Segment Reporting and Decentralization PDF

Segment Reporting and Decentralization McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-2 Decentralization in Organizations Benefits of...

Segment Reporting and Decentralization McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-2 Decentralization in Organizations Benefits of Top management Decentralization freed to concentrate on strategy. 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-3 Decentralization in Organizations May be a lack of coordination among autonomous Lower-level managers managers. may make decisions without seeing the “big picture.” Disadvantages of Lower-level manager’s Decentralization objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-4 Cost, Profit, and Investments Centers Cost Profit Investment Center Center Center Cost, profit, and investment centers are all Responsibility known as Center responsibility centers. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-5 Cost Center A segment whose manager has control over costs, but not over revenues or investment funds. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-6 Profit Center Revenues A segment whose Sales manager has control Interest over both costs and Other revenues, Costs but no control over Mfg. costs investment funds. Commissions Salaries Other McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-7 Investment Center Corporate Headquarters A segment whose manager has control over costs, revenues, and investments in operating assets. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-8 Responsibility Centers Investment Centers Superior Foods Corporation Corporate Headquarters President and CEO Operations Finance Legal Personnel Vice President Chief FInancial Officer General Counsel Vice President Salty Snacks Beverages Confections Product Manger Product Manager Product Manager Bottling Plant Warehouse Distribution Cost Manager Manager Manager Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-9 Responsibility Centers Superior Foods Corporation Corporate Headquarters President and CEO Operations Finance Legal Personnel Vice President Chief FInancial Officer General Counsel Vice President Salty Snacks Beverages Confections Product Manger Product Manager Product Manager Bottling Plant Warehouse Distribution Profit Manager Manager Manager Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-10 Responsibility Centers Superior Foods Corporation Corporate Headquarters President and CEO Operations Finance Legal Personnel Vice President Chief FInancial Officer General Counsel Vice President Salty Snacks Beverages Confections Product Manger Product Manager Product Manager Bottling Plant Warehouse Distribution Cost Manager Manager Manager Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-11 Learning Objective 1 Prepare a segmented income statement using the contribution margin format, and explain the difference between traceable fixed costs and common fixed costs. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-12 Decentralization and Segment Reporting An Individual Store Quick Mart A segment is any part or activity of an A Sales Territory organization about which a manager seeks cost, revenue, or profit data. A A Service Center segment can be... McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-13 Superior Foods: Geographic Regions Superior Foods Corporation $500,000,000 East West Midwest South $75,000,000 $300,000,000 $55,000,000 $70,000,000 Oregon Washington California Mountain States $45,000,000 $50,000,000 $120,000,000 $85,000,000 Superior Foods Corporation could segment its business by geographic regions. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-14 Superior Foods: Customer Channel Superior Foods Corporation $500,000,000 Convenience Stores Supermarket Chains Wholesale Distributors Drugstores $80,000,000 $280,000,000 $100,000,000 $40,000,000 Supermarket Chain A Supermarket Chain B Supermarket Chain C Supermarket Chain D $85,000,000 $65,000,000 $90,000,000 $40,000,000 Superior Foods Corporation could segment its business by customer channel. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-15 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-16 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 No computer division means... division manager. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-17 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 We still have a division but... company president. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-18 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-19 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. Profits Time McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-20 Traceable and Common Costs Fixed Don’t allocate Costs common costs to segments. Traceable Common McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-21 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-22 Levels of Segmented Statements Webber, Inc. has two divisions. Webber, Inc. Computer Division Television Division Let’s look more closely at the Television Division’s income statement. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-23 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. 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 Fixed and Total variable costs 150,000 variable costs Contribution margin 150,000 are listed in Traceable fixed costs 90,000 separate Division margin $ 60,000 sections. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-24 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Income Statement Contribution Margin Format Contribution margin Television Division is computed by Sales $ 300,000 taking sales minus Variable COGS 120,000 variable costs. 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 margin $ 60,000 to profits. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-25 Levels of Segmented Statements 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 Net operating income McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-26 Levels of Segmented Statements 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 Common costs should not Net operating be allocated to the income $ 75,000 divisions. These costs would remain even if one of the divisions were eliminated. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-27 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! McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-28 Traceable Costs Can Become Common Costs Webber’s Television Division Television Division Regular Big Screen Product Lines McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-29 Traceable Costs Can Become Common Costs Income Statement Television Division Regular Big Screen 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 We obtained the following information from the Regular and Big Screen segments. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-30 Traceable Costs Can Become Common Costs Income Statement Television Division Regular Big Screen 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-31 External Reports The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports. 1. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. 2. 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-32 Omission of Costs Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain. Business Functions Making Up The Value Chain Product Customer R&D Design Manufacturing Marketing Distribution Service McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-33 Inappropriate Methods of Allocating Costs Among Segments Failure to trace costs directly Inappropriate allocation base Segment Segment Segment Segment 1 2 3 4 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-34 Common Costs and Segments Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: 1. This practice may make a profitable business segment appear to be unprofitable. 2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control. Segment Segment Segment Segment 1 2 3 4 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-35 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 Hoagland's Lakeshore prepared its segmented income statement as shown. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-36 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-37 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-38 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-39 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 The bar would be b. $30,000 allocated 1/10 of the cost c. $40,000 or $20,000. d. $50,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-40 Quick Check ✓ If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-41 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 Hurray, now everything adds up!!! McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-42 Quick Check ✓ Should the bar be eliminated? a. Yes b. No McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-43 Quick Check ✓ Should the bar be eliminated? a. Yes b. No The profit was $44,000 before eliminating the bar. If we eliminate the bar, Income profit drops to $30,000! Statement Haglund's 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-44 Learning Objective 2 Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-45 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-46 Net Book Value vs. Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets. Acquisition cost Less: Accumulated depreciation Net book value McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-47 Understanding ROI Net operating income ROI = Average operating assets Net operating income Margin = Sales Turnover = Sales Average operating assets ROI = Margin  Turnover McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-48 Increasing ROI There are three ways to increase ROI... Reduce Expenses Increase Reduce Sales Assets McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-49 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 What is Regal Company’s ROI? ROI = Margin  Turnover Net operating income Sales ROI = Sales × Average operating assets McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-50 Increasing ROI – An Example ROI = Margin  Turnover Net operating income Sales ROI = Sales × Average operating assets ROI = $30,000 × $500,000 $500,000 $200,000 ROI = 6%  2.5 = 15% McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-51 Increasing Sales Without an Increase in Operating Assets Regale's manager was able to increase sales to $600,000, while operating expenses increased to $558,000. Regale's net operating income increased to $42,000. There was no change in the average operating assets of the segment. Let’s calculate the new ROI. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-52 Increasing Sales Without an Increase in Operating Assets ROI = Margin  Turnover Net operating income Sales ROI = Sales × Average operating assets ROI = $42,000 × $600,000 $600,000 $200,000 ROI = 7%  3.0 = 21% ROI increased from 15% to 21%. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-53 Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regale's manager was able to reduce operating expenses by $10,000, without affecting sales or operating assets. This would increase net operating income to $40,000. Regal Company reports the following: Net operating income $ 40,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 460,000 Let’s calculate the new ROI. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-54 Decreasing Operating Expenses with no Change in Sales or Operating Assets ROI = Margin  Turnover Net operating income Sales ROI = Sales × Average operating assets ROI = $40,000 × $500,000 $500,000 $200,000 ROI = 8%  2.5 = 20% ROI increased from 15% to 20%. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-55 Decreasing Operating Assets with no Change in Sales or Operating Expenses Assume that Regale's manager was able to reduce inventories by $20,000 using just-in-time techniques, without affecting sales or operating expenses. Regal Company reports the following: Net operating income $ 30,000 Average operating assets $ 180,000 Sales $ 500,000 Operating expenses $ 470,000 Let’s calculate the new ROI. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-56 Decreasing Operating Assets with no Change in Sales or Operating Expenses ROI = Margin  Turnover Net operating income Sales ROI = Sales × Average operating assets ROI = $30,000 × $500,000 $500,000 $180,000 ROI = 6%  2.78 = 16.7% ROI increased from 15% to 16.7%. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-57 Investing in Operating Assets to Increase Sales Assume that Regale's manager invests in a $30,000 piece of equipment that increases sales by $35,000, while increasing operating expenses by $15,000. Regal Company reports the following: Net operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000 Let’s calculate the new ROI. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-58 Investing in Operating Assets to Increase Sales ROI = Margin  Turnover Net operating income Sales ROI = Sales × Average operating assets ROI = $50,000 × $535,000 $535,000 $230,000 ROI = 9.35%  2.33 = 21.8% ROI increased from 15% to 21.8%. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-59 ROI and the Balanced Scorecard It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI. Which internal business process should be improved? Which customers should be targeted and how will they be attracted and retained at a profit? McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-60 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-61 Learning Objective 3 Compute residual income and understand its strengths and weaknesses. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-62 Residual Income - Another Measure of Performance Net operating income above some minimum return on operating assets McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-63 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-64 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-65 Residual Income – An Example Operating assets $ 100,000 Required rate of return × 20% Minimum required return $ 20,000 Actual income $ 30,000 Minimum required return (20,000) Residual income $ 10,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-66 Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-67 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% McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-68 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% ROI = NOI/Average operating assets c. 15% = $60,000/$300,000 = 20% d. 20% McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-69 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-70 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 ROI = $78,000/$400,000 = 19.5% b. No This lowers the division’s ROI from 20.0% down to 19.5%. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-71 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-72 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 ROI = $18,000/$100,000 = 18% b. No The return on the investment exceeds the minimum required rate of return. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-73 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-74 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 Net operating income $60,000 b. $ 45,000 Required return (15% of $300,000) (45,000) Residual income $15,000 c. $ 15,000 d. $ 51,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-75 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-76 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-77 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-78 Zephyr, Inc. - Continued Recall the following Assume the following information for the Retail information for the Wholesale Division of Zephyr, Inc. Division of Zephyr, Inc. Retail Wholesale Operating assets $ 100,000 $ 1,000,000 Required rate of return × 20% 20% Minimum required return $ 20,000 $ 200,000 Retail Wholesale Actual income $ 30,000 $ 220,000 Minimum required return (20,000) (200,000) Residual income $ 10,000 $ 20,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-79 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. Retail Wholesale Operating assets $ 100,000 $ 1,000,000 Required rate of return × 20% 20% Minimum required return $ 20,000 $ 200,000 Retail Wholesale Actual income $ 30,000 $ 220,000 Minimum required return (20,000) (200,000) Residual income $ 10,000 $ 20,000 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.  Transfer Pricing Appendix 12A McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-81 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-82 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-83 Learning Objective 4 Determine the range, if any, within which a negotiated transfer price should fall. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-84 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-85 Harris and Louder – An Example Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder). Imperial 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 Imperial Beverages ginger beer on the outside market £20 per barrel Pizza Maven: Purchase price of regular brand of ginger beer £18 per barrel Monthly comsumption of ginger beer 2,000 barrels McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-86 Harris and Louder – An Example The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as: Variable cost Total contribution margin on lost sales Transfer Price  + per unit Number of units transferred Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as: Transfer Price  Cost of buying from outside supplier If an outside supplier does not exist, the highest acceptable transfer price is calculated as: Transfer Price  Profit to be earned per unit sold (not including the transfer price) McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-87 Harris and Louder – An Example If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Maven’s demands (2,000 barrels), 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: £0 Transfer Price  £8 + = £8 2,000 Buying division’s highest possible transfer price: Transfer Price  Cost of buying from outside supplier = £18 Therefore, the range of acceptable transfer price is £8 – £18. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-88 Harris and Louder – An Example If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice other customer orders (2,000 barrels) to meet Pizza Maven’s demands (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: ( £20 - £8) × 2,000 Transfer Price  £8 + = £20 2,000 Buying division’s highest possible transfer price: Transfer Price  Cost of buying from outside supplier = £18 Therefore, there is no range of acceptable transfer prices. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-89 Harris and Louder – An Example If Imperial Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet Pizza Maven’s demands (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: ( £20 - £8) × 1,000 Transfer Price  £8 + = £14 2,000 Buying division’s highest possible transfer price: Transfer Price  Cost of buying from outside supplier = £18 Therefore, the range of acceptable transfer price is £14 – £18. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-90 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 no 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-91 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 and 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-92 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. 2. A market price approach does not work well when the selling division has idle capacity. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-93 Divisional Autonomy and Sub optimization 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. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-94 International Aspects of Transfer Pricing Transfer Pricing Objectives Domestic International Greater divisional autonomy Less taxes, duties, and tariffs Greater motivation for managers Less foreign exchange risks Better performance evaluation Better competitive position Better goal congruence Better governmental relations McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.  Service Department Charges Appendix 12B McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-96 Learning Objective 5 Charge operating departments for services provided by service departments. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-97 Service Department Charges Operating Service Departments Departments Do not directly Carry out central engage in purposes of operating organization. activities. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-98 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 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-99 Transfer Prices The service department charges considered in this appendix can be viewed as a transfer price that is charged for services provided by service departments to operating departments. Service Departments $ Operating Departments McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-100 Charging Costs by Behavior Whenever possible, variable and fixed service department costs should be charged separately. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-101 Charging Costs by Behavior Variable service department costs should be charged to consuming departments according to whatever activity causes the incurrence of the cost. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-102 Charging Costs by Behavior Charge fixed service department costs to consuming departments in predetermined lump-sum amounts that are based on the consuming departments’ peak-period or long- run average servicing needs. Are based on amounts of Should not vary from capacity each consuming period to period. department requires. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-103 Should Actual or Budgeted Costs Be Charged? Budgeted variable and fixed service department costs should be charged to operating departments. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-104 Sipco: An Example Sipco has a maintenance department and two operating departments: cutting and assembly. Variable maintenance costs are budgeted at $0.60 per machine hour. Fixed maintenance costs are budgeted at $200,000 per year. Data relating to the current year are: Allocate maintenance costs to the two operating departments. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-105 Sipco: Beginning of the Year Hours planned McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-106 Sipco: Beginning of the Year Hours planned Percent of peak-period capacity. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-107 Quick Check ✓ Foster City has an ambulance service that is used by the two public hospitals in the city. Variable ambulance costs are budgeted at $4.20 per mile. Fixed ambulance costs are budgeted at $120,000 per year. Data relating to the current year are: Percent of Peak-Period Capacity Miles Miles Hospitals Required Planned Used Mercy 45% 15,000 16,000 Northside 55% 17,000 17,500 Total 100% 32,000 33,500 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-108 Quick Check ✓ How much ambulance service cost will be allocated to Mercy Hospital at the beginning of the year? a. $117,000 b. $254,400 c. $114,480 d. $119,250 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-109 Quick Check ✓ How much ambulance service cost will be allocated to Mercy Hospital at the beginning of the year? a. $117,000 b. $254,400 c. $114,480 d. $119,250 McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-110 Pitfalls in Allocating Fixed Costs Pitfall 1 Allocating fixed costs using a variable Result allocation base Fixed costs allocated to one department are heavily influenced by what happens in other departments. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-111 Colby Products: An Example Colby Products has two sales territories, the Eastern Territory and the Western Territory. Both sales territories are serviced by one auto service center, whose costs are all fixed. Contrary to good practice, Colby allocates the fixed service center costs to the sales territories on the basis of actual miles driven (a variable base). McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-112 Colby Products: An Example Year 1 Year 2 Auto service center costs (all fixed) $ 120,000 $ 120,000 Miles driven Western sales territory 1,500,000 1,500,000 Eastern sales territory 1,500,000 900,000 Total miles driven 3,000,000 2,400,000 Allocation rate per mile $ 0.04 $ 0.05 $120,000 ÷ 3,000,000 miles $120,000 ÷ 2,400,000 miles McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-113 Colby Products: First–year Allocations Western sales territory 1,500,000 miles @ $0.04 per mile $ 60,000 Eastern sales territory 1,500,000 miles @ $0.04 per mile 60,000 Total cost allocated $ 120,000 The two sales territories share the service center’s costs equally because the miles driven in each territory are equal. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-114 Colby Products: Second–year Allocation Western sales territory 1,500,000 miles @ $0.05 per mile $ 75,000 Eastern sales territory 900,000 miles @ $0.05 per mile 45,000 Total cost allocated $ 120,000 Western territory has the same number of miles as last year, but $15,000 more cost is allocated because Eastern's miles declined in year 2. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-115 Pitfalls in Allocating Fixed Costs Pitfall 2 Using sales dollars as an allocation base Result Sales of one department influence the service department costs allocated to other departments. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-116 Clothier Inc. – An Example Clothier Inc., a men’s clothing store, has one service department and three sales departments, Suits, Shoes, and Accessories. Service department costs total $60,000 for both years in the example. Contrary to good practice, Clothier allocates the service department costs based on sales. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-117 Clothier Inc. – First-year Allocation Departments Suits Shoes Accessories Total Sales by department $ 260,000 $ 40,000 $ 100,000 $ 400,000 Percentage of total sales 65% 10% 25% 100% Allocation of service department costs $ 39,000 $ 6,000 $ 15,000 $ 60,000 $260,000 ÷ $400,000 65% of $60,000 In the next year, the manager of the Suit Department increases sales by $100,000. Sales in the other departments are unchanged. Let’s allocate the $60,000 service department cost for the second year given the sales increase. McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-118 Clothier Inc. – Second-year Allocation Departments Suits Shoes Accessories Total Sales by department $ 360,000 $ 40,000 $ 100,000 $ 500,000 Percentage of total sales 72% 8% 20% 100% Allocation of service department costs $ 43,200 $ 4,800 $ 12,000 $ 60,000 $360,000 ÷ $500,000 72% of $60,000 If you were the suit department manager, would you be happy with the increased service department costs allocated to your department? McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. 12-119 End McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.