LECTURE NOTE

ACCTBA3- Fundamentals of Accounting 3

Chapter 13- Segment Reporting and Responsibility Accounting
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Managers in large organizations have to delegate some decisions to those who are at lower
levels in the organization. This chapter explains how responsibility accounting systems,
segmented income statements, and return on investment (ROI), and residual income,are
used to help control decentralized organizations.

A decentralized organization does not confine decision-making authority to a few top

executives; rather, decision-making authority is spread throughout the organization.
The advantages of decentralization are as follows:

• It enables top management to concentrate on strategy, higher-level decision-

making, and coordinating activities.
• It acknowledges that lower-level managers have more detailed information about
local conditions that enable them to make better operational decisions.
• It enables lower-level managers to quickly respond to customers.
• It provides lower-level managers with the decision-making experience they will
need when promoted to higher level positions.
• It often increases motivation, resulting in increased job satisfaction and retention,
as well as improved performance.

The disadvantages of decentralization are as follows:

• Lower-level managers may make decisions without fully understanding the “big
picture.”
• There may be a lack of coordination among autonomous managers. The balanced
scorecard can help reduce this problem by communicating a company’s strategy
throughout the organization.
• Lower-level managers may have objectives that differ from those of the entire
organization. This problem can be reduced by designing performance evaluation
systems that motivate managers to make decisions which are in the
best interests of the company.
• It may difficult to effectively spread innovative ideas in a strongly decentralized
organization. This problem can be reduced through the effective use of intranet
systems, which enable globally dispersed employees to electronically share ideas.
Responsibility accounting systems link lower-level managers’ decision-making authority
with accountability for the outcomes of those decisions. The term responsibility center is
used for any part of an organization whose manager has control over, and is accountable for
cost, profit, or investments.

The three primary types of responsibility centers are

1. cost centers
2. profit centers, and
3. investment centers.

COST CENTER

 The manager of a cost center has control over costs, but not over revenue or
investment funds.
 Service departments such as accounting, general administration, legal, and personnel
are usually classified as cost centers, as are manufacturing facilities

PROFIT CENTER

 The manager of a profit center has control over both costs and revenue. Profit center
managers are often evaluated by comparing actual profit to targeted or budgeted
profit. An example of a profit center is a company’s cafeteria.

INVESTMENT CENTER
 The manager of an investment center has control over cost, revenue, and investments
in operating assets. Investment center managers are often evaluated using return on
investment (ROI) or residual income (discussed later in this chapter). An example of
an investment center would be the corporate headquarters
 Superior Foods Corporation provides an example of the various kinds of responsibility
centers that exist in an organization.

 The President and CEO, as well as the Vice President of Operations, manage investment
centers.

 The Chief Financial Officer, General Counsel, and Vice President of Personnel all
manage cost centers.

 Each of the three product managers that report to the Vice President of Operations (e.g.,
salty snacks, beverages, and confections) manages a profit center
  The bottling plant manager, warehouse manager, and distribution manager all
manage cost centers that report to the Beverages product manager.

DECENTRALIZATION AND SEGMENT REPORTING

A segment - is a part or activity of an organization about which managers would like cost,
revenue, or profit data. Examples of segments include divisions of a company, sales
territories, individual stores, service centers, manufacturing plants, marketing
departments, individual customers, and product lines.
 Superior Foods could segment its business by geographic region.
  Or, Superior Foods could segment its business by customer channel. In Asia, a similar
example of such operation is Diary Farm International which is listed on Hong Kong
Exchange. Well known brands under Diary Farm include Cold Storage, Giant, Shop n
Save, Market Place, Guardian, Mannings, 7-11, GNC, Wellcome, Ikea, Starmart.

There are two keys to building segmented income statements.

First, a contribution format should be used because it separates fixed from variable costs
and it enables the calculation of a contribution margin. The contribution margin is
especially useful in decisions involving temporary uses of capacity, such as special orders.
Second, traceable fixed costs should be separated from common fixed costs to enable the
calculation of a segment margin.

A traceable fixed cost of a segment is a fixed cost that is incurred because of the
existence of the segment. If the segment were eliminated, the fixed cost would
disappear. Examples of traceable fixed costs include the following:

 The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the
Fritos business segment of PepsiCo.
 The maintenance cost for the building in which Boeing 747s are assembled is a
traceable fixed cost of the 747 business segment of Boeing.

A common fixed cost is a fixed cost that supports the operations of more than one
segment, but is not traceable in whole or in part to any one segment. Examples of
common fixed costs include the following:

 The salary of the CEO of Honda Motors is a common fixed cost of the various
divisions of Honda Motors.
 The cost of heating a Carrefour or Giant Hypermarket is a common fixed cost of the
various departments – groceries, produce, and bakery.

It is important to realize that the traceable fixed costs of one segment may be a common
fixed cost of another segment. For example, the landing fee paid to land an airplane at an
airport is traceable to a particular flight, but it is not traceable to first-class, business-class,
and economy-class passengers.
A segment margin is computed by subtracting the traceable fixed costs of a segment from its
contribution margin. The segment margin is a valuable tool for assessing the long-run
profitability of a segment.

 Allocating common costs to segments reduces the value of the segment margin as a
guide to long-run segment profitability.

 As a result, common costs should not be allocated to segments.

The contribution format income statement for the Television Division is as shown. Notice
that:
• Cost of goods sold consists of variable manufacturing costs; and
• Fixed and variable costs are listed in separate sections.
Also notice that:
• Contribution margin is computed by subtracting variable costs from sales; and
• The divisional segment margin represents the Television Division’s contribution to
overall company profits.
 The Television Division’s results can be rolled into Webber, Inc.’s overall results as
shown. Notice that the results of the Television and Computer Divisions sum to the
results shown for the whole company.

 The common costs for the company as a whole ($25,000) are not allocated to the
divisions. Common costs are not allocated to segments because these costs would
remain even if one of the divisions were eliminated.
 The Television Division’s results can also be broken down into smaller segments. This
enables us to see how traceable fixed costs of the Television Division can become
common costs of smaller segments.
 Assume that the Television Division can be broken down into two major product lines –
Regular and Big Screen.
 Of the $90,000 of fixed costs that were previously traceable to the Television Division,
only $80,000 is traceable to the two product lines and $10,000 is a common cost.
  The costs assigned to a segment should include all the costs attributable to that
segment from the company’s entire value chain. The value chain consists of all major
business functions that add value to a company’s products and services.

Common costs should not be arbitrarily allocated to segments based on the rationale
that “someone has to cover the common costs” for two reasons:

 First, this practice may make a profitable business segment appear to be

unprofitable. If the segment is eliminated the revenue lost may exceed the traceable
costs that are avoided.

 Second, allocating common fixed costs forces managers to be held accountable for
costs that they cannot control.
INVESTMENT CENTERS
1. RETURN ON INVESTMENT
 An investment center’s performance is often evaluated using a measure called
return on investment (ROI). ROI is defined as net operating income divided by
average operating assets.

 Net operating income is income before taxes and is sometimes referred to as

earnings before interest and taxes (EBIT). Operating assets include cash, accounts
receivable, inventory, plant and equipment, and all other assets held for operating
purposes.

 Net operating income is used in the numerator because the denominator consists
only of operating assets.

 The operating asset base used in the formula is typically computed as the average
operating assets (beginning assets + ending assets/2).

 Most companies use the net book value (i.e., acquisition cost less accumulated
depreciation) of depreciable assets to calculate average operating assets. With this
approach, ROI mechanically increases over time as the accumulated depreciation
increases. Replacing a fully-depreciated asset with a new asset will decrease ROI.

 An alternative to using net book value is the use of the gross cost of the asset, which
ignores accumulated depreciation. With this approach, ROI does not grow
automatically over time, rather it stays constant; thus, replacing a fully-depreciated
asset does not adversely affect ROI.

 Any increase in ROI must involve at least one of the following – increased sales,
reduced operating expenses, or reduced operating assets.
 The fourth way to increase ROI is to invest in operating assets to increase sales.

 Assume that Regal's manager invests $30,000 in a piece of

equipment that increases sales by $35,000 while increasing
operating expenses by $15,000
2. RESIDUAL INCOME
 The residual income approach encourages managers to make investments that are
profitable for the entire company but that would be rejected by managers who are
evaluated using the ROI formula.

 It motivates managers to pursue investments where the ROI associated with those
investments exceeds the company’s minimum required return but is less than the
ROI being earned by the managers.