6882 A1 A7 D 01

Chapter
12
Decentralization
and
Segment Reporting
12-2
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Differentiate between a cost centre, profit
centre and investment centre and explain
how performance is measured in each.
2. Prepare a segmented income statement
using the contribution format, and explain the
difference between traceable fixed costs and
common fixed costs.
3. Identify three business practices that hinder
proper cost assignment.
4. Analyze variances from revenue targets.
© McGraw-Hill Ryerson Limited., 2001

12-3
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5. Analyze marketing expenses using cost drivers.
6. Compute the return on investment (ROI).
7. Show how changes in sales, expenses and
assets affect an organization’s ROI.
8. Compute residual income and understand the
strengths and weaknesses of this method of
measuring performance.
9. (Appendix 12A) Determine the range, if any,
within which a negotiated transfer price should
fall.
12-4
Decentralization in Organizations
Benefits of
Decentralization Top
Top management
management
freed
freed to
to concentrate
concentrate
on
onstrategy.
strategy.
Lower-level
Lower-level managers
managers
gain
gain experience
experience in
in
decision-making.
decision-making. Decision-making
Decision-making
authority
authority leads
leads to
to
job
jobsatisfaction.
satisfaction.
Lower-level decision
Lower-level decision
often
oftenbased
based on
on
better
betterinformation.
information.
Improves
Improves ability
ability to
to
evaluate
evaluate managers.
managers.

12-5
Decentralization in Organizations
May
May be
be aa lack
lack of
of
coordination
coordination among
among
autonomous
autonomous
Lower-level
Lower-level managers
managers managers.
managers.
may
may make
make decisions
decisions
without
without seeing
seeing the
the
“big
“bigpicture.”
picture.”
Disadvantages of
Decentralization
Lower-level
Lower-level manager’s
manager’s
objectives
objectives may
may not
not
be
be those
those of
of the
the
organization.
organization. May
May bebe difficult
difficult to
to
spread
spreadinnovative
innovative ideas
ideas
in
in the
the organization.
organization.

12-6
Decentralization and Segment Reporting

An Individual Store
A segment is any Canadian
Canadian Tire
Tire
part or activity of an
organization about A Sales Territory
which a manager
seeks cost,
revenue, or profit
data. A segment A Service Centre
can be . . .

12-7
Cost, Profit and Investment Centres
Cost Centre
A segment whose C
os
manager has t
control over costs,

but not over
revenues or st Co
investment funds. C o st

12-8
Profit Centre Revenues

Sales
A segment whose Interest
manager has Other
control over both Costs
costs and Mfg. costs
Commissions
revenues, Salaries
but no control over Other
investment funds.

12-9
Investment Centre Corporate Headquarters

A segment whose
manager has
control over costs,
revenues, and
investments in
operating assets.

12-10
Cost
Cost Profit
Profit Investment
Investment
Centre
Centre Centre
Centre Centre
Centre
Cost, profit
and investment
centres are all Responsibility
Responsibility
known as Centre
Centre
responsibility
centres.
12-11
Traceable and Common Costs
Fixed
Costs
Traceable Common
Costs arise because Costs arise because

of the existence of of overall operating
a particular segment activities.
12-12
Traceable and Common Costs

Fixed
Costs
Don’t allocate
common costs.
Traceable Common
Costs arise because Costs arise because

of the existence of of overall operating
a particular segment activities.
12-13
Identifying Traceable Fixed Costs
Traceable costs would disappear over

time if the segment itself disappeared.
No computer No computer
division means . . . division manager.

12-14
Identifying Common Fixed Costs
Common costs arise because of overall

operation of the company and are not due to
the existence of a particular segment.
No computer We still have a
division but . . . company president.

12-15
Levels of Segmented Statements

W ebber,Inc.has tw o divisions.
Webber, Inc.
Computer Division Television Division
Let’s
Let’s look
look more
more closely
closely at
at the
the Television
Television
Division’s
Division’s income
income statement.
statement.

12-16

Our approach to segment reporting uses the
contribution format.
Income Statement Cost
Cost of
of goods
goods
Contribution Margin Format sold
sold consists
consists of
of
Television Division variable
variable
Sales $300,000 manufacturing
manufacturing
Variable COGS 120,000 costs.
costs.
Other variable costs 30,000
Total variable costs 150,000 Fixed
Fixed and
and
Contribution margin 150,000 variable
variable costs
costs
Traceable fixed costs 90,000 are
are listed
listed in
in
Segment margin $ 60,000 separate
separate
sections.
sections.
12-17

Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution Margin Format
Television Division
Sales $300,000 Segment
Segment margin
margin
Variable COGS 120,000 is
is Television’s
Television’s
Other variable costs 30,000 contribution
contribution
Total variable costs 150,000 to
to overall
overall
Contribution margin 150,000 operations.
operations.
Traceable fixed costs 90,000
Segment margin $ 60,000

12-18
Let’s see how the Television

Division fits into Webber, Inc.

12-19

Incom e Statem ent
Com pany Television Com pute r
Sa les $ 300,000
Va ria ble costs (150,000)
CM 150,000
Tra ce a ble FC (90,000)
Division m a rgin 60,000
Com m on costs
Segment
Segment margin
margin has
has now
now
Ne t incom e
become
become division
division margin.
margin.
Let’s add the C om puter

D ivision’s num bers.

12-20

Incom e Statem ent
Sa les $ 500,000 $ 300,000 $ 200,000
Va ria ble costs (230,000) (150,000) (80,000)
CM 270,000 150,000 120,000
Tra ce a ble FC (170,000) (90,000) (80,000)
Division m a rgin 100,000 60,000 40,000
Com m on costs
Ne t incom e

12-21

Incom e Statem ent
Sa les $ 500,000 $ 300,000 $ 200,000
Va ria ble costs (230,000) (150,000) (80,000)
CM 270,000 150,000 120,000
Tra ce a ble FC (170,000) (90,000) (80,000)
Division m a rgin 100,000 60,000 40,000
Com m on costs (25,000)
Ne t incom e $ 75,000
Common
Common costs
costs arise
arise because
because of
of overall
overall
operating
operating activities.
activities. ABC
ABC may
may be
be helpful
helpful
in
in the
the analysis
analysis ofof common
common costs.
costs.
12-22
Traceable Costs Can Become Common Costs
Fixed costs that are traceable on one

segmented statement can become
common if the company is divided into
smaller segments.
Let’s see how this w orks!

12-23
Webber’s Television Division

Television
Product
Division Lines
Regular Big Screen
U.S. Sales Foreign Sales U.S. Sales Foreign Sales
Sales
Territories
12-24
Income Statement
Television
Division Regular Big Screen
S ale s $ 200,000 $ 100,000
Variable costs (95,000) (55,000)
CM 105,000 45,000
Tra ce able FC (45,000) (35,000)
Product line margin 60,000 10,000
Commo n costs
Divisional margin
W e obtained the follow ing inform ation from

the R egular and B ig Screen segm ents.
12-25
Income Statement
Television
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
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000

12-26
Income Statement
Television
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)
Common costs 10,000
Of the $90,000 cost directly traced to
the Television Division, $45,000 is
traceable to Regular and $35,000
traceable to Big Screen product lines.

12-27
Income Statement
Television
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)
Common costs 10,000
The remaining $10,000 cannot be traced to

either the Regular or Big Screen product lines.

12-28
Segment Margin
The segment margin is the best gauge of

the long-run profitability of a segment.
Profits
Time
12-29
Hindrances to Proper Cost Assignment
Three Problem s
Omission of some Assignment of costs
costs in the to segments that are
assignment process. really common costs of
the entire organization.
The use of inappropriate

methods for allocating
costs among segments.

12-30
Omission of Costs
Costs assigned to a segment should include all
costs attributable to that segment from the
company’s entire value chain.
chain
Life cycle costing focuses on all costs along the
value chain that will be generated throughout
the entire life of the product.
Business Functions
Making Up The
Value Chain
Product Customer
R&D Design Manufacturing Marketing Distribution Service

12-31
Inappropriate Methods of Allocating

Costs Among Segments
Arbitrarily dividing
common costs
among segments
Inappropriate
Failure to trace allocation base
costs directly
Segment Segment Segment Segment

1 2 3 4

12-32
Revenue Variance Analysis

Consider the following example for CardCo:
Budget Actual
Budget sales in units:
Deluxe cards 14,000 17,000
Standard cards 6,000 5,000
Budget price per unit:
Deluxe cards $18 $16
Standard cards $ 9 $10
Market volume expected:
Deluxe cards 75,000 85,000
Standard cards 95,000 90,000
Variable cost per unit:
Deluxe cards $ 8 $ 8
Standard cards $ 3 $ 3
12-33

CardCo Actual and Budgeted Results
Actual Results Flexible Budget Master Budget
Revenue:
Deluxe (17,000x16) $ 272,000 Actual results are based on
Standard (5,000x10) 50,000
the actual quantity sold
322,000
Variable expenses: multiplied by the actual
Deluxe (17,000x8) 136,000 selling price
Standard (5,000x3) 15,000
151,000
or
Contribution margin $ 171,000 variable cost

12-34

Revenue:
Deluxe (17,000x16) $ 272,000 (17,000x18) $ 306,000
Standard (5,000x10) 50,000 (5,000x9) 45,000
322,000 351,000
Variable expenses:
Deluxe (17,000x8) 136,000 (17,000x8) 136,000
Standard (5,000x3) 15,000 (5,000x3) 15,000
151,000 151,000
Contribution margin $ 171,000 $ 200,000
Flexible budget results are
based on the actual quantity
sold multiplied by the budgeted
selling price
or
variable cost
12-35

Revenue:
Deluxe (17,000x16) $ 272,000 (17,000x18) $ 306,000 (14,000x18) $ 252,000
Standard (5,000x10) 50,000 (5,000x9) 45,000 (6,000x9) 54,000
322,000 351,000 306,000
Variable expenses:
Deluxe (17,000x8) 136,000 (17,000x8) 136,000 (14,000x8) 112,000
Standard (5,000x3) 15,000 (5,000x3) 15,000 (6,000x3) 18,000
Master budget results are
151,000 151,000 130,000
based onmargin
Contribution the budgeted quantity
$ 171,000 $ 200,000 $ 176,000
sold multiplied by the budgeted
selling price
or
variable cost

12-36

Revenue:
Deluxe (17,000x16) $ 272,000 (17,000x18) $ 306,000 (14,000x18) $ 252,000
Standard (5,000x10) 50,000 (5,000x9) 45,000 (6,000x9) 54,000
322,000 351,000 306,000
Variable expenses:
Deluxe (17,000x8) 136,000 (17,000x8) 136,000 (14,000x8) 112,000
Standard (5,000x3) 15,000 (5,000x3) 15,000 (6,000x3) 18,000
151,000 151,000 130,000
Contribution margin $ 171,000 $ 200,000 $ 176,000
Sales Price Variance

$29,000 U

12-37

Revenue:
Deluxe (17,000x16) $ 272,000 (17,000x18) $ 306,000 (14,000x18) $ 252,000
Standard (5,000x10) 50,000 (5,000x9) 45,000 (6,000x9) 54,000
322,000 351,000 306,000
Variable expenses:
Deluxe (17,000x8) 136,000 (17,000x8) 136,000 (14,000x8) 112,000
Standard (5,000x3) 15,000 (5,000x3) 15,000 (6,000x3) 18,000
151,000 151,000 130,000
$29,000U
or
Sales Price Variance=(Actual - Budgeted price)x Actual sales volume
Deluxe =($16-$18) x 17,000 units = $34,000 U
Standard =($10-$9) x 5,000 units = $ 5,000 F
Total sales price variance = $29,000 U

12-38

Revenue:
Deluxe (17,000x16) $ 272,000 (17,000x18) $ 306,000 (14,000x18) $ 252,000
Standard (5,000x10) 50,000 (5,000x9) 45,000 (6,000x9) 54,000
322,000 351,000 306,000
Variable expenses:
Deluxe (17,000x8) 136,000 (17,000x8) 136,000 (14,000x8) 112,000
Standard (5,000x3) 15,000 (5,000x3) 15,000 (6,000x3) 18,000
151,000 151,000 130,000
Sales Quantity Variance

$24,000 F

12-39

! The Sales Quantity Variance can further
be broken down into the:
"Market Volume Variance
{
=
Actual
market
volume
-
}
Budget
market
volume
x
Expected
market
share %
x
Budgeted
CM per
unit
"Market Share Variance
=
[ { Actual
sales
quantity
-
Actual
market
share
-
Expected
market
share }] x
Budgeted
CM per
unit

12-40

! For CardCo, the Sales Quantity Variance
of $24,000 F breakdown further as follows:
"Market Volume Variance
Deluxe=(85,000-75,000) x (14,000/75,000) x (18-8) =18,667 F
Standard=(90,000-95,000) x (6,000/95,000) x (9-3) = 1,895 U
Total Market Volume Variance ❶ =16,772 F
"Market Share Variance
Deluxe=[17,000-(85,000 x 14,000/75,000)] x (18-8) =11,333 F
Standard=[5,000-(90,000 x 6,000/95,000)] x (9-3) = 4,105 U
Total Market Share Variance ❷ = 7,228 F
Sales Quantity Variance = ❶ + ❷ =24,000 F

12-41

! The Sales Quantity Variance can also be
broken down into the:
"Sales Mix Variance
{ }
Actual sales
Actual sales - quantity at
= x Budgeted CM
quantity expected sales per unit
mix
"Sales Quantity Variance
{ }
Actual sales
Anticipated
= quantity at - sales quantity x Budgeted CM
expected sales per unit
mix

12-42

! For CardCo, the Sales Quantity Variance
of $24,000F is made up of:
"Sales Mix Variance
Deluxe=[17,000-(22,000 x14/20)] x (18-8) =16,000 F
Standard=[(5,000-22,000 x 6/20)] x (9-3) = 9,600 U
Total Sales Mix Variance ❶ = 6,400 F
"Sales Quantity Variance
Deluxe=[(22,000 x 14/20)-14,000] x (18-8) =14,000 F
Standard=[(22,000 x 6/20)-6,000] x (9-3) = 3,600 F
Total Sales Quantity Variance ❷= 17,600F
Sales Quantity Variance = ❶ + ❷ = 24,000F
12-43
Costs factors to consider in

marketing strategy:
Transport Warehousing
Marketing Strategy
Advertising
Selling
Credit

12-44
Order Getting and Order Filling

More Discretionary
Order Getting
Advertising Selling Com m issions Travel
Ord er Filling
W arehousing Tran sportation Packin g Credit

12-45
Return on Investment (ROI) Formula

Income
Incomebefore
beforeinterest
interest
and
andtaxes
taxes(EBIT)
(EBIT)
N etoperating incom e
R O I=
A verage operating assets
Cash,
Cash,accounts
accountsreceivable,
receivable,inventory,
inventory,
plant
plant and
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.

12-46
Regal Company reports the following:

Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
$30,000
R O I= = 15%
$200,000

12-47
Controlling the Rate of Return

Three ways to improve ROI . . .
$Reduce
Expenses
#Increase %Reduce
Sales Assets

12-48
Controlling the Rate of Return
! Regal’s manager was able to increase

sales to $600,000 which increased net
operating income to $42,000.
! There was no change in the average
operating assets of the segment.
Let’s calculate the new R O I.

12-49
We can modify our original formula slightly:

Margin × Turnover
Netoperating incom e Sales
RO I = ×
Sales A verage operating assets
R O I = $42,000 ×
$600,000
$600,000 $200,000
R O I = 21%
We
We increased
increased ROI
ROI from
from 15%
15% to
to 21%
21%

12-50
ROI and the Balanced Scorecard
The balanced scorecard provides managers with

a roadmap that indicates how the company
intends to increase its ROI.
I’m
I’m glad
glad wewe used
used the
the
balanced
balanced scorecard
scorecard
$Reduce to
to tell
tell which
which approach
approach
Expenses is
is best.
best.
#Increase %Reduce
Sales Assets

12-51
Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.
Managers often inherit many

committed costs over which
they have no control.
Managers evaluated on ROI

may reject profitable
investment opportunities.

12-52
Criticisms of ROI
! As division manager at Winston, Inc., your
compensation package includes a salary plus bonus
based on your division’s ROI -- the higher your ROI,
the bigger your bonus.
! The company requires an ROI of 15% on all new
investments -- your division has been producing an
ROI of 30%.
! You have an opportunity to invest in a new project
that will produce an ROI of 25%.
As division manager would you
invest in this project?
12-53
Criticisms of ROI
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!

12-54
Criticisms of ROI
Gee . . .
I thought we were
supposed to do what
was best for the
company!

12-55
Residual Income - Another Measure of

Performance
Net operating income

above some minimum
return on operating
assets

12-56
Residual Income
! A division of Zepher, 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 residualincom e.

12-57
Residual Income
Operating
Operating assets
assets $$100,000
100,000
Required
Required rate
rate of
ofreturn
return ×× 20%
20%
Required
Required return
return $$ 20,000
20,000
Actual
Actual return
return $$ 30,000
30,000
Required
Required return
return (20,000)
(20,000)
Residual
Residual income
income $$ 10,000
10,000

12-58
Motivation and Residual Income

R esidualincom e encourages m anagers to
m ake profitable investm ents thatw ould
be rejected by m anagers using R O I.

Appendix
12A
Transfer Pricing
12-60
Transfer Pricing
! Fundamental Objective:
" Setting transfer prices to motivate the
managers to act in the
“best interest of the overall company”

12-61
Three Common Approaches:
❷
Set transfer price using either:
1. Variable Cost, or
2. Full (Absorption) Cost
❶ ❸
Managers negotiate Set transfer price at
their own transfer price market price

12-62
End of Chapter 12
Let’s getto w ork

on m y R O I ...

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Chapter

© McGraw-Hill Ryerson Limited., 2001

© McGraw-Hill Ryerson Limited., 2001

© McGraw-Hill Ryerson Limited., 2001

Decentralization and Segment Reporting

© McGraw-Hill Ryerson Limited., 2001

Cost, Profit and Investment Centres

control over costs,

© McGraw-Hill Ryerson Limited., 2001

Cost, Profit and Investment Centres

Profit Centre Revenues

© McGraw-Hill Ryerson Limited., 2001

Cost, Profit and Investment Centres

Investment Centre Corporate Headquarters

© McGraw-Hill Ryerson Limited., 2001

Cost, Profit and Investment Centres

Traceable and Common Costs

Costs arise because Costs arise because

Traceable and Common Costs

Costs arise because Costs arise because

Identifying Traceable Fixed Costs

Traceable costs would disappear over

© McGraw-Hill Ryerson Limited., 2001

Identifying Common Fixed Costs

Common costs arise because of overall

© McGraw-Hill Ryerson Limited., 2001

Levels of Segmented Statements

Computer Division Television Division

© McGraw-Hill Ryerson Limited., 2001

Levels of Segmented Statements

Levels of Segmented Statements

© McGraw-Hill Ryerson Limited., 2001

Levels of Segmented Statements

Let’s see how the Television

© McGraw-Hill Ryerson Limited., 2001

Levels of Segmented Statements

Let’s add the C om puter

© McGraw-Hill Ryerson Limited., 2001

Levels of Segmented Statements

© McGraw-Hill Ryerson Limited., 2001

Levels of Segmented Statements

Traceable Costs Can Become Common Costs

Fixed costs that are traceable on one

Let’s see how this w orks!

© McGraw-Hill Ryerson Limited., 2001

Traceable Costs Can Become Common Costs

Webber’s Television Division

Regular Big Screen

U.S. Sales Foreign Sales U.S. Sales Foreign Sales

Traceable Costs Can Become Common Costs

W e obtained the follow ing inform ation from

Traceable Costs Can Become Common Costs

© McGraw-Hill Ryerson Limited., 2001

Traceable Costs Can Become Common Costs

© McGraw-Hill Ryerson Limited., 2001

Traceable Costs Can Become Common Costs

The remaining $10,000 cannot be traced to

© McGraw-Hill Ryerson Limited., 2001

The segment margin is the best gauge of

Hindrances to Proper Cost Assignment

The use of inappropriate

© McGraw-Hill Ryerson Limited., 2001