Segment reporting and decentralization

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Segment Reporting and Decentralization UAA – ACCT 202 Principles of Managerial Accounting Dr Fred Barbee The Work of Management Planning Planning Evaluating Evaluating Decision Decision Making Making Controlling Controlling Organizing Organizing & & Directing Directing 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 P r e s id e n t and C E O V ic e P r e s id e n t M a r k e t in g V ic e P r e s id e n t P r o d u c t io n V ic e P r e s id e n t C o n t r o lle r 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 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 $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 Invested Capital *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 Invested Capital (1) New Overall $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 Invested Capital (1) New Overall $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 Invested Capital (1) NOPAT (2) Minimum RofR* Residual Income New Overall $1,000,000 $250,000 $1,250,000 200,000 40,000 240,000 $120,000 $30,000 $150,000 $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 [...]...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 an organization about which a manager seeks cost, revenue, or profit data A segment can be A Sales Territory A Service Center Cost, Profit, and Investments Centers... margin $ 60,000 Division Segment Margin Segment Segment margin margin is is Television’s Television’s contribution contribution to to profits profits Traceable and Common Costs Fixed Costs Don’t allocate common costs Traceable Common Costs arise because of the existence of a particular segment A cost that supports more than one segment but that would not go away if any particular segment were eliminated... able to generate Segments Classified as Cost, Profit and Investment Centers Responsibility 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... (i.e., comparison of actual with standard) Segments Classified as Cost, Profit and Investment Centers Responsibility Responsibility Centers: Centers: A A Systems Systems Perspective Perspective Input Input Process Process Profit Center Control these Output Output Cost, Profit, and Investments Centers Profit Center A segment whose manager has control over both costs and revenues, but no control over... Salaries 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 Responsibility Centers: Centers: A A Systems... 60,000 Cost Cost of of goods goods sold sold consists consists of of variable variable manufacturing manufacturing costs costs Fixed Fixed and and variable variable costs costs are are listed listed in in separate separate sections sections Our approach to segment reporting uses the contribution format Income Statement Contribution Margin Format Television Division Sales $ 300,000 Variable COGS 120,000... eliminated Identifying Traceable Fixed Costs Traceable costs would disappear over time if the segment itself disappeared No computer division means No computer 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 division but We still have a company president ... iv is io n T e le v is io n D iv is io n Let’s Let’s look look more more closely closely at at the the Television Television Division’s Division’s income income statement statement Our approach to segment reporting uses the contribution format Income Statement Contribution Margin Format Television Division Sales $ 300,000 Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000... Information Systems Systems Capital Working Working Capital Capital Equipment Equipment Etc Etc Information (Outputs) Output Goods, Goods, Services, Services, Ideas Ideas Cost, Profit, and Investments Centers Cost Center A segment whose manager has control over costs, but not over revenues or investment funds Responsibility Responsibility Centers: Centers: A A Systems Systems Perspective Perspective Input
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