Segment Reporting Decentralized

Operations and Responsibility

Accounting System
AE117
Segmented Income Statements Using
Variable Costing
• Variable costing is useful in preparing segmented income statements
because it gives useful information on variable and fixed expenses.
• A segment is a subunit of a company of sufficient importance to
warrant the production of performance reports.
• Segments can be divisions, departments, product lines, customer
classes, and so on.
• In segmented income statements, fixed expenses are broken down
into two categories:
• direct fixed expenses and
• common fixed expenses.
Direct Fixed Expenses
• Direct fixed expenses are fixed expenses that are directly traceable to
a segment.
• These are sometimes referred to as avoidable fixed expenses or
traceable fixed expenses because they vanish if the segment is
eliminated.
• For example, if the segments were sales regions, a direct fixed expense for
each region would be the rent for the sales office.
Common Fixed Expenses
• Common fixed expenses are jointly caused by two or more segments.
• These expenses persist even if one of the segments to which they are
common is eliminated.
• For example, depreciation on the corporate headquarters building or the
salary of the CEO would be a common fixed expense for most large
companies.
Performance Evaluation
• The evaluation of managers is often tied to the profitability of the
units that they control.
• If income performance is expected to reflect managerial performance,
then managers have the right to expect the following:
• As sales revenue increases from one period to the next, all other things being
equal, income should increase.
• As sales revenue decreases from one period to the next, all other things being
equal, income should decrease.
• As sales revenue remains unchanged from one period to the next, all
other things being equal, income should remain unchanged.
• Variable costing ensures that the above relationships hold; however,
absorption costing may not
Segmented Income Statement
Segmented Income Statement
Segmented Income Statement
Decentralization and
Responsibility Centers
• A company is organized along lines of responsibility. Most companies use a
more flattened hierarchy that emphasizes teams.
• Firms with multiple responsibility centers choose one of two decision-making
approaches to manage their diverse and complex activities: centralized or
decentralized.
• In centralized decision making, decisions are made at the very top level, and
lower level managers are charged with implementing these decisions.
• Allows managers at lower levels to make and implement key decisions
pertaining to their areas of responsibility.
• Delegating decision-making authority to the lower levels of management in a
company is called decentralization.
Centralization and Decentralization
Reasons for Decentralization
• Firms decide to decentralize for several reasons, including the
following:
• ease of gathering and using local information
• focusing of central management
• training and motivating of segment managers
• enhanced competition, exposing segments to market forces
Divisions in the Decentralized Firm
• Decentralization involves a cost-benefit trade-off.
• As a firm becomes more decentralized, it passes more decision authority
down the managerial hierarchy.
• Usually is achieved by creating units called divisions.
• Divisions can be differentiated a number of different ways, including
the following:
• types of goods or services
• geographic lines
• responsibility centers
Types of Goods or Services
Geographic Lines
• Divisions may also be created along geographic lines.
• The presence of divisions spanning one or more regions creates the
need for performance evaluation that can take into account
differences in divisional environments.
Responsibility Centers
• A third way divisions differ is by the type of responsibility given to the
divisional manager.
• A responsibility center is a segment of the business whose manager is
accountable for specified sets of activities.
Responsibility Centers
• The four major types of responsibility centers are as follows:
• Cost center: Manager is responsible only for costs.
• Revenue center: Manager is responsible only for sales, or revenue.
• Profit center: Manager is responsible for both revenues and costs.
• Investment center: Manager is responsible for revenues, costs, and
investments.
Responsibility Centers and Accounting
Information Used to Measure Performance
Responsibility Center Interdependencies
• The responsibility center manager has responsibility only for the
activities of that center.
• Decisions made by that manager can affect other responsibility
centers.
• Organizing divisions as responsibility centers creates the opportunity
to control the divisions through the use of responsibility accounting.
Performance Evaluation
• Prerequisites of performance evaluation
• There must be stated quantifiable objectives and plans for the responsibility
centers (budget or standard set by the company)
• The financial items can be attributed to the responsibility center in a rational
manner
• Responsibility accounting is used in order to assign cost and revenue items to the center
that can control or significantly influence these items
• Criteria for performance evaluation
• Depend on the nature of activities (operations) of the responsibility center
• For fair evaluation, managers should only be evaluated on the things they can
control
Indications of controllability
• Manager has the authority over the acquisition and use of service for
which the cost is incurred
• Manager can significantly influence the amount or occurrence of cost
by his actions
• Manager has no direct influence over the incurrence of cost, but can
help to influence those who are responsible for the cost
Evaluation Techniques
Responsibility Center Evaluation Techniques
Cost Cost variance analysis
Revenue Sales variance analysis
Profit Segment margin analysis
Investment center Return on investment; residual income; EVA
Actual Performance Evaluation
• Compare actual results against planned results
• Identify causes of variance for supplementing actions (rewards or
punishment)
Return on Investment
• One way to relate operating profits to assets employed is to compute
the return on investment (ROI), which is the profit earned per dollar
of investment.
• ROI is the most common measure of performance for an investment
center and is computed as follows:
• Operating income ÷ Average Operating Assets
Return on Investment
• Operating income refers to earnings before interest and taxes.
• Operating assets are all assets acquired to generate operating income,
including cash, receivables, inventories, land, buildings, and
equipment.
• Average operating assets is computed as:
• (Beginning assets + Ending assets) ÷ 2
Margin and Turnover
• A second way to calculate ROI is to separate the formula into margin
and turnover:
• Operating income ÷ Average operating assets
• Margin is the ratio of operating income to sales.
• How many cents of operating income result from each dollar of sales; it
expresses the portion of sales that is available for interest, taxes, and profit.
• Turnover is sales ÷ average operating assets.
• Turnover tells how many dollars of sales result from every dollar invested in
operating assets.
Margin and Turnover
• The equation that yields ROI from the Margin and Turnover is as
follows:

• Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield
the original ROI formula of Operating income/Average operating
assets.
Advantages of Return on Investment
• At least three positive results stem from the use of ROI:
• It encourages managers to focus on the relationship among sales, expenses,
and investment, as should be the case for a manager of an investment center.
• Managers focus on cost efficiency.
• It encourages managers to focus on operating asset efficiency.
Disadvantages of the Return on Investment
Measure
• Overemphasis on ROI can produce myopic behavior.
• Two negative aspects associated with ROI frequently are:
• 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.
Residual Income
• Companies have adopted alternative performance measures such as
residual income.
• ROI can discourage investments that are profitable for a company but lowers
a division’s ROI
• Residual income is the difference between operating income and the
minimum dollar return required on a company’s operating assets:
• Residual income = Operating income – (Minimum rate of return x Average
operating assets)
Advantage of Residual Income
• The advantage of using residual income is that its use encourages
managers to accept any project that earns a return that is above the
minimum rate.
• This prevents the fallacy of using ROI that may reject a profitable
project that reduces divisional ROI.
Disadvantages of Residual Income
• Residual income, like ROI, can encourage a short-run orientation.
• Unlike ROI, it is an absolute measure of profitability.
• Direct comparison of the performance of two different investment
centers becomes difficult, as the level of investment may differ.
• To correct this, compute both ROI and residual income and to use both
measures for performance evaluation. ROI could then be used for
interdivisional comparisons.
Economic Value Added (EVA)
• Another financial performance measure that is similar to residual
income is economic value added.
• Economic value added (EVA) is after tax operating income minus the
dollar cost of capital employed.
• The dollar cost of capital employed is the actual percentage cost of capital
multiplied by the total capital employed.
• EVA is expressed as follows:
Behavioral Aspects of Economic Value
Added
• The key feature of EVA is its emphasis on after-tax operating profit
and the actual cost of capital.
• Investors like EVA because it relates profit to the amount of resources
needed to achieve it.
• EVA helps to encourage the right kind of behavior from their divisions
in a way that emphasis on operating income alone cannot.
• The underlying reason is EVA’s reliance on the true cost of capital.
Behavioral Aspects of Economic Value
Added
• The responsibility for investment decisions rests with corporate
management.
• The cost of capital is considered a corporate expense rather than an
expense attributable to particular divisions.
• Without an EVA analysis, the result of investments do not show up as
reducing divisional operating income and may seem free to divisions
who want more.