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SEGMENT REPORTING,

DECENTRALIZATION,
AND THE BALANCED
SCORECARD
Decentralized Organizations
◦ Decision making authority is spread throughout the organization than being confined
to a few top executives.

MANAGEMENT ACCOUNTING 2 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.
MANAGEMENT ACCOUNTING 2 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
Decentralization
Lower-level manager’s
objectives may not
be those of the May be difficult to
organization. spread innovative ideas
in the organization.

MANAGEMENT ACCOUNTING 2 4
Responsibility Accounting
◦ Decentralized organizations need responsibility accounting systems that 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.

MANAGEMENT ACCOUNTING 2 5
Cost, Profit, and Investments Centers
Cost Profit Investment
Center Center Center

Cost, profit,
and investment
centers are all
known as Responsibility
Center
responsibility
centers.
MANAGEMENT ACCOUNTING 2 6
Cost Center
A segment whose manager has control over costs,
but not over revenues or investment funds.

MANAGEMENT ACCOUNTING 2 7
Cost Center
◦ Service Departments such as ◦ The managers of cost centers are
accounting, finance, general expected to minimize costs while
administration, legal, personnel, and providing the level of products and
manufacturing facilities are classified services demanded by other parts of
as cost centers. the organization.
◦ Standard cost variances and flexible
budget variances are often used to
evaluate cost center performance.

MANAGEMENT ACCOUNTING 2 8
Profit Center
Revenues
A segment whose
manager has control Sales
Interest
over both costs and
Other
revenues,
Costs
but no control over
investment funds. Mfg. costs
Commissions
Salaries
Other

MANAGEMENT ACCOUNTING 2 9
Profit Center
◦ e.g. Product Managers of product ◦ Profit center managers are often
families and branch bank managers evaluated by comparing actual profit
are profit center managers to targeted or budgeted profit.

MANAGEMENT ACCOUNTING 2 10
Investment CenterCorporate Headquarters

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

MANAGEMENT ACCOUNTING 2 11
Investment Center
◦ e.g. Vice president for Operations, ◦ Investment center managers are
Chief Executive Officer are investment usually evaluated using Return on
center managers. Investment or Residual Income
measures.

MANAGEMENT ACCOUNTING 2 12
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.
MANAGEMENT ACCOUNTING 2 13
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.
MANAGEMENT ACCOUNTING 2 14
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.
MANAGEMENT ACCOUNTING 2 15
Learning Objective 1
Prepare a segmented
income statement using the
contribution format, and
explain the difference
between traceable fixed
costs and common fixed
costs.

MANAGEMENT ACCOUNTING 2 16
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 Service Center

MANAGEMENT ACCOUNTING 2 17
Sample Segment Report

MANAGEMENT ACCOUNTING 2 18
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MANAGEMENT ACCOUNTING 2 23
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 region.
MANAGEMENT ACCOUNTING 2 24
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.
MANAGEMENT ACCOUNTING 2 25
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.
MANAGEMENT ACCOUNTING 2 26
Contribution Margin
◦ The contribution margin tells us what happens to profits as volume changes – holding a
segment’s capacity and fixed costs constant.
◦ The contribution margin is especially useful in decisions involving temporary uses of
capacity such as special orders.

MANAGEMENT ACCOUNTING 2 27
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.

MANAGEMENT ACCOUNTING 2 28
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.

MANAGEMENT ACCOUNTING 2 29
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.
MANAGEMENT ACCOUNTING 2 30
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
MANAGEMENT ACCOUNTING 2 31
Traceable and Common Costs
Fixed Don’t allocate
Costs common costs to
segments.

Traceable Common

MANAGEMENT ACCOUNTING 2 32
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

MANAGEMENT ACCOUNTING 2 33
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.
MANAGEMENT ACCOUNTING 2 34
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.
MANAGEMENT ACCOUNTING 2 35
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.
MANAGEMENT ACCOUNTING 2 36
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

MANAGEMENT ACCOUNTING 2 37
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.
MANAGEMENT ACCOUNTING 2 38
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!
MANAGEMENT ACCOUNTING 2 39
Traceable Costs Can Become
Common Costs
Webber’s Television Division
Television
Division

Regular Big Screen

Product
Lines
MANAGEMENT ACCOUNTING 2 40
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.
MANAGEMENT ACCOUNTING 2 41
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
MANAGEMENT ACCOUNTING 2 42
Hindrances to Proper Cost
Assignment
◦ Omission of Costs
◦ Inappropriate methods for assigning traceable costs among segments.

MANAGEMENT ACCOUNTING 2 43
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

MANAGEMENT ACCOUNTING 2 44
Inappropriate Methods of Allocating
Costs Among Segments
Failure to trace
costs directly Inappropriate
allocation base

Segment Segment Segment Segment


1 2 3 4

MANAGEMENT ACCOUNTING 2 45
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

MANAGEMENT ACCOUNTING 2 46
Quick CheckIncome

Statement

Hoagland'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.
MANAGEMENT ACCOUNTING 2 47
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.

MANAGEMENT ACCOUNTING 2 48
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.
MANAGEMENT ACCOUNTING 2 49
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

MANAGEMENT ACCOUNTING 2 50
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 The bar would be
c. $40,000 allocated 1/10 of the cost
d. $50,000 or $20,000.

MANAGEMENT ACCOUNTING 2 51
Quick Check 
If Hoagland's allocates its common
costs to the bar and the restaurant,
what would be the reported profit of
each segment?

MANAGEMENT ACCOUNTING 2 52
Allocations of Common Costs
Income Statement

Hoagland'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!!!


MANAGEMENT ACCOUNTING 2 53
Quick Check 
Should the bar be eliminated?
a. Yes
b. No

MANAGEMENT ACCOUNTING 2 54
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

Hoagland'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
MANAGEMENT ACCOUNTING 2 55
Learning Objective 2
Compute return on investment
(ROI) and show how changes in
sales, expenses, and assets
affect ROI.

MANAGEMENT ACCOUNTING 2 56
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.
MANAGEMENT ACCOUNTING 2 57
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

MANAGEMENT ACCOUNTING 2 58
Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating assets

ROI = Margin  Turnover


MANAGEMENT ACCOUNTING 2 59
Increasing ROI
There are three ways to increase ROI . . .
Reduce
Increase Expenses Reduce
Sales Assets

MANAGEMENT ACCOUNTING 2 60
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
MANAGEMENT ACCOUNTING 2 61
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%

MANAGEMENT ACCOUNTING 2 62
Investing in Operating Assets to
Increase Sales
Assume that Regal'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.


MANAGEMENT ACCOUNTING 2 63
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%.

MANAGEMENT ACCOUNTING 2 64
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.

MANAGEMENT ACCOUNTING 2 65
Learning Objective 3
Compute residual income and
understand its strengths and
weaknesses.

MANAGEMENT ACCOUNTING 2 66
Residual Income - Another Measure
of Performance
Net operating income
above some minimum
return on operating
assets

MANAGEMENT ACCOUNTING 2 67
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.
MANAGEMENT ACCOUNTING 2 68
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.

MANAGEMENT ACCOUNTING 2 69
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

MANAGEMENT ACCOUNTING 2 70
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

MANAGEMENT ACCOUNTING 2 71
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%

MANAGEMENT ACCOUNTING 2 72
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% ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%

MANAGEMENT ACCOUNTING 2 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. 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

MANAGEMENT ACCOUNTING 2 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. 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

ROI = $78,000/$400,000 = 19.5%


This lowers the division’s ROI from
20.0% down to 19.5%.
MANAGEMENT ACCOUNTING 2 75
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

MANAGEMENT ACCOUNTING 2 76
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

ROI = $18,000/$100,000 = 18%


The return on the investment
exceeds the minimum required rate
of return.
MANAGEMENT ACCOUNTING 2 77
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

MANAGEMENT ACCOUNTING 2 78
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
Net operating income $60,000
Required return (15% of $300,000) (45,000)
Residual income $15,000

MANAGEMENT ACCOUNTING 2 79
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

MANAGEMENT ACCOUNTING 2 80
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.

MANAGEMENT ACCOUNTING 2 81
Divisional Comparisons and Residual
Income
The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of different
sizes.

MANAGEMENT ACCOUNTING 2 82
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
MANAGEMENT ACCOUNTING 2 83
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
MANAGEMENT ACCOUNTING 2 84
Learning Objective 4

Understand how to construct


and use a balanced
scorecard.

MANAGEMENT ACCOUNTING 2 85
The Balanced Scorecard
Management translates its strategy into
performance measures that employees
understand and influence.

Financial Customers

Performance
measures
Internal Learning
business and growth
processes
MANAGEMENT ACCOUNTING 2 86
The Balanced Scorecard: From
Strategy to Performance Measures
Performance Measures
Financial What are our
Has our financial financial goals?
performance improved?

Customer What customers do Vision


we want to serve and
Do customers recognize that how are we going to and
we are delivering more value? win and retain them? Strategy

Internal Business Processes What internal busi-


Have we improved key business ness processes are
processes so that we can deliver critical to providing
more value to customers? value to customers?

Learning and Growth


Are we maintaining our ability
to change and improve? MANAGEMENT ACCOUNTING 2 87
The Balanced Scorecard:
Non-financial Measures
The balanced scorecard relies on non-financial measures
in addition to financial measures for two reasons:

 Financial measures are lag indicators that summarize


the results of past actions. Non-financial measures are
leading indicators of future financial performance.

 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.
MANAGEMENT ACCOUNTING 2 88
The Balanced Scorecard for
Individuals
The entire organization Each individual should
should have an overall have a personal
balanced scorecard. 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.
MANAGEMENT ACCOUNTING 2 89
The Balanced Scorecard
A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.

If we improve Another desired


Then
one performance performance measure
measure . . . will improve.

The balanced scorecard lays out concrete


actions to attain desired outcomes.
MANAGEMENT ACCOUNTING 2 90
The Balanced Scorecard and
Compensation
Incentive compensation should be
linked to
balanced scorecard performance
measures.

MANAGEMENT ACCOUNTING 2 91
The Balanced Scorecard ─
Jaguar Example
Profit
Financial
Contribution per car

Number of cars sold


Customer
Customer satisfaction
with options

Internal
Business Number of Time to
options available install option
Processes

Learning Employee skills in


and Growth installing options
MANAGEMENT ACCOUNTING 2 92
The Balanced Scorecard ─
Jaguar Example
Profit

Contribution per car

Number of cars sold

Customer satisfaction Results


with options Satisfaction
Increases
Strategies
Increase Number of Time to
Options options available install option Time
Decreases

Increase Employee skills in


Skills installing options
MANAGEMENT ACCOUNTING 2 93
The Balanced Scorecard ─
Jaguar Example
Profit

Contribution per car


Results
Cars sold
Number of cars sold Increase

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option

Employee skills in
installing options
MANAGEMENT ACCOUNTING 2 94
The Balanced Scorecard ─
Jaguar Example Profit
Results
Contribution per car Contribution
Increases

Number of cars sold

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option Time
Decreases

Employee skills in
installing options
MANAGEMENT ACCOUNTING 2 95
The Balanced Scorecard ─
Jaguar Example Profit Results
Profits
Increase
If number
Contribution per car Contribution
of cars sold Increases
and contribution
Cars Sold
per car increase, Number of cars sold
Increases
profits
increase. Customer satisfaction
with options

Number of Time to
options available install option

Employee skills in
installing options
MANAGEMENT ACCOUNTING 2 96
TRANSFER PRICING
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.

MANAGEMENT ACCOUNTING 2 98
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.

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Learning Objective 5
Determine the range, if any,
within which a negotiated
transfer price should fall.

MANAGEMENT ACCOUNTING 2 100


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.

MANAGEMENT ACCOUNTING 2 101


Grocery Storehouse – An Example
Assume the information as shown with
respect to West Coast Plantations and Grocery
Mart (both companies are owned by Grocery
Storehouse).

West Coast Plantations:


Naval orange harvest capactiy per month 10,000 crates
Variable cost per crate of naval oranges $ 10 per crate
Fixed costs per month $ 100,000
Selling price of navel oranges on the outside
market $ 25 per crate
Grocery Mart:
Purchase price of current naval oranges $ 20 per crate
Monthly sales of naval oranges 1,000 crates
MANAGEMENT ACCOUNTING 2 102
Grocery Storehouse – An Example
The selling division’s (West Coast Plantations) 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 (Grocery Mart) 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)
MANAGEMENT ACCOUNTING 2 103
Grocery Storehouse – An Example
If West Coast Plantations has sufficient idle capacity (3,000 crates) to
satisfy Grocery Mart’s demands (1,000 crates), 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:
$ -
Transfer Price  $10 + = $ 10
1,000
Buying division’s highest possible transfer price:
Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable


transfer prices is $10 – $20.
MANAGEMENT ACCOUNTING 2 104
Grocery Storehouse – An Example
If West Coast Plantations has no idle capacity (0 crates) and must
sacrifice other customer orders (1,000 crates) to meet Grocery Mart’s
demands (1,000 crates), then the lowest and highest possible transfer
prices are computed as follows:
Selling division’s lowest possible transfer price:
( $25 - $10) × 1,000
Transfer Price  $ 10 + = $ 25
1,000

Buying division’s highest possible transfer price:


Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, there is no range of


acceptable transfer prices.
MANAGEMENT ACCOUNTING 2 105
Grocery Storehouse – An Example
If West Coast Plantations has some idle capacity (500 crates) and
must sacrifice other customer orders (500 crates) to meet Grocery
Mart’s demands (1,000 crates), then the lowest and highest possible
transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
( $25 - $10) × 500
Transfer Price  $ 10 + = $ 17.50
1,000

Buying division’s highest possible transfer price:


Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable


transfer prices is $17.50 – $20.00.
MANAGEMENT ACCOUNTING 2 106
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 noncooperative
atmosphere is almost guaranteed.

Given the disputes that often accompany the


negotiation process, most companies rely on
some other means of setting transfer prices.

MANAGEMENT ACCOUNTING 2 107


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
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.
MANAGEMENT ACCOUNTING 2 108
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.
MANAGEMENT ACCOUNTING 2 109
Divisional Autonomy and
Suboptimization 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.
MANAGEMENT ACCOUNTING 2 110
SERVICE
DEPARTMENT
CHARGES
Learning Objective 6

Charge operating departments


for services provided by service
departments.

MANAGEMENT ACCOUNTING 2 112


Service Department Charges
Operating Service
Departments Departments

Do not directly
Carry out central
engage in
purposes of
operating
organization.
activities.

MANAGEMENT ACCOUNTING 2 113


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


profitability of incentive for service
operating departments to
departments. operate efficiently.
MANAGEMENT ACCOUNTING 2 114
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
MANAGEMENT ACCOUNTING 2 115
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.

MANAGEMENT ACCOUNTING 2 116


Charging Costs by Behavior
Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.

MANAGEMENT ACCOUNTING 2 117


Charging Costs by Behavior
Charge fixed service department costs to
consuming departments in
predetermined lump-sum amounts that
are based on the consuming
department’s 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.
MANAGEMENT ACCOUNTING 2 118
Should Actual or Budgeted Costs Be
Charged?
Budgeted variable
and fixed service department
costs should be charged to
operating departments.

MANAGEMENT ACCOUNTING 2 119


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.


MANAGEMENT ACCOUNTING 2 120
Sipco: End of the Year
Actual hours

MANAGEMENT ACCOUNTING 2 121


Sipco: End of the Year
Actual hours

Percent of peak-period capacity.


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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
MANAGEMENT ACCOUNTING 2 123
Quick Check 
How much ambulance service cost will be
allocated to Mercy Hospital at the end of
the year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000

MANAGEMENT ACCOUNTING 2 124


Quick Check 
How much ambulance service cost will be
allocated to Mercy Hospital at the end of
the year?
a. $121,200
b. $254,400
c. $139,500
d. $117,000

MANAGEMENT ACCOUNTING 2 125


Pitfalls in Allocating Fixed Costs

Allocating fixed
costs using a variable Result
allocation base.
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.

MANAGEMENT ACCOUNTING 2 126


Pitfalls in Allocating Fixed Costs

Using sales
dollars as an
allocation base. Result
Sales of one department
influence the service
department costs
allocated to other
departments.

MANAGEMENT ACCOUNTING 2 127


Autos R Us – An Example
Autos R Us has one service department and three
sales departments, New Cars, Used Cars, and Car
Parts. The service department costs total $80,000
for both years in the example.
Contrary to good practice, Autos R Us allocates the
service department costs based on sales.

MANAGEMENT ACCOUNTING 2 128


Autos R Us – First-year Allocation
Departments
New Used Parts Total
Sales by department $ 1,500,000 $ 900,000 $ 600,000 $ 3,000,000
Percentage of total sales 50% 30% 20% 100%
Allocation of service
department costs $ 40,000 $ 24,000 $ 16,000 $ 80,000

$1,500,000 ÷ $3,000,000 50% of $80,000

In the next year, the manager of the New Cars department


increases sales by $500,000. Sales in the other departments
are unchanged. Let’s allocate the $80,000 service department
cost for the second year given the sales increase.
MANAGEMENT ACCOUNTING 2 129
Autos R Us – Second-year Allocation
Departments
New Used Parts Total
Sales by department $ 2,000,000 $ 900,000 $ 600,000 $ 3,500,000
Percentage of total sales 57% 26% 17% 100%
Allocation of service
department costs $ 45,714 $ 20,571 $ 13,714 $ 80,000

$2,000,000 ÷ $3,500,000 57% of $80,000


If you were the manager of the New Cars department, would
you be happy with the increased service department
costs allocated to your department?
MANAGEMENT ACCOUNTING 2 130
Reference:
◦ Managerial Accounting by Garrison, Noreen and Brewer

MANAGEMENT ACCOUNTING 2 131