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Responsibility Accounting

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					Segment Reporting and
Decentralization


UAA – ACCT 202
Principles of Managerial Accounting
Dr. Fred Barbee
The Work of Management
               Planning



               Decision     Organizing &
 Evaluating                  Directing
               Making



              Controlling
Controlling Operations
• Management by exception
• Responsibility Accounting

• Delegation of authority

• Management by walking around
Responsibility Accounting
• . . . is a reporting system in which a
  cost is charged to the lowest level of
  management that has responsibility for
  it.
                                 President
                                 and CEO


              Vice President   Vice President   Vice President
                Marketing        Production       Controller
Installing Responsibility
Accounting
• Create a set of financial
  performance goals (budgets).
• Measure and report actual
  performance.
• Evaluate based on comparison of
  actual with budget.
Responsibility Accounting
• Evaluation of responsibility centers
  depends on . . .
  – The extent of delegation of authority; and
  – A manager’s preference
Decentralization . . .
 • . . . the delegation of authority to the
   lowest level of management
   responsibility that can make decisions.
Centralization . . .
 • . . . A centralized organization is one in
   which little authority is delegated to
   lower level managers.
Decentralization
• The more decentralized the firm, the
  greater the need for control.
  – Monitor employees
  – Motivate employees
Advantages of Decentralization

• Top level managers are relieved of
  making routine decisions.
• Higher employee morale

• Training
• Decisions are made where the action is
  taking place.
Disadvantages of Decentralization

• Upper level management loses some
  control.
• Lack of goal congruence.

• Duplication of effort.
Decentralization and Segment
Reporting
                        An Individual Store
                             Quick Mart

  A segment is any
  part or activity of    A Sales Territory
  an organization
  about which a
  manager seeks
  cost, revenue, or
  profit data. A         A Service Center

  segment can be
Cost, Profit, and Investments
Centers
            Responsibility
              Centers




    Cost       Profit        Investment
   Center      Center          Center
   Responsibility Centers: A Systems Perspective



     Data                Processing Steps       Information
                              Within
    (Inputs)           Information Systems      (Outputs)


Resources used . . .    Capital . . .        Output . . .

                            Working
      DM                                          Goods,
                            Capital
       DL                                        Services,
                           Equipment
      MOH                                          Ideas
                              Etc.
Cost, Profit, and Investments
Centers
    Cost Center
  A segment whose
     manager has
     control over
        costs,
    but not over
     revenues or
  investment funds.
        Responsibility Centers:
        A Systems Perspective


   Input        Process      Output



             Cost Center
Control only this
Evaluation . . .
 • A cost center is evaluated by means of
  performance reports (i.e., comparison
  of actual with standard).
Segments Classified as Cost, Profit and
        Investment Centers
         Responsibility Centers:
         A Systems Perspective



Input           Process            Output



        Profit Center
             Control these
Cost, Profit, and Investments
Centers
    Profit Center      Revenues
  A segment whose        Sales
     manager has         Interest
                         Other
  control over both
      costs and        Costs
                         Mfg. costs
      revenues,          Commissions
 but no control over     Salaries

  investment funds.
                         Other
A Profit Center . . .
 • A profit center is evaluated by
  means of contribution margin
  income statements.
Segments Classified as Cost, Profit and
        Investment Centers
Cost, Profit, and Investments
Centers
  Investment
     Center
 A segment whose
   manager has
control over costs,
  revenues, and
 investments in
 operating assets.    Corporate Headquarters
        Responsibility Centers:
        A Systems Perspective



Input         Process         Output



         Investment Center
            Control these
Investment Center
• An investment center is evaluated by
  means of the Return on Investment
  (ROI) or the Residual Income (RI) it is
  able to generate.
                Segments Classified as Cost, Profit and
Responsibility Centers
                        Investment Centers
Profit Center Vs. Investment
Center

 • A profit center is focused on profits as
   measured by the difference between
   revenues and expenses.
 • An investment center is compared with
   the assets employed in earning
   revenues.
Levels of Segmented
Statements
Levels of Segmented
Statements
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.
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.
Our approach to segment reporting uses the
            contribution format.

          Income Statement
     Contribution Margin Format
          Television Division
  Sales                     $ 300,000   Segment margin
  Variable COGS               120,000    is Television’s
  Other variable costs         30,000      contribution
  Total variable costs        150,000       to profits.
  Contribution margin         150,000
  Traceable fixed costs        90,000
  Division margin           $ 60,000

      Division Segment Margin
Traceable and Common Costs
                       Fixed
                       Costs
                                   Don’t allocate
                                  common costs.


   Traceable                      Common

Costs arise because    A cost that supports more than one
 of the existence of     segment but that would not go
a particular segment     away if any particular segment
                                 were eliminated.
Identifying Traceable Fixed
Costs
Traceable costs would disappear over
time if the segment itself disappeared.
No computer            No computer
division means . . .   division manager.
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.
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.
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 works!
     Traceable Costs Can Become
           Common Costs
             Webber’s Television Division
                        Television
                                               Product
                         Division               Lines

         Regular                        Big Screen


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



                        Sales
                      Territories
   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
    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

      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.
   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


       The remaining $10,000 cannot be traced to
     either the Regular or Big Screen product lines.
Segment Margin
The segment margin is the best gauge of
  the long-run profitability of a segment.
        Profits




                   Time
Responsibility and Controllability
Controllability is . . .
 • The degree of influence that a specific
  manager has over costs, revenues, or
  other items in question.
Controllability

                  • Few costs are
                   clearly under the
                   sole influence of
                   one manager.
Controllability
                  • With a long
                   enough time
                   span, all costs
                   will come under
                   someone’s
                   control.
The Controllability Principle

Management
  Actions

                         Managers only
                 Costs   partially control
                              costs.
Uncontrollable
Environmental
   Effects
 The Controllability Principle

                           . . . lead to more predictable
Management                      rewards for managers.
  Actions


                              Performance
                 Costs                              Rewards
                               Measures

Uncontrollable
Environmental
   Effects               Performance measurement
                         systems that are based on
                           controllable costs . . .
The Controllability Principle
              The performance measures and rewards
             will influence management to focus on the
                          controllable costs.

Management
  Actions


                           Performance
              Costs                           Rewards
                            Measures
 The Controllability Principle
Management
  Actions


                              Performance
                 Costs                            Rewards
                               Measures

Uncontrollable
Environmental
   Effects               When performance measures
                         are affected by uncontrollable
                           environmental effects . . .
 The Controllability Principle

Management
  Actions


                             Performance
                 Costs                          Rewards
                              Measures

Uncontrollable
Environmental
   Effects          . . . management may try to control
                   the performance measure rather than
                             the underlying cost.
Hindrances to Proper Cost
Assignment
             The Problems
 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.
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
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
Return on Investment
• The ROI formula is expressed as:
Return on Investment
• Where . . .


                  Income
    Margin = --------------------
                    Sales
Return on Investment
• Where . . .


                      Sales
 Turnover = ------------------------------
               Invested Capital
             Return on Investment


        Income                                 Sales
------------------------------   x   ------------------------------
          Sales                      Invested Capital


    The ratio of                        The efficiency
     operating                             of asset
  income to sales                        utilization.
             Return on Investment


          Income                                 Sales
------------------------------
            Sales
                                 x   ------------------------------
                                         Invested Capital



    The ratio of                        The efficiency
     operating                             of asset
  income to sales                        utilization.
      Return on Investment



          Income
------------------------------
    Invested Capital
                                 =   ROI
                Sales
  Cost of
 Goods Sold   Sales - OE    Net Oper.
                             Income
  Selling     Operating                  Margin
  Expense     Expenses     NOI / Sales
  Admin.
                              Sales
  Expense




Margin is a measure of management’s
ability to control operating expenses in
relation to sales.
Turnover is a measure of the amount of
sales that can be generated in an
investment center for each dollar invested
in operating assets.
      Cash                      Sales

    Accounts      Current
    Receivable     Assets    Sales / AOA   Turnover

    Inventory
                 CA + NCA     Ave Oper
                               Assets

      PP&E
                  Noncurr.
      Other        Assets
      Assets
               Sales
 Cost of
Goods Sold   Sales - OE    Net Oper.
                            Income
 Selling     Operating                  Margin
 Expense     Expenses     NOI / Sales
 Admin.
                             Sales
 Expense
                                         MxT       ROI
  Cash                       Sales

Accounts      Current
Receivable     Assets     Sales / AOA   Turnover

Inventory
             CA + NCA      Ave Oper
                            Assets

  PP&E
              Noncurr.
  Other        Assets
  Assets
  Measuring Income and
  Invested Capital



          Income                                 Sales
------------------------------
            Sales
                                 x   ------------------------------
                                         Invested Capital
Measuring Income
• Variety of possibilities

• Text uses EBIT (Net Operating Income)
  – Earnings Before Interest and Taxes
Measuring Invested Capital
• Variety of possibilities

• Text uses Net Book Value
  – Consistent with how PP&E is listed on the
    Balance Sheet.
  – Consistent with the computation of
    operating income.
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.
Improving the ROI
               Reduce
   Increase   Expenses   Reduce
     Sales                 Assets
                   XYZ Company



Income (EBIT)                     $30,000



Sales                            $500,000


Invested Capital                 $200,000
     Return on Investment

  $30,000               $500,000
--------------         --------------
 $500,000
                 x      $200,000


    6%                     2.5
                 x
     =           15%
Approach #1:
Increase Sales
Increase Sales . . .
• Assume that XYZ is able to increase
  sales to $600,000.
• Net Operating Income increases to
  $42,000.
• Average Operating Assets remain
  unchanged.
• What is the impact on ROI?
     Return on Investment

  $42,000               $600,000
--------------   x     --------------
 $600,000               $200,000


    7%           x         3.0


     =           21%
Reduce Expenses . . .
• Assume that XYZ is able to reduce
  expenses by $10,000
• Net Operating Income increases to
  $40,000.
• Average Operating Assets and sales
  remain unchanged.
• What is the impact on ROI?
     Return on Investment

  $40,000               $500,000
--------------   x     --------------
 $500,000               $200,000


    8%           x         2.5


     =           20%
Reduce Assets . . .
• Assume that XYZ is able to reduce
  its operating assets from $200,000
  to $125,000.
• Sales and Net Operating Income
  remain unchanged.
• What is the impact on ROI?
     Return on Investment

  $30,000               $500,000
--------------   x     --------------
 $500,000               $125,000


    6%           x         2.4


                 24%
     =
Advantages of ROI . . .
• It encourages managers to focus on the
  relationship among sales, expenses,
  and investment.
• It encourages managers to focus on
  cost efficiency.
• It encourages managers to focus on
  operating asset efficiency.
Disadvantages of ROI
• It can produce a narrow focus on
  divisional profitability at the expense of
  profitability for the overall firm.
• It encourages managers to focus on the
  short run at the expense of the long
  run.
Overinvestment
• Evaluation in terms of profit can lead
  to overinvestment.
Overinvestment

• Increases in
  Assets
                            Company

                  Manager

                 • Increases in
                  Profits
Underinvestment
• Evaluation in terms of ROI can lead to
  underinvestment.
Overinvestment

• Decreases in
  Assets
                            Company

                  Manager

                 • Increases in
                  ROI
Criticisms of ROI . . .
 • ROI tends to emphasize short-run
  performance over long-run profitability.
 • ROI may not be completely controllable
  by the division manager due to
  committed costs.
Multiple Criteria . . .
 • Growth in market share

 • Increases in productivity
 • Dollar profits

 • Receivables turnover
 • Inventory turnover

 • Product innovation
Residual Income . . .
• . . . is the net operating income
  that an investment center is able to
  earn above some minimum rate of
  return on its operating assets.
  Residual Income = EBIT – Required Profit

    = EBIT – Cost of Capital x Investment
            Residual Income Example

                              Division A    Division B


Invested Capital               $1,000,000   $3,000,000

EBIT Last Year                    200,000      450,000

*Min. Required R of R             120,000      360,000

Residual Income                   $80,000      $90,000


*Minimum Required Rate of Return = 12%
Problem with RI . . .
• RI cannot be used to compare
  performance of divisions of different
  sizes.
Advantage of RI . . .
• RI encourages managers to make
  profitable investments that would be
  rejected under the ROI approach.
Example . . .
• Assume that ABC Company’s Division A
  has an opportunity to make an
  investment of $250,000 that would
  generate a 16% return.
• The Division’s current ROI is 20%.
  Should the investment be made?
                         Marsh Company
                       Return on Investment


                            Present      New         Overall



Invested Capital (1)        $1,000,000   $250,000    $1,250,000


NOPAT (2)                     200,000     *40,000      240,000

ROI (1)/(2)                       20%          16%       19.2%


*$250,000 x 16% = $40,000
                         Marsh Company
                       Return on Investment
        Reject - Reduces overall ROI!!!
                            Present      New         Overall



Invested Capital (1)        $1,000,000   $250,000    $1,250,000


NOPAT (2)                     200,000     *40,000      240,000

ROI (1)/(2)                       20%          16%       19.2%


*$250,000 x 16% = $40,000
                       Marsh Company
                       Residual Income
   Accept - Positive Residual Income!!!
                          Present       New          Overall


Invested Capital (1)     $1,000,000     $250,000     $1,250,000

NOPAT (2)                   200,000       40,000       240,000

Minimum RofR*              $120,000      $30,000      $150,000

Residual Income             $80,000      $10,000       $90,000



*Minimum Required Rate of Return = 12% x Invested Capital
Economic Value Added
• Economic Value Added (EVA) is after-
  tax operating profit minus the total
  annual cost of capital
  – If EVA is positive, the company is creating
    wealth.
  – If EVA is negative, the company is
    destroying capital.
Calculating EVA . . .
• EVA = After-tax operating income
  minus (the weighted-average cost of
  capital times total capital employed)
  – Determine weighted average cost of capital
  – Determine total dollar amount of capital
    employed

				
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