Segment Reporting and Decentralization

Chapter 12 (Garrison Text)                                                                                                        

Dr. M.S. Bazaz

Segment Reporting and Decentralization

• Segments could be in forms of Geographic region, product, or line of business segments.
• Segment reports can provide information for evaluating the profitability and performance of division, product line, sales territories, and other segments of a company.
• Advantage of decentralization:
• better focused on day-to-day problem solving and more concentrate on strategy.
• make lower level manager a more experienced person.
• increased job satisfaction and higher moral.
• better decision making as having detailed information.
• performance evaluation of a manager is making more cense where a manager has better control.
• Disadvantage of decentralization:
• may make unreasonable decision due to lack of fully understanding the “big picture”.
• may be lack of coordination among autonomous managers.
• lower-level managers may have objectives that are different from the objectives of the entire organization.
• it may be more difficult to effectively spread innovative ideas.
• Effective decentralization requires segmental reporting
• By carefully examining trends and results in each segment, a manager is able to gain considerable insight into the company’s operations viewed from many different angles.
• Forms of decentralization:
• Cost Center – is a business segment whose manager has control over costs but not over revenue or investment funds, i.e. service departments such as: accounting, general administration, legal or personal.
• Profit Center – a business segment whose manager has control over both cost and revenue, i.e. six flags amusement park in Dallas.
• Investment Center – a business segment whose manager has control over cost, revenue and investment in operating assets.
• Responsibility Center – is any part of an organization whose manager has control over cost, revenue, or investment funds.  Cost, profit and investment center are all responsibility center.
• Sales and Contribution Margin (CM)
• CM tells us what happens to profits as volume changes – holding a segment’s capacity and fixed costs constant.
• CM is especially useful in decisions involving temporary uses of capacity such as special orders.
• Traceable and Common Fixed Costs:
• Traceable fixed cost – is a fixed cost that is incurred because of the existence of the segment.  If the segment were eliminated, the fixed cost would disappear. i.e., salary of a segment manager.
• 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. If a segment were entirely eliminated, there would be no change in a true common fixed cost. i.e. salary of a firm’s CEO.
• A fixed traceable cost of a segment may be a common cost of another segment. I.E., a division manager salary is a common cost of the division’s product lines.
• segment margin – is obtained by deducting the traceable fixed costs of a segment from the segment’s contribution margin.  It represents the margin available after a segment has covered all of its own costs.  It is the best gauge of the long-run profitability of a segment, since it includes only those costs that are caused by the segment.
• To be relevant, all traceable costs must be assigned properly to a segment. 
• Three possibilities that hinder proper cost assignment:
• Omission of some costs in the assignment process.
• omission of some “upstream” costs such as R&D or product design costs.
• omission of some “downstream” costs such as marketing, distribution, and customer service.
• the use of inappropriate methods for cost allocation.
• When companies fail to trace costs directly to segments in those situations where it is feasible to do so.
• When companies use inappropriate bases to allocate costs. Lack of causality.
• assignment to segments of costs that are really common costs.

• Measuring Managerial Performance
• Return on Investment (ROI) -- = Net Operating Income (NOI)/ Average Operating Assets (AOA).

       = EBIT / Avg. Operating Assets

• Arguments for using net book value (net of depreciation) in measuring Op. Assets in  ROI:
• is consistent with balance sheet.
• is consistent with computation of operating income.
• Arguments for using gross cost method(before depreciation) in measuring Op. Assets in ROI
• Eliminate two factors of age of asset and the method of depreciation.  (Under the net book value method, ROI will tend to increase over time as net book value declines due to depreciation).
• The gross cost method does not discourage replacement of old, worn-out equipment. (Under the net book value method replacement of fully depreciated assets will have dramatic adverse effect on ROI).
• Dupont Model of ROI:
• ROI = (NOI / Sales)  x (Sales / AOA)  = (margin) x  (asset turn-over)
• Dupont model forces managers to control the investment in operating assets as well as to control expenses and the margin.  (See also Dupont diagram in Exhibit 12-6 of the book)
• An investment center manager can increase ROI in basically three ways:
• Increase sales
• Reduce expenses
• Reduce assets. (Application of JIT is an effective technique)
• We should NOT cancel sales from Dupont model for two reasons:
• this would keep attention of management to the fact that the rate of return is a function of two variables, margin and turnover.
• It would emphasis to the fact that a change in sales can affect both the margin and the turnover in an organization.
• Critics of ROI:
• managers may not know how to increase ROI
• they may increase ROI in a way that is inconsistent with company’s strategy.
• They may take action to increase ROI in the short run but damage the firm in the long run, i.e., cutting back on R&D.  a balanced scorecard will prevent wrong doing.
• a manager who takes over a business segment typically inherits many committed costs over which the manager has no control.
• a manager who is evaluated on ROI may reject profitable investment opportunity.

• Residual Income – is the net operating income that an investment center earns above the minimum required return  on its operating assets.

Economic value added (EVA) – is a similar concept that differs in some details from residual income.

• The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated by the ROI formula.
• Basically, a manager who is evaluated based on ROI will reject any project whose rate of return is below the division’s current ROI even if the rate of return on the project is above the minimum required rate of return for the entire company.
• The disadvantage of residual income approach is that it can’t be used to compare the performance of divisions of different sizes.
• Transfer Pricing:
• Three common approaches are used to set transfer prices:
• Allow the managers involved in the transfer to negotiate their own transfer price.
• Several advantages:
• Preserve the autonomy of the divisions and it is consistent with the sprit of decentralization.
• manager of the divisions are likely to have much better information about the potential costs and benefit of the transfer than others in the company.
• The negotiation must be within an acceptable range within which the profits of both divisions participating in a transfer would increase.
• Lowest level (to seller):

Transfer Price >= Variable cost per unit +(Total contribution margin on lost sales/Number of units transferred).

• Highest limit (to purchaser):

Transfer price <= Cost of buying from outside supplier.

• Set transfer prices at cost using:
• Variable cost.
• Full (absorption) cost.

Pros and cons:

• Set transfer prices at the market prices.

Pros and cons:

• The fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company.
• Transfer pricing objectives:
• Domestic:
• Greater divisional autonomy
• greater motivation for managers
• better performance evaluation
• better goal congruence.
• International:
• Less taxes, duties, and tariffs
• less foreign exchange risks
• better competitive position
• better governmental relations