Chapter 12

Segment Reporting and
Decentralization
Chapter Twelve
McGrawHill/Irwin
Copyright2008,TheMcGrawHillCompanies,Inc.
12-2
Decentralization in Organizations
Benefits of
Decentralization
Top
Top management
management
freed
freed to
to concentrate
concentrate
on
on strategy.
strategy.
Lower-level
Lower-level managers
managers
gain
gain experience
experience in
in
decision-making.
decision-making.
Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
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.
McGrawHill/Irwin
12-3
Decentralization in Organizations
Lower-level
managers
may
may make
make decisions
decisions
without
without seeing
seeing the
the
big
big picture.
picture.
Lower-level
managers
objectives
objectives may
may not
not
be
be those
those of
of the
the
organization.
organization.
McGrawHill/Irwin
May
May be
be aa lack
lack of
of
coordination
coordination among
among
autonomous
autonomous
managers.
managers.
Disadvantages of
Decentralization
May
May be
be difficult
difficult to
to
spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.
12-4
Cost, Profit, and Investments Centers
Cost
Cost
Center
Center
Cost, profit,
and investment
centers are all
known as
responsibility
centers.
McGrawHill/Irwin
Profit
Profit
Center
Center
Investment
Investment
Center
Center
Responsibility
Responsibility
Center
Center
12-5
Cost Center
A segment whose
manager has control
over costs,
but not over revenues
or investment funds.
McGrawHill/Irwin
12-6
Profit Center
A segment whose
manager has control
over both costs and
revenues,
but no control over
investment funds.
Revenues
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Other
McGrawHill/Irwin
12-7
Investment Center
Corporate Headquarters
A segment whose
manager has control
over costs, revenues,
and investments in
operating assets.
McGrawHill/Irwin
12-8
Responsibility Centers
Investment
Centers
O p e r a tio n s
V ic e P r e s id e n t
S a lty S n a c k s
P ro d u c t M a n g er
B o ttlin g P la n t
M anager
B e v era g es
P ro d u c t M a n a g e r
W a re h o u s e
M anager
S u p e r io r F o o d s C o r p o r a tio n
C o r p o r a te H e a d q u a r te rs
P r e s id e n t a n d C E O
F in a n c e
C h ie f F In a n c ia l O ffic e r
Legal
G e n e ra l C o u n s e l
P e rs o n n e l
C o n fe c tio n s
D is tr ib u tio n
M anager
Cost
Centers
Superior Foods Corporation provides an example of the

various kinds of responsibility centers that exist in an
organization.
McGrawHill/Irwin
12-9
O p e r a tio n s
S a lty S n a c k s
M anager
B e v era g es
W a re h o u s e
M anager
F in a n c e
C o n fe c tio n s
D is tr ib u tio n
M anager
Legal
P e rs o n n e l
Profit
Centers

organization.
McGrawHill/Irwin
12-10
O p e r a tio n s
S a lty S n a c k s
M anager
B e v era g es
W a re h o u s e
M anager
F in a n c e
Legal
P e rs o n n e l
C o n fe c tio n s
D is tr ib u tio n
M anager
Cost
Centers

organization.
McGrawHill/Irwin
12-11
Learning Objective 1
Prepare a segmented
income statement using
the contribution margin
format, and explain the
difference between
traceable fixed costs and
common fixed costs.
McGrawHill/Irwin
Decentralization and
Segment Reporting
12-12
An Individual Store
A segment is any part

or activity of an
organization about
which a manager
seeks cost, revenue,
or profit data. A
segment can be . . .
McGrawHill/Irwin
Quick Mart
A Sales Territory
A Service Center
12-13
Superior Foods: Geographic Regions

$ 5 0 0 , 0 0 0 ,0 0 0
E ast
$ 7 5 ,0 0 0 ,0 0 0
O re g o n
$ 4 5 ,0 0 0 ,0 0 0
W est
$ 3 0 0 , 0 0 0 ,0 0 0
W a s h in g to n
$ 5 0 ,0 0 0 ,0 0 0
M id w e s t
$ 5 5 ,0 0 0 ,0 0 0
C a l if o r n ia
$ 1 2 0 , 0 0 0 ,0 0 0
S o u th
$ 7 0 ,0 0 0 ,0 0 0
M o u n t a in S t a t e s
$ 8 5 ,0 0 0 ,0 0 0
Superior Foods Corporation could segment its business

by geographic regions.
McGrawHill/Irwin
12-14
Superior Foods: Customer Channel
$ 5 0 0 ,0 0 0 ,0 0 0
C o n v e n ie n c e S to r e s
$ 8 0 ,0 0 0 ,0 0 0
S u p e r m a r k e t C h a in A
$ 8 5 ,0 0 0 ,0 0 0
S u p e r m a r k e t C h a in s
$ 2 8 0 , 0 0 0 ,0 0 0
S u p e r m a r k e t C h a in B
$ 6 5 ,0 0 0 ,0 0 0
W h o l e s a l e D i s t r ib u t o r s
$ 1 0 0 , 0 0 0 ,0 0 0
S u p e r m a r k e t C h a in C
$ 9 0 ,0 0 0 ,0 0 0
D ru g s to re s
$ 4 0 ,0 0 0 ,0 0 0
S u p e r m a r k e t C h a in D
$ 4 0 ,0 0 0 ,0 0 0
Superior Foods Corporation could segment its business

by customer channel.
McGrawHill/Irwin
12-15
Keys to Segmented Income Statements

There are two keys to building
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.
McGrawHill/Irwin
12-16
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
division means . . .
McGrawHill/Irwin
No computer
division manager.
12-17
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
division but . . .
McGrawHill/Irwin
We still have a
company president.
Traceable Costs Can Become

Common Costs
12-18
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.
McGrawHill/Irwin
12-19
Segment Margin
Profits
The segment margin, which is computed by subtracting

the traceable fixed costs of a segment from its
contribution margin, is the best gauge of the long-run
profitability of a segment.
McGrawHill/Irwin
Time
12-20
Traceable and Common Costs
Fixed
Costs
Traceable
McGrawHill/Irwin
Dont allocate
common costs to
segments.
Common
12-21
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
McGrawHill/Irwin
12-22
Levels of Segmented Statements
Webber, Inc. has two divisions.

W e b b e r , In c .
C o m p u te r D iv is io n
T e le v is io n D iv is io n
Lets
Lets look
look more
more closely
closely at
at the
the Television
Television
Divisions
Divisions income
income statement.
statement.
McGrawHill/Irwin
12-23

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
Contribution margin
150,000
Traceable fixed costs
90,000
Division margin
$ 60,000
McGrawHill/Irwin
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.
12-24

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
Contribution margin
150,000
Traceable fixed costs
90,000
Division margin
$ 60,000
McGrawHill/Irwin
Contribution
Contribution margin
margin
is
is computed
computed by
by
taking
taking sales
sales minus
minus
variable
variable costs.
costs.
Segment
Segment margin
margin
is
is Televisions
Televisions
contribution
contribution
to
to profits.
profits.
12-25
Sales
Variable costs
CM
Traceable FC
Division margin
Common costs
Net operating
income
McGrawHill/Irwin
Income Statement
Company
Television
$ 500,000
$ 300,000
230,000
150,000
270,000
150,000
170,000
90,000
100,000
$ 60,000
Computer
$ 200,000
80,000
120,000
80,000
$ 40,000
12-26
Sales
Variable costs
CM
Traceable FC
Division margin
Common costs
Net operating
income
McGrawHill/Irwin
Income Statement
Company
Television
$ 500,000
$ 300,000
230,000
150,000
270,000
150,000
170,000
90,000
100,000
$ 60,000
25,000
$
75,000
Computer
$ 200,000
80,000
120,000
80,000
$ 40,000
Common
Common costs
costs should
should not
not
be
be allocated
allocated to
to the
the
divisions.
divisions. These
These costs
costs
would
would remain
remain even
even ifif one
one
of
of the
the divisions
divisions were
were
eliminated.
eliminated.

Common Costs
12-27
As previously mentioned, fixed costs that

are traceable to one segment can become
common if the company is divided into
smaller segments.
Lets see how this works

using the Webber, Inc.
example!
McGrawHill/Irwin
12-28

Common Costs
Webbers Television Division
Television
Division
Regular
Big Screen
Product
Lines
McGrawHill/Irwin

Common Costs
12-29
Income Statement
Television
Division
Regular
Sales
$ 200,000
Variable costs
95,000
CM
105,000
Traceable FC
45,000
Product line margin
$ 60,000
Common costs
Divisional margin
Big Screen
$ 100,000
55,000
45,000
35,000
$ 10,000
We obtained the following information from

the Regular and Big Screen segments.
McGrawHill/Irwin

Common Costs
12-30
Income Statement
Television
Division
Regular
Sales
$ 300,000
$ 200,000
Variable costs
150,000
95,000
CM
150,000
105,000
Traceable FC
80,000
45,000
Product line margin
70,000
$ 60,000
Common costs
10,000
Divisional margin
$ 60,000
Big Screen
$ 100,000
55,000
45,000
35,000
$ 10,000
Fixed
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000
McGrawHill/Irwin
12-31
External Reports
The Financial Accounting Standards Board now requires
that companies in the United States include segmented
financial data in their annual reports.
1.
Companies must 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.
McGrawHill/Irwin
12-32
Omission of Costs
Costs assigned to a segment should include all
costs attributable to that segment from the
companys entire value chain.
chain
Business Functions
Making Up The
Value Chain
R&D
McGrawHill/Irwin
Product
Design
Customer
Manufacturing Marketing Distribution Service
Inappropriate Methods of Allocating Costs

Among Segments
12-33
Failure to trace
costs directly
Segment
1
McGrawHill/Irwin
Segment
2
Inappropriate
allocation base
Segment
3
Segment
4
12-34
Common Costs and Segments

Common costs should not be arbitrarily allocated to segments
based on the rationale that someone has to cover the
common costs for two reasons:
1. This practice may make a profitable business segment appear
to be unprofitable.
2. Allocating common fixed costs forces managers to be held
accountable for costs they cannot control.
Segment
1
McGrawHill/Irwin
Segment
2
Segment
3
Segment
4
12-35
Quick Check
Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
Income Statement
Haglund's
Lakeshore
Bar
$ 800,000
$ 100,000
310,000
60,000
490,000
40,000
246,000
26,000
244,000
$ 14,000
200,000
$ 44,000
Restaurant
$ 700,000
250,000
450,000
220,000
$ 230,000
Assume that Hoagland's Lakeshore prepared its

segmented income statement as shown.
McGrawHill/Irwin
12-36
Quick Check
How much of the common fixed cost of $200,000
can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
McGrawHill/Irwin
12-37
Quick Check
How much of the common fixed cost of $200,000
can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
A common fixed cost cannot be

eliminated by dropping one of
the segments.
McGrawHill/Irwin
12-38
Quick Check
Suppose square feet is used as the basis for
allocating the common fixed cost of $200,000. How
much would be allocated to the bar if the bar
occupies 1,000 square feet and the restaurant
9,000 square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000
McGrawHill/Irwin
12-39
Quick Check
Suppose square feet is used as the basis for
allocating the common fixed cost of $200,000. How
much would be allocated to the bar if the bar
occupies 1,000 square feet and the restaurant
9,000 square feet?
a. $20,000
The bar would be
b. $30,000
allocated 1/10 of the cost
c. $40,000
or $20,000.
d. $50,000
McGrawHill/Irwin
12-40
Quick Check
If Hoagland's allocates its common
costs to the bar and the restaurant,
what would be the reported profit of
each segment?
McGrawHill/Irwin
12-41
Allocations of Common Costs
Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
Income Statement
Haglund's
Lakeshore
Bar
$ 800,000
$ 100,000
310,000
60,000
490,000
40,000
246,000
26,000
244,000
14,000
200,000
20,000
$ 44,000
$
(6,000)
Restaurant
$ 700,000
250,000
450,000
220,000
230,000
180,000
$ 50,000
Hurray, now everything adds up!!!

McGrawHill/Irwin
12-42
Quick Check
Should the bar be eliminated?
a. Yes
b. No
McGrawHill/Irwin
12-43
Quick Check
Should the bar be eliminated?
a. Yes
The profit was $44,000 before
b. No
eliminating the bar. If we eliminate

the bar,
profit drops to $30,000!
Income
Statement
Sales
Variable costs
CM
Traceable FC
Segment margin
Common costs
Profit
McGrawHill/Irwin
Haglund's
Lakeshore
$ 700,000
250,000
450,000
220,000
230,000
200,000
$ 30,000
Bar
Restaurant
$ 700,000
250,000
450,000
220,000
230,000
200,000
$ 30,000
12-44
Compute return on
investment (ROI) and
show how changes in
sales, expenses, and
assets affect ROI.
McGrawHill/Irwin
12-45
Return on Investment (ROI) Formula

Income
Incomebefore
before interest
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.
McGrawHill/Irwin
12-46
Net Book Value vs. 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
McGrawHill/Irwin
12-47
Understanding ROI

ROI =
Margin =
Sales
Sales
Turnover =
Average operating
assets
Turnover
ROI Margin
=
McGrawHill/Irwin
12-48
Increasing ROI
There are three ways to increase ROI . . .

Increase
Sales
McGrawHill/Irwin
Reduce
Expenses
Reduce
Assets
12-49
Increasing ROI An Example
Regal Company reports the following:

Sales
Operating expenses
$ 30,000
$ 200,000
$ 500,000
$ 470,000
WhatisRegalCompanysROI?
Turnover
ROI Margin
=
Sales
ROI = Net operating income
Sales
McGrawHill/Irwin
12-50
Increasing ROI An Example
Turnover
ROI Margin
=
Sales
Sales
ROI = $30,000 $500,000

$500,000
$200,000
ROI =6% 2.5 = 15%
McGrawHill/Irwin
12-51
Increasing Sales Without an Increase in Operating

Assets
Regale's manager was able to increase sales to
$600,000, while operating expenses increased to
$558,000.
Regale's net operating income increased to $42,000.
There was no change in the average operating assets
of the segment.
Lets calculate the new ROI.

McGrawHill/Irwin
12-52
Increasing Sales Without an Increase in Operating Assets
Turnover
ROI Margin
=
Sales
Sales
ROI = $42,000 $600,000

$600,000
$200,000
ROI =7% 3.0 = 21%
ROI
ROI increased
increased from
from 15%
15% to
to 21%.
21%.
McGrawHill/Irwin
12-53
Decreasing Operating Expenses with no Change in Sales or

Operating Assets
Assume that Regale's manager was able to

reduce operating expenses by $10,000, without
affecting sales or operating assets. This would
increase net operating income to $40,000.

Sales
Operating expenses
$ 40,000
$ 200,000
$ 500,000
$ 460,000

McGrawHill/Irwin
12-54
Decreasing Operating Expenses with no Change in Sales or

Operating Assets
Turnover
ROI Margin
=
Sales
Sales
ROI = $40,000 $500,000

$500,000
$200,000
ROI =8% 2.5 = 20%
ROI
ROI increased
increased from
from 15%
15% to
to 20%.
20%.
McGrawHill/Irwin
12-55
Decreasing Operating Assets with no

Change in Sales or Operating Expenses
Assume that Regale's manager was able to
reduce inventories by $20,000 using just-in-time
techniques, without affecting sales or operating
expenses.

Sales
Operating expenses
$ 30,000
$ 180,000
$ 500,000
$ 470,000

McGrawHill/Irwin
12-56
Decreasing Operating Assets with no

Change in Sales or Operating Expenses
Turnover
ROI Margin
=
Sales
Sales
ROI = $30,000 $500,000

$500,000
$180,000
ROI =6% 2.78 = 16.7%
ROI
ROI increased
increased from
from 15%
15% to
to 16.7%.
16.7%.
McGrawHill/Irwin
12-57
Investing in Operating Assets to Increase

Sales
Assume that Regale's manager invests in a
$30,000 piece of equipment that increases
sales by $35,000, while increasing operating
expenses by $15,000.

Sales
Operating expenses
$ 50,000
$ 230,000
$ 535,000
$ 485,000

McGrawHill/Irwin
12-58
Investing in Operating Assets to Increase

Sales
Turnover
ROI Margin
=
Sales
Sales
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%.
McGrawHill/Irwin
12-59
ROI and the Balanced Scorecard

It may not be obvious to managers how to increase
sales, decrease costs, and decrease investments in a
way that is consistent with the companys strategy. A
well constructed balanced scorecard can provide
managers with a road map that indicates how the
company intends to increase ROI.
Which internal business
process should be
improved?
Which customers should
be targeted and how will
they be attracted and
retained at a profit?
McGrawHill/Irwin
12-60
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.
McGrawHill/Irwin
12-61
Compute residual income

and understand its
strengths and
weaknesses.
McGrawHill/Irwin
12-62
Residual Income - Another Measure of

Performance
above some minimum
return on operating
assets
McGrawHill/Irwin
12-63
Calculating Residual Income
Residual
=
income
Net
operating income
Average
operating
assets
Minimum
required rate of
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.
McGrawHill/Irwin
12-64
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 to
to earn
earn aa return
return of
of
20%
20% on
on these
these assets.
assets.
In
In the
the current
current period,
period, the
the division
division
earns
earns $30,000.
$30,000.
Lets calculate residual income.

McGrawHill/Irwin
12-65
Residual Income An Example
Operating
Operating assets
assets
Required
Required rate
rate of
of return
return
Minimum
Minimum required
required return
return
$$100,000
100,000
20%
20%
$$ 20,000
20,000
Actual
Actual income
income
Minimum
Minimum required
requiredreturn
return
Residual
Residual income
income
McGrawHill/Irwin
$$ 30,000
30,000
(20,000)
(20,000)
$$ 10,000
10,000
12-66
Motivation and Residual Income
Residual income encourages managers to

make profitable investments that would
be rejected by managers using ROI.
McGrawHill/Irwin
12-67
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 divisions ROI?
a. 25%
b. 5%
c. 15%
d. 20%
McGrawHill/Irwin
12-68
Quick Check
company is 15%. What is the divisions ROI?
a. 25%
b. 5% ROI = NOI/Average operating assets
c. 15%
= $60,000/$300,000 = 20%
d. 20%
McGrawHill/Irwin
12-69
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
McGrawHill/Irwin
12-70
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
ROI = $78,000/$400,000 = 19.5%
b. No
This lowers the divisions ROI from

20.0% down to 19.5%.
McGrawHill/Irwin
12-71
Quick Check
The companys 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
McGrawHill/Irwin
12-72
Quick Check
The companys 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.
McGrawHill/Irwin
12-73
Quick Check
company is 15%. What is the divisions
residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
McGrawHill/Irwin
12-74
Quick Check
company is 15%. What is the divisions
residual income?
a. $240,000 Net operating income
$60,000
b. $ 45,000 Required return (15% of $300,000) (45,000)
Residual income
$15,000
c. $ 15,000
d. $ 51,000
McGrawHill/Irwin
12-75
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
McGrawHill/Irwin
12-76
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
operating income
$78,000
b. No Net
Required return (15% of $400,000)
(60,000)
Residual income
$18,000
Yields an increase of $3,000 in the residual income.
McGrawHill/Irwin
12-77
Divisional Comparisons and Residual

Income
The residual
income approach
has one major
disadvantage.
It cannot be used to
compare
performance of
divisions of
different sizes.
McGrawHill/Irwin
12-78
Zephyr, Inc. - Continued

Recall the following
information for the Retail
Division of Zephyr, Inc.
Assume the following

information for the Wholesale
Division of Zephyr, Inc.
Retail
Retail
$$ 100,000
100,000
20%
20%
$$ 20,000
20,000
Wholesale
Wholesale
$$ 1,000,000
1,000,000
20%
20%
$$ 200,000
200,000
Retail
Retail
Actual
$$ 30,000
Actual income
income
30,000
Minimum
(20,000)
Minimum required
required return
return
(20,000)
Residual
$$ 10,000
Residual income
income
10,000
Wholesale
Wholesale
$$ 220,000
220,000
(200,000)
(200,000)
$$
20,000
20,000
Operating
Operating assets
assets
Required
Required rate
rate of
ofreturn
return
Minimum
Minimum required
required return
return
McGrawHill/Irwin
12-79
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 Divisions residual income is larger than the
Retail Division simply because it is a bigger division.
Retail
Retail
$$ 100,000
100,000
20%
20%
$$ 20,000
20,000
Wholesale
Wholesale
$$ 1,000,000
1,000,000
20%
20%
$$ 200,000
200,000
Retail
Retail
Actual
$$ 30,000
Actual income
income
30,000
Minimum
(20,000)
Minimum required
required return
return
(20,000)
Residual
$$ 10,000
Residual income
income
10,000
Wholesale
Wholesale
$$ 220,000
220,000
(200,000)
(200,000)
$$
20,000
20,000
Operating
Operating assets
assets
Required
Required rate
rate of
ofreturn
return
Minimum
Minimum required
required return
return
McGrawHill/Irwin
Transfer Pricing
Appendix 12A
McGrawHill/Irwin
12-81
Key Concepts/Definitions
A transfer price is the price
charged when one segment of
a company provides goods or
services to another segment of
the company.
The fundamental objective in
setting transfer prices is to
motivate managers to act in the
best interests of the overall
company.
McGrawHill/Irwin
12-82
Three Primary Approaches
There are three primary

approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.
McGrawHill/Irwin
12-83
Determine the range, if

any, within which a
negotiated transfer price
should fall.
McGrawHill/Irwin
12-84
Negotiated Transfer Prices

A negotiated transfer price results from discussions
between the selling and buying divisions.
Advantages of negotiated transfer prices:
1.
They preserve the autonomy of the

divisions, which is consistent with
the spirit of decentralization.
2.
The managers negotiating the

transfer price are likely to have much
better information about the potential
costs and benefits of the transfer
than others in the company.
McGrawHill/Irwin
Range of Acceptable
Transfer Prices
Upper limit is
determined by the
buying division.
Lower limit is
determined by the
selling division.
12-85
Harris and Louder An Example

Assume the information as shown with respect
to Imperial Beverages and Pizza Maven (both
companies are owned by Harris and Louder).
Imperial Beverages:
Ginger beer production capactiy per month
Variable cost per barrel of ginger beer
Fixed costs per month
Selling price of Imperial Beverages ginger beer
on the outside market
Pizza Maven:
Purchase price of regular brand of ginger beer
Monthly comsumption of ginger beer
McGrawHill/Irwin
10,000 barrels
8 per barrel
70,000
20 per barrel
18 per barrel
2,000 barrels
12-86

The selling divisions (Imperial Beverages) lowest acceptable transfer
price is calculated as:
Transfer Price
Variable cost
Total contribution margin on lost sales
+
per unit
Number of units transferred
Lets calculate the lowest and highest acceptable

transfer prices under three scenarios.
The buying divisions (Pizza Maven) highest acceptable transfer price is
calculated as:
Transfer Price Cost of buying from outside supplier

If an outside supplier does not exist, the highest acceptable transfer price
is calculated as:
Transfer Price Profit to be earned per unit sold (not including the transfer price)
McGrawHill/Irwin
12-87

If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy
Pizza Mavens demands (2,000 barrels), without sacrificing sales to other
customers, then the lowest and highest possible transfer prices are
computed as follows:
Selling divisions lowest possible transfer price:
Transfer Price 8 +
0
= 8
2,000
Buying divisions highest possible transfer price:
= 18
Therefore, the range of acceptable

transfer price is 8 18.
McGrawHill/Irwin
12-88

If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice other
customer orders (2,000 barrels) to meet Pizza Mavens demands (2,000
barrels), then the lowest and highest possible transfer prices are computed
as follows:
( 20 - 8) 2,000
Transfer Price 8 +
= 20
2,000
= 18
Therefore, there is no range of

acceptable transfer prices.
McGrawHill/Irwin
12-89

If Imperial Beverages has some idle capacity (1,000 barrels) and must
sacrifice other customer orders (1,000 barrels) to meet Pizza Mavens
demands (2,000 barrels), then the lowest and highest possible transfer prices
are computed as follows:
( 20 - 8) 1,000
Transfer Price 8 +
= 14
2,000
= 18
Therefore, the range of acceptable

transfer price is 14 18.
McGrawHill/Irwin
12-90
Evaluation of Negotiated Transfer Prices

If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices within which
both the selling and buying divisions would
have higher profits if they agree to the transfer.
If managers are pitted against each other

rather than against their past performance or
reasonable benchmarks, a no cooperative
atmosphere is almost guaranteed.
Given the disputes that often accompany the

negotiation process, most companies rely on
some other means of setting transfer prices.
McGrawHill/Irwin
12-91
Transfers at the Cost to the Selling Division

Many companies set transfer prices at either
the variable cost or full (absorption) cost
incurred by the selling division.
Drawbacks of this approach include:
1. Using full cost as a transfer price
and can lead to suboptimization.
2. The selling division will never
show a profit on any internal
transfer.
3. Cost-based transfer prices do not
provide incentives to control
costs.
McGrawHill/Irwin
12-92
Transfers at Market Price

A market price (i.e., the price charged for an
item on the open market) is often regarded as
the best approach to the transfer pricing
problem.
1. A market price approach works
best when the product or service
is sold in its present form to
outside customers and the
selling division has no idle
capacity.
2. A market price approach does
not work well when the selling
division has idle capacity.
McGrawHill/Irwin
12-93
Divisional Autonomy and Sub optimization

The principles of
decentralization suggest
that companies should
grant managers autonomy
to set transfer prices and
to decide whether to sell
internally or externally,
even if this may
occasionally result in
suboptimal decisions.
This way top management
allows subordinates to
control their own destiny.
McGrawHill/Irwin
12-94
International Aspects of Transfer Pricing

Transfer Pricing
Objectives
Domestic
Greater divisional autonomy
Greater motivation for managers
Better performance evaluation
Better goal congruence
McGrawHill/Irwin
International
Less taxes, duties, and tariffs
Less foreign exchange risks
Better competitive position
Better governmental relations
Service Department Charges
Appendix 12B
McGrawHill/Irwin
12-96
Charge operating
departments for services
provided by service
departments.
McGrawHill/Irwin
12-97
Service Department Charges
Operating
Departments
Service
Departments
Carry out central

purposes of
organization.
Do not directly
engage in
operating
activities.
McGrawHill/Irwin
Reasons for Charging Service Department

Costs
12-98
Service department costs are charged to operating

departments for a variety of reasons including:
To
To encourage
encourage
operating
operating departments
departments
to
to wisely
wisely use
use service
service
department
department resources.
resources.
To
To provide
provide operating
operating
departments
departments with
with
more
more complete
complete cost
cost
data
data for
for making
making
decisions.
decisions.
To
To help
help measure
measure the
the
profitability
profitability of
of
operating
operating
departments.
departments.
To
To create
create an
an incentive
incentive
for
for service
service
departments
departments to
to
operate
operate efficiently
efficiently
McGrawHill/Irwin
12-99
Transfer Prices
The
The service
service department
department charges
charges
considered
considered in
in this
this appendix
appendix can
can be
be
viewed
viewed as
as aa transfer
transfer price
price that
that is
is
charged
charged for
for services
services provided
provided by
by
service
service departments
departments to
to operating
operating
departments.
departments.
Service
Departments
McGrawHill/Irwin
Operating
Departments
12-100
Charging Costs by Behavior
Whenever possible,
variable and fixed
service department costs
should be charged
separately.
McGrawHill/Irwin
12-101
Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.
McGrawHill/Irwin
12-102

Charge
Charge fixed
fixed service
service department
department costs
costs to
to
consuming
consuming departments
departments in
in predetermined
predetermined
lump-sum
lump-sum amounts
amounts that
that are
are based
based on
on the
the
consuming
consuming departments
departments peak-period
peak-period or
or
long-run
long-run average
average servicing
servicing needs.
needs.
Are based on amounts of
capacity each consuming
department requires.
McGrawHill/Irwin
Should not vary from

period to period.
12-103
Should Actual or Budgeted Costs Be

Charged?
Budgeted variable
and fixed service department
costs should be charged to
operating departments.
McGrawHill/Irwin
12-104
Sipco: An Example
Sipco has a maintenance department and two operating
departments: cutting and assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixed
maintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:
Operating
Departments
Cutting
Assembly
Total hours
Percent of
Peak-Period
Capacity
Required
60%
40%
100%
Hours
Planned
75,000
50,000
125,000
Hours
Used
80,000
40,000
120,000
Allocate maintenance costs to the two operating departments.

McGrawHill/Irwin
12-105
Sipco: Beginning of the Year
Hours planned
McGrawHill/Irwin
12-106
Sipco: Beginning of the Year
Hours planned
Cutting
Department
Variable cost allocation:
$0.60 75,000 hours
$0.60 50,000 hours
Fixed cost allocation:
60% of $200,000
40% of $200,000
Total allocated cost
Assembly
Department
45,000
$
30,000
80,000
110,000
120,000
$
165,000
Percent of peak-period capacity.

McGrawHill/Irwin
12-107
Quick Check
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:
Hospitals
Mercy
Northside
Total
McGrawHill/Irwin
Percent of
Peak-Period
Capacity
Required
45%
55%
100%
Miles
Planned
15,000
17,000
32,000
Miles
Used
16,000
17,500
33,500
12-108
Quick Check
How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the beginning
beginning
of
of the
the year?
year?
a.
a. $117,000
$117,000
b.
b. $254,400
$254,400
c.
c. $114,480
$114,480
d.
d. $119,250
$119,250
McGrawHill/Irwin
12-109
Quick Check
How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the beginning
beginning
of
of the
the year?
year?
a.
a. $117,000
$117,000
b.
b. $254,400
$254,400
Mercy
Northside
Variable
cost allocation:
c.
$114,480
c.
$114,480
$4.20 15,000 miles
$
63,000
d.
$4.20 17,000 miles
$
71,400
d. $119,250
$119,250
Fixed cost allocation
45% of $120,000
55% of $120,000
Total allocated cost
McGrawHill/Irwin
54,000
$
117,000
66,000
137,400
12-110
Pitfalls in Allocating Fixed Costs
Pitfall 1
Allocating fixed
costs using a variable
allocation base
McGrawHill/Irwin
Result
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.
12-111
Colby Products: An Example

Colby
Colby Products
Products has
has two
two sales
sales territories,
territories,
the
the Eastern
Eastern Territory
Territory and
and the
the Western
Western Territory.
Territory.
Both
Both sales
sales territories
territories are
are serviced
serviced by
by one
one auto
auto
service
service center,
center, whose
whose costs
costs are
are all
all fixed.
fixed. Contrary
Contrary
to
to good
good practice,
practice, Colby
Colby allocates
allocates the
the fixed
fixed service
service
center
center costs
costs to
to the
the sales
sales territories
territories on
on the
the basis
basis
of
of actual
actual miles
miles driven
driven (a
(a variable
variable base).
base).
McGrawHill/Irwin
12-112
Colby Products: An Example

Year 1
$ 120,000
Year 2
$ 120,000
Miles driven
Western sales territory
Eastern sales territory
1,500,000
1,500,000
1,500,000
900,000
Total miles driven
3,000,000
2,400,000
Auto service center costs (all fixed)
Allocation rate per mile
0.04
0.05
$120,000 3,000,000 miles

$120,000 2,400,000 miles
McGrawHill/Irwin
Colby Products:
Firstyear Allocations
12-113
Western
Western sales
salesterritory
territory
1,500,000
1,500,000 miles
miles @
@ $0.04
$0.04 per
per mile
mile
Eastern
Eastern sales
salesterritory
territory
1,500,000
1,500,000 miles
miles @
@ $0.04
$0.04 per
per mile
mile
Total
Total cost
cost allocated
allocated
$$
60,000
60,000
60,000
60,000
$$ 120,000
120,000
The two sales territories share the service

centers costs equally because the miles
driven in each territory are equal.
McGrawHill/Irwin
Colby Products:
Secondyear Allocation
12-114
Western
Western sales
salesterritory
territory
1,500,000
1,500,000 miles
miles @
@ $0.05
$0.05 per
per mile
mile
Eastern
Eastern sales
salesterritory
territory
900,000
900,000 miles
miles @
@ $0.05
$0.05 per
per mile
mile
Total
Total cost
cost allocated
allocated
$$
75,000
75,000
45,000
45,000
$$ 120,000
120,000
Western territory has the same number of miles as

last year, but $15,000 more cost is allocated
because Eastern's miles declined in year 2.
McGrawHill/Irwin
12-115
Pitfalls in Allocating Fixed Costs
Pitfall 2
Using sales
dollars as an
allocation base
Result
Sales of one department
influence the service
department costs
allocated to other
departments.
McGrawHill/Irwin
12-116
Clothier Inc. An Example

Clothier
Clothier Inc.,
Inc., aa mens
mens clothing
clothing store,
store, has
has one
one
service
service department
department and
and three
three sales
sales departments,
departments,
Suits,
Suits, Shoes,
Shoes, and
and Accessories.
Accessories. Service
Service department
department
costs
costs total
total $60,000
$60,000 for
for both
both years
years in
in the
the example.
example.
Contrary
Contrary to
to good
good practice,
practice, Clothier
Clothier allocates
allocates the
the
service
service department
department costs
costs based
based on
on sales.
sales.
McGrawHill/Irwin
12-117
Clothier Inc. First-year Allocation
Suits
Sales by department
$ 260,000
Percentage of total sales
65%
Allocation of service
department costs
$
39,000
$260,000 $400,000
Departments
Shoes
$
40,000
10%
$
6,000
Accessories
$ 100,000
25%
$
15,000
Total
$ 400,000
100%
$
60,000
65% of $60,000
In
In the
the next
next year,
year, the
the manager
manager of
of the
the Suit
Suit Department
Department
increases
increases sales
sales by
by $100,000.
$100,000. Sales
Sales in
in the
the other
other departments
departments
are
are unchanged.
unchanged. Lets
Lets allocate
allocate the
the $60,000
$60,000 service
service department
department
cost
cost for
for the
the second
second year
year given
given the
the sales
sales increase.
increase.
McGrawHill/Irwin
12-118
Clothier Inc. Second-year Allocation
Suits
Sales by department
$ 360,000
Percentage of total sales
72%
Allocation of service
department costs
$
43,200
$360,000 $500,000
Departments
Shoes
$
40,000
8%
$
4,800
Accessories
$ 100,000
20%
$
12,000
Total
$ 500,000
100%
$
60,000
72% of $60,000
IfIf you
you were
were the
the suit
suit department
department manager,
manager, would
would
you
you be
be happy
happy with
with the
the increased
increased service
service department
department
costs
costs allocated
allocated to
to your
your department?
department?
McGrawHill/Irwin
12-119
End of Chapter 12
McGrawHill/Irwin

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Segment Reporting and

Cost, Profit, and Investments Centers

Superior Foods Corporation provides an example of the

Superior Foods Corporation provides an example of the

Superior Foods Corporation provides an example of the

A segment is any part

Superior Foods: Geographic Regions

Superior Foods Corporation could segment its business

Superior Foods: Customer Channel

Superior Foods Corporation could segment its business

Keys to Segmented Income Statements

Identifying Traceable Fixed Costs

Identifying Common Fixed Costs

Traceable Costs Can Become

It is important to realize that the traceable

The segment margin, which is computed by subtracting

Traceable and Common Costs

Levels of Segmented Statements

Webber, Inc. has two divisions.

Levels of Segmented Statements

Levels of Segmented Statements

Levels of Segmented Statements

Levels of Segmented Statements

Traceable Costs Can Become

As previously mentioned, fixed costs that

Lets see how this works

Traceable Costs Can Become

Traceable Costs Can Become

We obtained the following information from

Traceable Costs Can Become

Companies must report segmented

Since the contribution approach to

Inappropriate Methods of Allocating Costs

Common Costs and Segments

Assume that Hoagland's Lakeshore prepared its

A common fixed cost cannot be

Allocations of Common Costs

Hurray, now everything adds up!!!

eliminating the bar. If we eliminate

Return on Investment (ROI) Formula

Net operating income

Net Book Value vs. Gross Cost

Net operating income

There are three ways to increase ROI . . .

Increasing ROI An Example

Regal Company reports the following:

Increasing ROI An Example

ROI = $30,000 $500,000

Increasing Sales Without an Increase in Operating

Lets calculate the new ROI.

Increasing Sales Without an Increase in Operating Assets

ROI = $42,000 $600,000

Decreasing Operating Expenses with no Change in Sales or

Assume that Regale's manager was able to

Regal Company reports the following:

Lets calculate the new ROI.

Decreasing Operating Expenses with no Change in Sales or

ROI = $40,000 $500,000

Decreasing Operating Assets with no

Regal Company reports the following:

Lets calculate the new ROI.

Decreasing Operating Assets with no

ROI = $30,000 $500,000

Investing in Operating Assets to Increase