Overview managerial accounting chapter 012

Prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed costs.. A common fixed cost is a fixed cost

Chapter 12

Segment Reporting and Decentralization

Learning Objectives

LO1 Prepare a segmented income statement using the contribution format, and explain the

difference between traceable fixed costs and common fixed costs

LO2 Compute return on investment (ROI) and show how changes in sales, expenses, and

assets affect ROI

LO3 Compute residual income and understand the strengths and weaknesses of this method

of measuring performance

LO4 (Appendix 12A) Determine the range, if any, within which a negotiated transfer price

should fall

New in this Edition

• This chapter has been extensively rewritten

• Many new In Business boxes have been added

• Additional exercises have been written

Chapter Overview

A Responsibility Accounting. Responsibility accounting is concerned with designing reports that help motivate managers to make decisions and to take actions that are in the best interests of the overall organization

1 The benefits of decentralization In a decentralized organization, decision making is not

confined to a few top executives, but rather is spread throughout the organization Responsibility accounting functions most effectively in an organization that is decentralized A number of benefits result from decentralization

a Top management is relieved of much day-to-day problem solving and is left free to concentrate on strategy, higher-level decision-making and coordinating activities

b Lower-level managers generally have more detailed and up-to-date information about local conditions than top managers Therefore, lower-level managers are often capable

of making better operational decisions

c Delegating decision-making authority to lower-level managers enables them to quickly respond to customers

2 Disadvantages of decentralization Particularly in larger organizations, the benefits of

decentralization usually outweigh the disadvantages Nevertheless, it is important to be aware of the potential problems with decentralization

a Lower-level managers may make decisions without fully understanding the “big picture.” While top-level managers typically have less detailed information about local operations than the lower-level managers, they usually have more information about the company as a whole and should have a better understanding of the company’s strategy

b In a truly decentralized organization, there may be a lack of coordination among autonomous managers This problem can be reduced by clearly defining the company’s strategy and communicating it effectively throughout the organization through the use

of a well-designed Balanced Scorecard (see Chapter 10)

c Lower-level managers may have objectives that are different from the objectives of the entire organization For example, some managers may be more interested in increasing the sizes of their departments than in increasing the profits of the company To some degree, this problem can be overcome by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company

3 Investment, Profit, and Cost Centers There are at least three types of responsibility

centers

a A cost center manager has control over cost Cost center managers are evaluated based

on how well costs are controlled, given the level of activity

b A profit center manager has control over both cost and revenue Profit center managers are usually evaluated based on performance relative to profit targets

c An investment center manager has control over cost and revenue and also has control over the use of investment funds Investment center managers are usually evaluated based on rate of return on investment (ROI)

B Segmented Reporting. (Exercises 12-1, 12-5, 12-7, and 12-8.) To operate effectively, managers need a great deal more information than is provided by a single, company-wide income statement Income statements are needed that focus on segments of the company

1 Segments A segment is any part or activity of an organization about which a manager

seeks cost or revenue data Examples of segments include sales territories, manufacturing facilities, service centers, individual products, and individual customers

2 Segmented statements Segmented statements can be prepared for activity at many

different levels in an organization Exhibit 12-2 in the text illustrates three levels of segmented statements

3 Sales and contribution margin Sales for each segment should be identified along with

variable costs, resulting in a contribution margin The segment contribution margin is especially valuable in decisions that involve the use of excess capacity

4 Traceable vs Common Fixed Costs Whether a fixed cost is assigned to a segment should

depend on whether it is traceable to that segment or is a common cost A cost may be traceable to one segment and common to another

a Traceable Fixed Costs Traceable costs arise because of the existence of a particular

segment If a cost is avoidable if a segment were discontinued, then it is a traceable cost of that segment

b Common Fixed Costs A common fixed cost is a fixed cost that supports more than

one business segment, but is not traceable in whole or in part to any one of the business segments A fixed cost that is common to a particular segment would continue even if that particular segment were discontinued Since common costs are not avoidable costs

of the segment, they should not be considered costs of the segment for purposes such as product drop decisions or pricing Of course, it is always possible to arbitrarily allocate any cost—including common fixed costs—among segments However, if common costs are allocated among segments, the resulting segment statements are potentially very misleading and erroneous decisions may result For example, a manager might drop a segment that appears to be operating at a loss, only to discover later that the common fixed costs that were arbitrarily allocated to the segment do not disappear and are simply reallocated to the remaining segments

c Do common costs exist? There is a great deal of disagreement about what costs are

and are not traceable to segments

• Some people allege that essentially the only costs traceable to products are direct materials whereas others assert that all costs can be traced to products That is, some commentators believe almost all costs are common with respect to products whereas others believe there are no common costs at all (For example, the early ABC literature implicitly assumed common costs do not exist.) Our belief is that the truth lies somewhere in the middle—a lot of costs can be traced to products but by no means all costs The illustrations in the text and in the exercises, problems, and cases reflect that belief

• Cooper and Kaplan, the leading architects of activity-based costing, have advocated a system of segmented reports that is very much in the spirit of what we recommend in this chapter They define a hierarchy of costs in which costs can be usefully aggregated upwards but should not be allocated downwards Essentially, costs at each level of the hierarchy are common to the activities carried out lower down in the hierarchy For example, they advocate that facility-sustaining costs, which are common to products, should not be allocated to the products (See Cooper and Kaplan, “Profit Priorities from

Activity-Based Costing,” Harvard Business Review, May-June 1991, pp 130-135.)

• With so much disagreement among the experts concerning which costs can and cannot

be traced to products, it should not be surprising that there is a great deal of uncertainty

in practice concerning whether a particular cost is traceable or not The text and problem material have been carefully worded to eliminate this sort of ambiguity The introductory course does not seem to us to be the most appropriate place to grapple with all of the complexities of this issue

d What is common and what is traceable depends on the segment A cost that is

traceable to a segment may not be traceable when the segment is further divided into smaller segments The salary of the vice president of the automotive products division

is a traceable cost of the segment “automotive products division” but it is not a traceable cost of any particular product that is sold by the division This is true even if someone were to keep track of how much time the vice president devotes to each particular product

5 Segment Margin The segment margin is obtained by deducting the traceable fixed costs

of a segment from the segment’s contribution margin The segment margin indicates how much the segment is contributing toward covering common costs and towards profits

C Return on Investment (ROI) for Measuring Managerial Performance.

(Exercises 12-2, 12-6, 12-9, 12-10, 12-11, and 12-13.) Investment centers are usually evaluated based on some measure of the rate of return on investment; that is, some measure of profits divided by some measure of investment This presumably provides incentives to increase profits while controlling the amount of funds tied up in an organization

1 The definition of ROI Companies measure the rate of return on investment in many

different ways To keep things simple, we use the following definition in the book:

Net operating incomeROI

Average operating assets

=

Net operating income is income before interest and taxes Average operating assets are discussed below

2 Measuring Average Operating Assets

a From a theoretical standpoint, one can argue that the denominator in the ROI formula should be the market value of the segment at the beginning of the period The investment in the segment is implicitly the proceeds that could have been realized from its sale Unfortunately, reliable estimate of the market value of a segment are difficult

to obtain So that approach is rarely, if ever, used in practice

b In the text we define operating assets as cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization And after some discussion of net book value versus original cost as a basis for valuation, we settle on net book value This way of measuring the denominator in the ROI calculations is pretty typical of practice We suggest you not dwell on this issue in class; the figures for average operating assets are given in all of the exercises and problems

3 ROI in terms of Margin and Turnover A company’s ROI can be expressed as a simple

function of its margin and turnover:

ROI = Margin × Turnover

or Net operating income SalesROI

Sales Average operating assets

ROI in this format provides some valuable insights Very roughly speaking, in long-run equilibrium the ROI should be about the same across all industries If the ROI is above the norm in any industry, investment dollars will flood into that industry until the ROI becomes comparable to the ROIs in other industries Therefore in industries characterized by large turnovers, margins should be relatively small and in industries characterized by relatively small turnovers, margins should be relatively large The trick for a company is to try to break out of this long-run equilibrium position and to realize some combination of margins and turnover that is higher than the norm

4 How actions affect the rate of return ROI can be improved by doing at least one of the

following: increasing sales, reducing expenses, or reducing assets

a Ordinarily, an increase in sales will increase margin and turnover because of leverage Since fixed costs do not increase with sales, net operating income should increase faster than sales, and the margin should go up And modest increases in sales can often

be supported with very little increase in operating assets

b A decrease in expenses will increase margins through an increase in net operating income In hard times, managers often turn to cost cutting as the first line of defense Conventional wisdom holds that “fat” can creep into an organization during good times and that such fat can be cut away without a great deal of pain when necessary Critics point out that morale suffers during and after periodic cost cutting binges It is now generally acknowledged that it is best to always be “lean and mean” and to avoid the wrenching effects caused by cost cutting campaigns

c Many approaches to increasing ROI involve increasing operating assets or expenses in order to improve sales and margins

5 The problem of allocated expenses and assets In practice, corporate headquarters

expenses and other common costs are usually allocated to divisions Arbitrary allocations

of common costs should be avoided in ROI computations They undermine the credibility

of the measure of performance, generate arguments among managers, and serve no apparent useful purpose

6 Criticisms of ROI The use of ROI as a performance measure has been criticized

a ROI tends to emphasize short-run rather than long-term performance Managers can often improve short-term profitability by taking actions that hurt the company in the long-term Prominent examples include neglecting maintenance and training, slashing prices at the end of the fiscal year to induce customers to make unusually large purchases in advance of their needs, purchasing lower quality inputs, and skimping on quality control

b A manager who takes over an investment center typically inherits many committed costs over which the manager has little control These committed costs may be relevant for assessing how well the investment center has performed as an investment, but are less relevant for assessing how well the current manager is performing

c A division may reject an investment that would lower its own ROI even though it would increase the ROI for the entire company

D Residual Income. (Exercises 12-3, 12-12, 12-14, and 12-16.) Residual income (or economic value added) is an alternative to ROI for measuring the performance of an investment center

1 Motivation for the residual income approach Profitable investments may be rejected if a

segment is evaluated based on the ROI formula For example, suppose a company’s minimum required rate of return on new investments is 15% and one of its investment centers currently has an ROI of 20% If a new investment promises a return of greater than 15%, the company would want that investment made However, if the investment’s rate of return is less than 20%, it would be rejected by the manager of the investment center The residual income approach does not suffer from this particular problem, but it does suffer from many of the other problems with ROI

2 Definition of residual income Residual income is the net operating income that an

investment center is able to earn above the minimum required rate of return on its operating assets Ideally, the minimum required rate of return should be the company’s cost of capital

or opportunity cost of funds When residual income is used to measure performance, the goal is to maximize the total amount of residual income generated for a period

3 Divisional comparison and residual income A major disadvantage of the residual

income approach is that it cannot be easily used to compare the performance of divisions of different sizes Larger divisions naturally have more residual income than smaller divisions, not necessarily because they are better managed, but simply because they are bigger Nevertheless, residual income can be used to track the performance of a division over time and actual residual income can be compared to target residual income

4 Economic Valued Added (EVA) The residual income approach, which was never as

popular as ROI in practice, has been given new life and is now being used by a number of prominent companies in the form of “economic value added” or EVA The consulting firm Stern Stewart is largely responsible for this revival and has trademarked the terms economic value added and EVA Many other consulting firms have jumped on the bandwagon and give residual income their own unique twists and marketing nomenclature The major differences between traditional residual income and economic value added in the Stern Stewart approach center on the accounting treatment of some transactions For example, research and development costs are capitalized and then amortized under the EVA approach rather than being currently expensed in their entirety However, we believe

it is best not to emphasize these differences between residual income and EVA in the introductory course

E (Appendix 12A) Transfer Pricing. (Exercises 12-4, 12-15, and 12-17.) A transfer price

is the price charged when one segment of a company provides goods or services to another segment of the company Transfer prices are necessary to calculate costs and revenues in cost,

profit, and investment centers Clearly, the division that is selling the good or service would prefer a high transfer price while the division that is buying would prefer a low transfer price

1 Do transfer prices matter? From the standpoint of the company as a whole, the transfer

price has no effect on aggregate income (other than perhaps from tax effects when divisions are in different states or countries) What is counted as revenue to one division is a cost to the other and is eliminated in the consolidation process From an economic perspective, it is like taking money out of one pocket and putting it into the other What does matter is how the transfer price affects the decisions made by the segment managers In companies in which decentralization is really practiced, segment managers are given a lot of latitude in dealing with each other Based on the transfer price, a division manager will decide whether to sell a service on the outside market or sell it internally to another division, or whether to buy a part from an outside supplier or internally from another division

2 Negotiated transfer prices In principle, if managers understand their own businesses and

are cooperative, negotiated transfer prices should work quite well

a If a transfer is in the best interests of the entire company, the profits of the entire company should increase It is always possible in such a situation (barring externalities)

to find a transfer price that would increase each participating division’s profits A pie analogy is helpful to explain this principle The profits of the entire company are the pie By cooperating in a transfer, the division managers can make the pie bigger With

a bigger pie, it is always possible to divide it in such a way that everyone gets a bigger piece And transfer prices provide a means for dividing up the pie

b While negotiated transfer prices can work quite well under the right conditions, if managers are uncooperative and highly competitive, negotiations may go nowhere

3 The lowest acceptable transfer price for the selling division Clearly, the selling division

would like for the transfer price to be as high as possible, but how low would the manager

of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost.” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer Therefore, the lowest acceptable transfer price as far as the selling division is concerned is:

Total contribution margin of lost salesTransfer price Variable cost +

Total number of units transferred

When there is idle capacity, there are no lost sales and so the total contribution margin of lost sales is zero

4 Highest transfer price the buying division is willing to pay In the book and in problems,

we generally consider only the situation in which the buying division can buy the transferred item from an outside supplier In that case, the buying division clearly would not voluntarily agree to a transfer unless:

5 The range of acceptable negotiated transfer prices Combining the selling and buying

divisions’ perspectives, we can find the range within which a negotiated transfer price will lie Two situations should be considered

a A transfer makes sense from the standpoint of the company if the item can be made inside the company (including opportunity costs) for less that it costs to buy the item from the outside In algebraic form:

Total contribution margin of lost sales

from outside suppliercost Total number of units transferred ≤

In this case, any transfer price within the following range will increase the profits of both divisions:

Total contribution margin of lost salesVariable + Transfer Cost of purchasing

from outside suppliercost Total number of units transferred ≤ price ≤

b A transfer does not make sense from the standpoint of the company if the item can be purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs) In algebraic form:

Total contribution margin of lost sales

from outside suppliercost Total number of units transferred ≥

In this case, it is impossible to satisfy both the selling division and the buying division and no transfer will be made voluntarily And, of course, no transfer should be forced

on the managers since a transfer would not be in the best interests of the entire company

6 Alternative approaches to transfer pricing If managers understand their own businesses

and are cooperative, negotiated transfer prices should work very well But, if managers do not understand their own businesses or are uncooperative, negotiations are likely to be fruitless As a consequence, most companies rely on either cost-based or market price-based transfer prices

a Cost-based transfer prices In many companies, transfers are recorded at variable

cost, at full cost, or at variable or full cost plus some arbitrary mark-up These transfer pricing systems are easy to administer, but suffer from serious limitations

• Cost-based transfer prices can easily lead to bad decisions If variable costs are used, the transfer price will be too low when there is no idle capacity If full cost is used, the transfer price will never be correct for decision-making purposes—it will always indicate to the buying division that the cost of the transfer is something other than what it really is to the entire company

• If there is no profit margin built into the transfer price, then the selling division has

no incentive to cooperate in the transfer

• If the costs of one division are simply passed on to the next division, then there is little incentive for cost control anywhere in the organization If transfer prices are to

be based on cost, then standard cost rather than actual cost should be used

b Market-based transfer prices When there is a competitive outside market for the

good or service transferred between the divisions, the market price is often used as a transfer price This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity However, when there

is idle capacity in the selling division, the transfer price will be too high and the buying

division may inappropriately purchase from an outside supplier or cut back on volume

Assignment Materials

Assignment Topic

Level of Difficulty

Suggested Time

Exercise 12-1 Basic segmented income statement Basic 15 min Exercise 12-2 Compute the return on investment (ROI) Basic 10 min Exercise 12-3 Residual income Basic 10 min Exercise 12-4 (Appendix 12A) Transfer pricing basics Basic 30 min Exercise 12-5 Segmented income statement Basic 20 min Exercise 12-6 Effects of changes in sales, expenses, and assets on ROI Basic 20 min Exercise 12-7 Working with a segmented income statement Basic 20 min Exercise 12-8 Working with a segmented income statement Basic 15 min Exercise 12-9 Effects of changes in profits and assets on return on

investment (ROI) Basic 30 min Exercise 12-10 Cost-volume-profit analysis and return on investment

(ROI) Basic 20 min Exercise 12-11 Return on investment (ROI) Basic 15 min Exercise 12-12 Evaluating new investments using return on investment

(ROI) and residual income Basic 30 min Exercise 12-13 Computing and interpreting return on investment (ROI) Basic 15 min Exercise 12-14 Contrasting return on investment (ROI) and residual

income Basic 20 min Exercise 12-15 (Appendix 12A) Transfer pricing from the viewpoint of the

entire company Basic 15 min Exercise 12-16 Return on investment (ROI) and residual income relations Basic 15 min Exercise 12-17 (Appendix 12A) Transfer pricing situations Basic 20 min Problem 12-18 Segment reporting and decision-making Basic 30 min Problem 12-19 Comparison of performance using return on investment

(ROI) Basic 30 min Problem 12-20 Return on investment (ROI) and residual income Basic 30 min Problem 12-21 (Appendix 12A) Transfer price with an outside market Basic 45 min Problem 12-22 Basic segmented reporting; activity-based cost assignment Basic 60 min Problem 12-23 Return on investment (ROI) and residual income Basic 20 min Problem 12-24 (Appendix 12A) Basic transfer pricing Basic 60 min Problem 12-25 Restructuring a segmented income statement Basic 60 min Problem 12-26 Segment reporting; activity-based cost assignment Medium 60 min Problem 12-27 Return on investment (ROI) analysis Medium 30 min Problem 12-28 Return on investment (ROI) and residual income;

decentralization Medium 30 min Problem 12-29 (Appendix 12A) Market-based transfer price Medium 45 min Problem 12-30 Multiple segmented income statements Medium 60 min Problem 12-31 (Appendix 12A) Cost-volume-profit analysis; return on

investment (ROI); transfer pricing Medium 45 min Problem 12-32 (Appendix 12A) Negotiated transfer price Medium 30 min Case 12-33 Segmented statements; product line analysis Difficult 90 min Case 12-34 (Appendix 12A) Transfer pricing; divisional performance Difficult 45 min Case 12-35 Service organization; segment reporting Difficult 75 min

Essential Problems: Problem 12-19, Problem 12-20, Problem 12-22 or Problem 12-25

Supplementary Problems: Problem 12-18, Problem 12-23, Problem 12-26, Problem 12-27, Problem 12-28, Problem 12-30, Case 12-33, Case 12-35

Appendix 12A Essential Problems: Problem 12-24

Appendix 12A Supplementary Problems: Problem 12-21, Problem 12-29, Problem 12-31, Problem 12-32, Case 12-34

1 2

Chapter 12 Lecture Notes

Helpful Hint: Before beginning the lecture, show students the 14th and 15th segments from the McGraw- Hill/Irwin Managerial/Cost Accounting video library These segments discuss many of the concepts included

in chapter 12 The lecture notes reinforce the concepts

in the video

Chapter theme: Managers in large organizations have to delegate some decisions to those who are at lower levels in

the organization This chapter explains how responsibility

accounting systems, segmented income statements, and return on investment (ROI) and residual income

measures are used to help control decentralized

organizations

I Decentralization in organizations

A A decentralized organization does not confine

decision-making authority to a few top executives;

rather, decision-making authority is spread

throughout the organization The advantages and

disadvantages of decentralization are as follows:

1 It enables top management to concentrate

on strategy, higher-level decision-making, and coordinating activities

2 It acknowledges that lower-level managers have more detailed information about local

conditions that enable them to make better

1

2

2 3

3 It enables lower-level managers to quickly

respond to customers

4 It provides lower-level managers with the

decision-making experience they will need

when promoted to higher level positions

5 It often increases motivation, resulting in

increased job satisfaction and retention, as well as improved performance

ii Disadvantages of decentralization

1 Lower-level managers may make decisions

without fully understanding the “big

picture.”

2 There may be a lack of coordination among

autonomous managers

a The balanced scorecard can help

reduce this problem by communicating

a company’s strategy throughout the organization

3 Lower-level managers may have objectives

that differ from those of the entire

organization

a This problem can be reduced by

designing performance evaluation systems that motivate managers to

make decisions that are in the best interests of the company

4 It may difficult to effectively spread

innovative ideas in a strongly decentralized

organization

a This problem can be reduced through

the effective use of intranet systems,

which enable globally dispersed

2

3

3 4 5

6

employees to electronically share ideas

II Responsibility accounting

A Responsibility accounting systems 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 The three

primary types of responsibility centers are cost

centers, profit centers, and investment centers

1 The manager of a cost center has control

over costs, but not over revenue or

investment funds

a Service departments such as

accounting, general administration, legal, and personnel are usually classified as cost centers, as are

manufacturing facilities

b Standard cost variances and flexible

budget variances, such as those

discussed in Chapters 10 and 11, are often used to evaluate cost center performance

ii Profit center

1 The manager of a profit center has control

over both costs and revenue

5

3

4

6

6 7

a Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit

iii Investment center

1 The manager of an investment center has

control over cost, revenue, and

investments in operating assets

a Investment center managers are usually evaluated using return on investment (ROI) or residual income,

as discussed later in this chapter

“In Business Insights”

It is important to correctly manage the incentives offered to responsibility center managers, otherwise the consequences can be disastrous For example:

“Extreme Incentives” (page 542)

• In 2003 Tyco International, Ltd was rocked by a

series of scandals including disclosure of $2 billion of accounting-related problems Was this foreseeable? Well, in a word, yes

• Business Week reported in 1996 that the CEO of

Tyco International, Ltd., Dennis Kozlowski, was putting unrelenting pressure on his managers to deliver growth If his managers met or exceeded their targets they were given a bonus that could

be many times their salary But if they fell even a bit short, the bonus plummeted

• If a manager is barely under the target, this type

of bonus scheme creates pressure the accelerate earnings If a manager is barely over the bonus

6

7

8 9 10

11

threshold, it creates an incentive to push earnings

to the next period

• If top executives, such as Kozlowski, set profit

targets too high or turn a blind eye to how managers achieve them, the incentive for managers to cut corners is enormous

B An organizational view of responsibility centers

example of the various kinds of responsibility centers that exist in an organization

1 The President and CEO as well as the Vice

President of Operations manage investment

centers

2 The Chief Financial Officer, General Counsel, and Vice President of Personnel all

manage cost centers

3 Each of the three product managers that report to the Vice President of Operations (e.g., salty snacks, beverages, and

confections) manages a profit center

4 The bottling plant manager, warehouse manager, and distribution manager all

manage cost centers that report to the

Beverages product manager

III Decentralization and segment reporting

A Key concepts/definitions

i A segment is a part or activity of an

organization about which managers would like cost, revenue, or profit data

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9

10

11

11 12 13

14

1 Examples of segments include divisions of

a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual

customers, and product lines

a Superior Foods Corporation could segment its business as follows:

• By geographic region

• By customer channel

Helpful Hint: If students have been introduced to database software, Exhibit 12-2 can be used to review how segmentation could be accomplished with the aid

of a computer The number of possible breakdowns, or segmentations, is only limited by the list of attributes coded along with each transaction To accomplish the breakdown in Exhibit 12-2, the attributes geographic region (e.g., east, west, etc.), state, customer channel, and supermarket chain would need to be recorded for each sale

ii There are two keys to building segmented

14 15 16

enable the calculation of a segment margin

Further clarification of these terms is as follows:

a A traceable fixed cost of a segment is

a fixed cost that is incurred because of the existence of the segment If the segment were eliminated, the fixed cost would disappear Examples of traceable fixed costs include:

• The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo

• The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment

of Boeing

b A common fixed cost is a fixed cost

that supports the operations of more

than one segment, but is not traceable

in whole or in part to any one segment Examples of common fixed

costs include:

• The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors

• The cost of heating a Safeway or Kroger grocery store is a

common fixed cost of the various departments – groceries,

produce, bakery, etc

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15

16

17

“In Business Insights”

Common fixed costs are often arbitrarily allocated to segments for cost recovery purposes Invariably, this leads to disputes about the fairness of the allocation process For example:

“The Big Gouge” (page 555)

• The Big Dig in Boston is a $14 billion-plus

project to bury major roads underground in downtown Boston Two companies – Bechtel and Parsons Brinckerhoff (PB) – manage the 20 year project, which is $1.6 billion over budget

• Bechtel and PB have many projects underway at

any one time and many common fixed costs These common fixed costs are not caused by the Big Dig project and yet portions of these costs have been claimed as reimbursable expenses under the premise that someone must pay for these costs

• Massachusetts has lodged a number of complaints

concerning Bechtel’s cost recovery claims Such complaints are almost inevitable when common fixed costs are allocated to segments

c 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 a particular flight, but it is not traceable to first-class, business- class, and economy-class

passengers

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18 19

Helpful Hint: In practice, a great deal of disagreement exists about what costs are traceable and what costs are common Some people claim that except for direct materials, virtually all costs are common fixed costs that cannot be traced to products Others assert that all costs are traceable to products; there are no common costs The truth probably lies somewhere in the middle – many costs can be traced to products but not all costs

d A segment margin is computed by

subtracting the traceable fixed costs of

a segment from its contribution margin

• The segment margin is a valuable

tool for assessing the long-run

profitability of a segment

• Allocating common costs to

segments reduces the value of

the segment margin as a guide

to long-run segment profitability

“In Business Insights”

Segment margins can be computed in numerous ways depending upon the industry For example:

“What’s in a Segment?” (page 552)

• Continental Airlines could figure out the

profitability of a specific route on a monthly basis – for example Houston to Los Angeles – but

management did not know the profitability of a particular flight on that route

• The company’s CFO responded by developing a

flight profitability system that would break out the profit (or loss) for each individual flight

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19

20

• Once completed the new cost system revealed

such money-losing flights as two December flights that left Houston for London within a four-hour period with only about 30 passengers each

• With the data on the profitability of individual

flights, Continental was able to design more appropriate schedules

Helpful Hint: Explain that a segment shouldn’t automatically be eliminated if its segment margin is negative If a company that produces hair-styling products discontinues its styling gel, sales on its shampoo and conditioner might fall due to the unavailability of the eliminated product

iii Activity-based costing can help identify how

costs shared by more than one segment are traceable to individual segments For example:

1 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

2 If the 9-inch, 12-inch, and 18-inch pipes

occupy 1,000, 4,000, and 5,000 square feet,

respectively, then activity-based costing can

be used to trace the warehousing costs to the three products as shown

a When using activity-based costing to trace fixed costs to segments,

managers must still ask themselves if the traceable costs that they have been identified would disappear over time if the segment disappeared

20

20

b In this example, if the warehouse was owned rather than leased, perhaps the warehousing costs assigned to a given

segment would not disappear if the

segment was discontinued

“In Business Insights”

Activity-based costing can be used by companies to more accurately trace costs to business segments For example:

“Using ABC to Assign Data Center Costs” (page 549)

• Harris Corporation consolidated its division-level

data centers into a centralized data center called the Computing and Communication Services (CCS) Department

• CCS is a cost center that recovers its operating

costs by charging other divisions within Harris for the use of its resources

• To facilitate the “chargeback” process, CCS

developed an activity-based costing system

Activities such as “test systems,” “monitor network,” “schedule jobs,” “install software,” and “print reports” were used to ensure that internal customers were only charged for the dollar value of the resources that they consumed

Helpful Hint: In several articles, Cooper and Kaplan, the leading architects of activity-based costing, have proposed that costs be sorted into a hierarchy of unit- level, batch-level, product-level, and facility-level costs This hierarchy can be viewed as a pyramid with

facility-level costs at the top and unit-level costs at the bottom Cooper and Kaplan basically view costs at

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activities carried out at the lower levels They strongly recommend that these common costs should not be allocated downwards in the pyramid This

conceptualization is highly consistent with the segmented reports discussed in this chapter

B Segmented income statements – an example

i Assume that Webber, Inc has two divisions –

the Computer Division and the Television Division

1 The contribution format income statement

for the Television Division is as shown

c Contribution margin is computed by

taking sales minus variable costs

d The divisional segment margin

represents the Television Division’s contribution to overall company profits

2 The Television Division’s results can be rolled into Webber, Inc.’s overall results as shown Notice:

a The results of the Television and

Computer Divisions sum to the results

shown for the whole company

b The common costs for the company as

a whole ($25,000) are not allocated to

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3 The Television Division’s results can also be broken down into smaller segments This

enables us to see how traceable fixed costs

of the Television Division can become common costs of smaller segments

a Assume that the Television Division can be broken down into two major

product lines – Regular and Big

Screen

b Assume that the segment margins for

these two product lines are as shown

c Of the $90,000 of fixed costs that were

previously traceable to the Television

Division, $80,000 ($45,000 + $35,000)

is traceable to the two product lines

and $10,000 is a common cost

“In Business Insights”

Segmental income statements have the potential to be useful to front-line employees For example:

“Daily Segment Feedback Fuels Innovation” (page 551)

• Steve Briley, the department manager of

Cracking Plant 3B at Texas Eastman Company’s chemical plant in Longview, Texas, created an innovative daily performance report to help guide his department

• Briley issued an income statement to his

employees at the beginning of each day The daily income statement assigned revenues to the output of the previous day and costs to the inputs used

• Briley found that giving his employees the

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provided three key benefits First, it gave employees rapid feedback regarding what actions increased or decreased profits Second, it

empowered workers to make decisions quickly in response to changes in the operating environment Third, the daily income statement helped

employees make trade-offs and set priorities

C Segmented financial information on external reports

i The Financial Accounting Standards Board

now requires that companies in the United

States include segmented financial data in

their annual reports This ruling has implications for internal segment reporting because:

1 It mandates that companies report segmented

results to shareholders using the same

methods that are used for internal

segmented reports

2 Since the contribution approach to segment

reporting does not comply with GAAP, it is

likely that some managers will choose to construct their segmented financial

statements using the absorption approach

to comply with GAAP

a The absorption approach hinders

internal decision making because it

does not distinguish between fixed and variable costs or common and

traceable costs

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