11-1

Bachelor of Business Administration

Course: Management Accounting

Segment Reporting & Decentralization

11-2
11-3

Responsibility Accounting

Cost
Cost Profit
Profit Investment
Investment
Center
Center Center
Center Center
Center

Cost, profit,
and investment
centers are all Responsibility
Responsibility
known as Center
Center
responsibility
centers.
11-4

Cost Center
A segment whose manager has control over
costs, but not over revenues or investment
funds.
11-5

Profit Center

Revenues
A segment whose
Sales
manager has control
Interest
over both costs and
Other
revenues,
Costs
but no control over
investment funds. Mfg. costs
Commissions
Salaries
Other
11-6

Investment Center

A segment whose
manager has control
over costs,
revenues, and
investments in
operating assets.
11-7

Learning Objective 1

Compute return on
investment (ROI) and
show how changes in
sales, expenses, and
assets affect ROI.
11-8

Return on Investment (ROI) Formula

Income
Incomebefore
beforeinterest
interest
and
andtaxes
taxes(EBIT)
(EBIT)

Net operating income

ROI =
Average operating assets

Cash,
Cash, accounts
accountsreceivable,
receivable, inventory,
inventory,
plant
plantand
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.
11-9

Net Book Value versus 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
11-10

Understanding ROI

Net operating income

Margin =
Sales

Turnover = Sales
Average operating
assets
ROI =
Margin  Turnover
11-11

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
ROI = Net operating income × Sales
Sales Average operating assets
11-12

Increasing ROI – An Example

ROI =
Margin  Turnover
Sales
ROI = Net operating income × Average operating assets
Sales

ROI = $30,000 × $500,000

$500,000 $200,000

ROI =6%  2.5 = 15%

11-13

Investing in Operating Assets to

Increase Sales
Assume that Regal's manager invests $30,000 in a
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.

11-14

Investing in Operating Assets to

Increase Sales

ROI =
Margin  Turnover
ROI = Net operating income × Sales
Sales Average operating assets

ROI = $50,000 × $535,000

$535,000 $230,000

ROI =
9.35%  2.33 = 21.8%

ROI
ROI increased
increased from
from 15%
15% to
to 21.8%.
21.8%.
11-15

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

12-15
11-16

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.
11-17

Learning Objective 2

Compute residual
income and understand
its strengths and
weaknesses.
11-18

Residual Income - Another Measure of

Performance

Net operating income

above some minimum
return on operating
assets
11-19

Calculating Residual Income

( )
Net Average Minimum
Residual  required rate of
= operating - operating
income
income assets 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.
11-20

Residual Income – An Example

••The
The Retail
Retail Division
Division of
of Zephyr,
Zephyr, Inc.
Inc. has
has
average
average operating
operating assets
assets of
of $100,000
$100,000 and
and is
is
required
required toto earn
earn aa return
return of
of 20%
20% on
on these
these
assets.
assets.
••InIn the
the current
current period,
period, the
the division
division earns
earns
$30,000.
$30,000.

Let’s calculate residual income.

11-21

Residual Income – An Example

Operating
Operating assets
assets $$100,000
100,000
Required
Required rate
rate of
of return
return ×× 20%
20%
Minimum
Minimum required
required return
return $$ 20,000
20,000

Actual
Actual income
income $$ 30,000
30,000
Minimum
Minimum required
requiredreturn
return (20,000)
(20,000)
Residual
Residual income
income $$ 10,000
10,000
11-22

Motivation and Residual Income

Residual income encourages managers to

make profitable investments that would
be rejected by managers using ROI.
11-23

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%
11-24

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%
ROI = NOI/Average operating assets
c. 15%
d. 20% = $60,000/$300,000 = 20%
11-25

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
11-26

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? ROI = $78,000/$400,000 = 19.5%
a. Yes
This lowers the division’s ROI from
b. No
20.0% down to 19.5%.
11-27

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
11-28

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?
ROI = $18,000/$100,000 = 18%
a. Yes
b. No The return on the investment
exceeds the minimum required rate
of return.
11-29

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
11-30

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 Net operating income $60,000
Required return (15% of $300,000) (45,000)
d. $ 51,000 Residual income $15,000
11-31

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
11-32

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
Net operating income $78,000
b. No Required return (15% of $400,000) (60,000)
Residual income $18,000

Yields an increase of $3,000 in the residual income.

11-33

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.
11-34

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
Retail Wholesale
Wholesale
Operating
Operating assets
assets $$ 100,000
100,000 $$ 1,000,000
1,000,000
Required
Required rate
rate of
ofreturn
return ×× 20%
20% 20%
20%
Minimum
Minimum required
required return
return $$ 20,000
20,000 $$ 200,000
200,000

Retail
Retail Wholesale
Wholesale
Actual
Actual income
income $$ 30,000
30,000 $$ 220,000
220,000
Minimum
Minimum required
required return
return (20,000)
(20,000) (200,000)
(200,000)
Residual
Residual income
income $$ 10,000
10,000 $$ 20,000
20,000
11-35

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
Retail Wholesale
Wholesale
Operating
Operating assets
assets $$ 100,000
100,000 $$ 1,000,000
1,000,000
Required
Required rate
rate of
ofreturn
return ×× 20%
20% 20%
20%
Minimum
Minimum required
required return
return $$ 20,000
20,000 $$ 200,000
200,000

Retail
Retail Wholesale
Wholesale
Actual
Actual income
income $$ 30,000
30,000 $$ 220,000
220,000
Minimum
Minimum required
required return
return (20,000)
(20,000) (200,000)
(200,000)
Residual
Residual income
income $$ 10,000
10,000 $$ 20,000
20,000
11-36

• Centralization --- The top level management

may centralize all decision.
Decentralization--- The hiring the decisions
to first level management for clerical workers
and let operational decisions be made where
appropriate.
11-37
11-38

Decentralization in Organizations
Benefits of Top
Top management
management
Decentralization freed
freed toto concentrate
concentrate
on
on strategy.
strategy.
Lower-level decisions
Lower-level decisions
often
often based
based on
on
better
better information.
information. Lower
Lower level
level managers
managers
can
can respond
respond quickly
quickly
to
to customers.
customers.
Lower-level
Lower-level managers
managers
gain
gain experience
experience inin
decision-making.
decision-making. Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
11-39

Decentralization in Organizations
Lower-level
Lower-level managers
managers
may
may make
make decisions
decisions
without
without seeing
seeing the
the
May
May be
be aa lack
lack of
of “big
“big picture.”
picture.”
coordination
coordination among
among
autonomous
autonomous
managers.
managers. Disadvantages of
Decentralization
Lower-level
Lower-level manager’s
manager’s
objectives
objectives may
may not
not
be
be those
those of
of the
the May
May bebe difficult
difficult to
to
organization.
organization. spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.
11-40

Decentralization and Segment

Reporting
An Individual Store

A segment is any part Quick Mart

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

12-40
11-41

Keys to 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.
12-41
11-42

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.

12-42
11-43

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.

12-43
11-44

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.

12-44
11-45

Segment Margin
The segment margin, which is computed by subtracting the
traceable fixed costs of a segment from its contribution
margin, is the main measuring device of the long-run
profitability of a segment.
Profits

Time
12-45
11-46

Traceable and Common Costs

Fixed Don’t allocate
Costs common costs to
segments.

Traceable Common

12-46
11-47

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

12-47