 239,500 $ 1,120,500 Answer: d. $ 49,500 $36,000 + ($90,000 x 18/(18+102) = $49,500 $36,000 + $13,500 = $49, 500 © 2024 McGraw Hill Limited 11-135  Quick Check Data Service Departments Operating Departments ADMIN BACS Accounting Others Departmental costs before allocation $ 180,000 $ 90,000 $ 190,000 $ 900,000 Number of employees 15 5 20 80 Number of PCs 12 20 18 102 The step method of allocation is used. Allocation bases: Business school administration costs (ADMIN): Number of employees Business administration computer services (BACS): Number of personal computers © 2024 McGraw Hill Limited 11-136  Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting department? a. $35,250 b. $49,072 c. $18,000 d. $26,333 © 2024 McGraw Hill Limited 11-137  Quick Check  How much total cost will be allocated from ADMIN and BACS combined to the Accounting department? Answer: b. $49,072 Service Departments Operating Departments ADMIN BACS Accounting Others Departmental costs before allocation $ 180,000 $ 90,000 $ 190,000 $ 900,000 ADMIN allocation (180,000) 8,571 34,286 137,143 BACS allocation - (98,571) 14,786 83,786 Total after allocation $ - $ - $ 239,071 $ 1,120,929 © 2024 McGraw Hill Limited 11-138