Chapter 12 Controller Ship
Transcript of Chapter 12 Controller Ship
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11th EditionChapter 12
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Segment Reporting andDecentralization
Chapter Twelve
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Decentralization in Organizations
Benefits of
DecentralizationTop management
freed to concentrateon strategy.
Top managementfreed to concentrate
on strategy.
Lower-level managersgain experience indecision-making.
Lower-level managersgain experience indecision-making.
Decision-makingauthority leads tojob satisfaction.
Decision-makingauthority leads tojob satisfaction.
Lower-level decisionoften based on
better information.
Lower-level decisionoften based onbetter information.
Lower level managerscan respond quickly
to customers.
Lower level managerscan respond quickly
to customers.
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Decentralization in Organizations
Disadvantages of
Decentralization
Lower-level managersmay make decisionswithout seeing the
big picture.
Lower-level managersmay make decisions
without seeing thebig picture.
May be a lack ofcoordination among
autonomousmanagers.
May be a lack ofcoordination among
autonomousmanagers.
Lower-level managers
objectives may notbe those of theorganization.
Lower-level managers
objectives may notbe those of theorganization. May be difficult to
spread innovative ideasin the organization.
May be difficult tospread innovative ideas
in the organization.
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Cost, Profit, and Investments Centers
Responsibility
Center
Responsibility
Center
CostCenter
CostCenter
ProfitCenter
ProfitCenter
InvestmentCenter
InvestmentCenter
Cost, profit,
and investmentcenters areallknown asresponsibility
centers.
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Cost, Profit, and Investments Centers
Cost Center
A segment whosemanager has control
over costs,
but not over revenuesor investment funds.
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Cost, Profit, and Investments Centers
Profit Center
A segment whosemanager has controloverbothcosts and
revenues,
but no control overinvestment funds.
Revenues
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Other
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Cost, Profit, and Investments Centers
Investment Center
A segment whosemanager has controlover costs, revenues,
and investments inoperating assets.
Corporate Headquarters
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Responsibility Centers
S a l t y S nP r o d u c t
B o t t l i nM a n a
W a r e hM a n a
D i s t r i bM a n a
B e v e r aP r o d u c t
C o n f e cP r o d u c t
O p e r a t i oV i c e P r e s
F i n a n c eC h i e f F I n a n
L e g a lG e n e r a l C
P e r s o n nV i c e P r e s
S u p e r i o r F o oC o r p o r a t e H e
P r e s i d e n t a
Cost
Centers
InvestmentCenters
Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an
organization.
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Responsibility Centers
S a l t y S nP r o d u c t
B o t t l i nM a n a
W a r e hM a n a
D i s t r i bM a n a
B e v e r aP r o d u c t
C o n f e cP r o d u c t
O p e r a t i oV i c e P r e s
F i n a n c eC h i e f F I n a n
L e g a lG e n e r a l C
P e r s o n nV i c e P r e s
S u p e r i o r F o oC o r p o r a t e H e
P r e s i d e n t a
Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an
organization.
Profit
Centers
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Responsibility Centers
S a l t y S nP r o d u c t
B o t t l i nM a n a
W a r e hM a n a
D i s t r i bM a n a
B e v e r aP r o d u c t
C o n f e cP r o d u c t
O p e r a t i oV i c e P r e s
F i n a n c eC h i e f F I n a n
L e g a lG e n e r a l C
P e r s o n nV i c e P r e s
S u p e r i o r F o oC o r p o r a t e H e
P r e s i d e n t a
Cost
Centers
Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an
organization.
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Decentralization and Segment Reporting
Asegmentsegmentis any partor activity of an
organization about
which a managerseeks cost, revenue,
or profit data. A
segment can be . . .
Quick MartQuick Mart
An Individual Store
A Sales Territory
A Service Center
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Superior Foods: Geographic Regions
E a s t
$ 7 5 , 0 0 0
O r e g o$ 4 5 , 0 0 0
W a s h i n$ 5 0 , 0 0 0
C a l i f o r $ 1 2 0 , 0 0
M o u n t a i$ 8 5 , 0 0 0
W e s t
$ 3 0 0 , 0 0
M i d w e
$ 5 5 , 0 0 0
S o u t h
$ 7 0 , 0 0 0
S u p e r i o r F o o d$ 5 0 0 , 0 0 0 , 0
Superior Foods Corporation could segment its businessby geographic regions.
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Keys to Segmented Income Statements
There are two keys to buildingsegmented income statements:
A contribution format should be used because itseparates 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 ofa segment margin.
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Identifying Traceable Fixed Costs
Traceable costsarise because of the existence of aparticular segment and would disappear over time if the
segment itself disappeared.
No computerNo computerdivision means . . .division means . . .
No computerNo computerdivision manager.division manager.
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Identifying Common Fixed Costs
Common costsarise because of the overalloperation of the company and would not disappear
if any particular segment were eliminated.
No computerNo computerdivision but . . .division but . . .
We still have aWe still have acompany president.company president.
T bl C t C B C
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Traceable Costs Can Become CommonCosts
It is important to realize that the traceablefixed costs of one segment may be a
common fixed cost of another segment.
For example, the landing feepaid to land an airplane at an
airport is traceable to the
particular flight, but it is nottraceable to first-class,
business-class, andeconomy-class passengers.
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Segment Margin
The segment marginsegment margin, which is computed by subtractingthe traceable fixed costs of a segment from its
contribution margin, is the best gaugebest gaugeof the long-runprofitability of a segment.
TimeTime
Pro
fit
s
Pro
fit
s
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Traceable and Common Costs
FixedCosts
TraceableTraceable CommonCommon
Dont allocateDont allocate
common costs tocommon costs to
segments.segments.
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Activity-Based Costing
9-inch 12-inch 18-inch Tota l
W a re house sq. ft. 1,000 4,000 5,000 10,000
Le a se price pe r sq. ft. 4$ 4$ 4$ 4$
Tota l le a se cost 4,000$ 16,000$ 20,000$ 40,000$
Pipe Products
Activity-based costing can help identify how costsshared 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 $4 per squarefoot.
If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 squarefeet, respectively, then ABC can be used to trace the warehousing costs to the
three products as shown.
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Levels of Segmented Statements
Lets look more closely at the TelevisionDivisions income statement.
Lets look more closely at the TelevisionDivisions income statement.
Webber, Inc. has two divisions.
C o m p u t e r T e l e v i s i o n
W e b b e r ,
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Levels of Segmented Statements
Our approach to segment reporting uses thecontribution format.
Income Statement
Contribution Margin Format
Television Division
Sales 300,000$
Variable COGS 120,000
Other variable costs 30,000
Total variable costs 150,000Contribution margin 150,000
Traceable fixed costs 90,000
Division margin 60,000$
Cost of goodssold consists of
variablemanufacturing
costs.
Cost of goodssold consists of
variablemanufacturing
costs.
Fixed andvariable costsare listed in
separatesections.
Fixed andvariable costsare listed in
separatesections.
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Levels of Segmented Statements
Segment marginis Televisions
contributionto profits.
Segment marginis Televisions
contributionto profits.
Our approach to segment reporting uses thecontribution format.
Income Statement
Contribution Margin Format
Television Division
Sales 300,000$
Variable COGS 120,000
Other variable costs 30,000
Total variable costs 150,000Contribution margin 150,000
Traceable fixed costs 90,000
Division margin 60,000$
Contribution margin
is computed bytaking sales minus
variable costs.
Contribution margin
is computed bytaking sales minus
variable costs.
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Levels of Segmented Statements
Income Statement
Company Television Computer
Sales 500,000$ 300,000$ 200,000$
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000Traceable FC 170,000 90,000 80,000
Division margin 100,000 60,000$ 40,000$
Common costs
Net operatingincome
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Levels of Segmented Statements
Income Statement
Company Television Computer
Sales 500,000$ 300,000$ 200,000$
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000Traceable FC 170,000 90,000 80,000
Division margin 100,000 60,000$ 40,000$
Common costs 25,000
Net operatingincome 75,000$
Common costs should not
be allocated to thedivisions. These costs
would remain even if oneof the divisions were
eliminated.
Common costs should not
be allocated to thedivisions. These costs
would remain even if oneof the divisions were
eliminated.
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Traceable Costs Can Become Common Costs
As previously mentioned, fixed costs that aretraceable to one segment can become commonif the company is divided intosmallersmallersegments.
Lets see how this works
using the Webber Inc.example!
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Traceable Costs Can Become Common Costs
ProductProduct
LinesLines
Webbers Television Division
Regular Big Screen
Television
Division
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Traceable Costs Can Become Common Costs
We obtained the following information fromthe Regular and Big Screen segments.
Income StatementTelevision
Division Regular Big Screen
Sales 200,000$ 100,000$
Variable costs 95,000 55,000
CM 105,000 45,000Traceable FC 45,000 35,000
Product line margin 60,000$ 10,000$
Common costs
Divisional margin
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Income StatementTelevision
Division Regular Big Screen
Sales 300,000$ 200,000$ 100,000$
Variable costs 150,000 95,000 55,000
CM 150,000 105,000 45,000Traceable FC 80,000 45,000 35,000
Product line margin 70,000 60,000$ 10,000$
Common costs 10,000
Divisional margin 60,000$
Traceable Costs Can Become Common Costs
Fixed costs directly tracedto the Television Division
$80,000 + $10,000 = $90,000
Fixed costs directly tracedto the Television Division
$80,000 + $10,000 = $90,000
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External Reports
The Financial Accounting Standards Board now requiresthat companies in the United States include segmented
financial data in their annual reports.
1. Companies must report segmentedresults to shareholders using the samemethods that are used for internalsegmented reports.
2. Since the contribution approach to
segment reporting does not complywith GAAP, it is likely that somemanagers will choose to constructtheir segmented financial statementsusing the absorption approach tocomply with GAAP.
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Omission of Costs
Costs assigned to a segment should include allcosts attributable to that segment from thecompanys entirevalue chainvalue chain.
Product CustomerR&D Design Manufacturing Marketing Distribution Service
Business FunctionsBusiness Functions
Making Up TheMaking Up The
Value ChainValue Chain
Inappropriate Methods of Allocating Costs Among
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Inappropriate Methods of Allocating Costs AmongSegments
Segment1
Segment3
Segment4
Inappropriateallocation base
Segment2
Failure to tracecosts directly
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Common Costs and Segments
Segment1
Segment3
Segment4
Segment2
Common costs should not be arbitrarily allocated to segmentsbased on the rationale that someone has to cover the
common costs for two reasons:
1. This practice may make a profitable business segment appearto be unprofitable.
2. Allocating common fixed costs forces managers to be heldaccountable for costs they cannot control.
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Income StatementHaglund's
Lakeshore Bar Restaurant
Sales 800,000$ 100,000$ 700,000$
Variable costs 310,000 60,000 250,000CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 14,000$ 230,000$
Common costs 200,000
Profit 44,000$
Allocations of Common Costs
Assume that Haglunds Lakeshore prepared thesegmented income statement as shown.
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Quick Check
How much of the common fixed cost of $200,000can be avoided by eliminating the bar?
a. None of it.
b. Some of it.c. All of it.
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Quick Check
How much of the common fixed cost of $200,000can be avoided by eliminating the bar?
a. None of it.
b. Some of it.c. All of it.
A common fixed cost cannot beeliminated by dropping one of
the segments.
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Quick Check
Suppose square feet is used as the basis forallocating the common fixed cost of $200,000. Howmuch would be allocated to the bar if the baroccupies 1,000 square feet and the restaurant9,000 square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000
Q i k Ch k
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Quick Check
Suppose square feet is used as the basis forallocating the common fixed cost of $200,000. Howmuch would be allocated to the bar if the baroccupies 1,000 square feet and the restaurant9,000 square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000
The bar would be allocated
1/10 of the cost or $20,000.
Q i k Ch k
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Quick Check
If Haglunds allocates its commoncosts to the bar and the restaurant,what would be the reported profit of
each segment?
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Income StatementHaglund's
Lakeshore Bar Restaurant
Sales 800,000$ 100,000$ 700,000$
Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000Traceable FC 246,000 26,000 220,000
Segment margin 244,000 14,000 230,000
Common costs 200,000 20,000 180,000
Profit 44,000$ (6,000)$ 50,000$
Allocations of Common Costs
Hurray, now everything adds up!!!
Q i k Ch k
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Quick Check
Should the bar be eliminated?
a. Yes
b. No
Q i k Ch k
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Should the bar be eliminated?
a. Yes
b. No
Quick Check
Income Statement
Haglund's
Lakeshore Bar Restaurant
Sales 700,000$ 700,000$
Variable costs 250,000 250,000CM 450,000 450,000
Traceable FC 220,000 220,000
Segment margin 230,000 230,000
Common costs 200,000 200,000
Profit 30,000$ 30,000$
The profit was $44,000 beforeeliminating the bar. If we eliminate
the bar, profit drops to $30,000!
R t I t t (ROI) F l
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Return on Investment (ROI) Formula
ROI =ROI = Net operating incomeNet operating incomeAverage operating assetsAverage operating assets
Cash, accounts receivable, inventory,plant and equipment, and other
productive assets.
Cash, accounts receivable, inventory,plant and equipment, and other
productive assets.
Income before interestand taxes (EBIT)
Income before interestand taxes (EBIT)
N t B k V l G C t
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Net Book Value vs. Gross Cost
Most companies use the net book value ofdepreciable assets to calculate average
operating assets.
Acquisition cost
Less: Accumulated depreciation
Net book value
R t I t t (ROI) F l
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Return on Investment (ROI) Formula
ROI =ROI =Net operating incomeNet operating income
Average operating assetsAverage operating assets
Margin =Margin =Net operating incomeNet operating incomeSalesSales
Turnover =Turnover =SalesSales
Average operating assetAverage operating asset
ROI =ROI =MarginMargin TurnoverTurnover
I i ROI
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Increasing ROI
There are three ways to increase ROI . . .There are three ways to increase ROI . . .
IncreaseIncrease
SalesSales
ReduceReduce
ExpensesExpensesReduceReduce
AssetsAssets
I i ROI A E l
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Increasing ROI An Example
Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000
Average operating assets $ 200,000Average operating assets $ 200,000
Sales $ 500,000Sales $ 500,000Operating expenses $ 470,000Operating expenses $ 470,000
ROI =ROI =MarginMargin TurnoverTurnoverNet operating income
SalesSales
Average operating assetsROI =
What is Regal Companys ROI?
I i ROI A E l
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Increasing ROI An Example
$30,000$500,000
$500,000$200,000
ROI =
6%6% 2.5 = 15%2.5 = 15%ROI =
ROI =ROI =MarginMargin TurnoverTurnoverNet operating income
SalesSales
Average operating assetsROI =
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Increasing Sales Without an Increase in
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Increasing Sales Without an Increase inOperating Assets
$42,000$600,000
$600,000$200,000
ROI =
7%7% 3.0 = 21%3.0 = 21%ROI =
ROI increased from 15% to 21%.ROI increased from 15% to 21%.
ROI =ROI =MarginMargin TurnoverTurnoverNet operating income
SalesSales
Average operating assetsROI =
Decreasing Operating Expenses with no
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Decreasing Operating Expenses with noChange in Sales or Operating Assets
Assume that Regals manager was able to reduceoperating expenses by $10,000 withoutaffecting sales or operating assets. This would
increase net operating income to $40,000.
Lets calculate the new ROI.Lets calculate the new ROI.
Regal Company reports the following:Regal Company reports the following:
Net operating income $ 40,000Net operating income $ 40,000
Average operating assets $ 200,000Average operating assets $ 200,000
Sales $ 500,000Sales $ 500,000
Operating expenses $ 460,000Operating expenses $ 460,000
Decreasing Operating Expenses with no
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Decreasing Operating Expenses with noChange in Sales or Operating Assets
$40,000$500,000
$500,000$200,000
ROI =
8%8% 2.5 = 20%2.5 = 20%ROI =
ROI increased from 15% to 20%.ROI increased from 15% to 20%.
ROI =ROI =MarginMargin TurnoverTurnoverNet operating income
SalesSales
Average operating assetsROI =
Decreasing Operating Assets with no
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Decreasing Operating Assets with noChange in Sales or Operating Expenses
Assume that Regals manager was able to reduceinventories by $20,000 using just-in-timetechniques without affecting sales or operating
expenses.
Lets calculate the new ROI.Lets calculate the new ROI.
Regal Company reports the following:Regal Company reports the following:
Net operating income $ 30,000Net operating income $ 30,000
Average operating assets $ 180,000Average operating assets $ 180,000
Sales $ 500,000Sales $ 500,000
Operating expenses $ 470,000Operating expenses $ 470,000
Decreasing Operating Assets with no
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Decreasing Operating Assets with noChange in Sales or Operating Expenses
$30,000$500,000
$500,000$180,000
ROI =
6%6% 2.77 = 16.7%2.77 = 16.7%ROI =
ROI increased from 15% to 16.7%.ROI increased from 15% to 16.7%.
ROI =ROI =MarginMargin TurnoverTurnoverNet operating income
SalesSales
Average operating assetsROI =
Investing in Operating Assets to
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Investing in Operating Assets toIncrease Sales
Assume that Regals manager invests in a$30,000 piece of equipment that increasessales by $35,000 while increasing operating
expenses by $15,000.
Lets calculate the new ROI.Lets calculate the new ROI.
Regal Company reports the following:Regal Company reports the following:
Net operating income $ 50,000Net operating income $ 50,000
Average operating assets $ 230,000Average operating assets $ 230,000
Sales $ 535,000Sales $ 535,000
Operating expenses $ 485,000Operating expenses $ 485,000
Investing in Operating Assets to
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est g Ope at g ssets toIncrease Sales
$50,000$535,000
$535,000$230,000
ROI =
9.35%9.35% 2.33 = 21.8%2.33 = 21.8%ROI =
ROI increased from 15% to 21.8%.ROI increased from 15% to 21.8%.
ROI =ROI =MarginMargin TurnoverTurnoverNet operating income
SalesSales
Average operating assetsROI =
ROI and the Balanced Scorecard
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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 constructedbalanced scorecard can provide managers with a road map that
indicates how the company intends to increase ROI.
Which internal businessprocess should be
improved?
Which customers shouldbe targeted and how will
they be attracted and
retained at a profit?
Criticisms of ROI
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Criticisms of ROI
In the absence of the balancedscorecard, management may
not know how to increase ROI.
Managers often inherit manycommitted costs over whichthey have no control.
Managers evaluated on ROI
may reject profitableinvestment opportunities.
Residual Income - Another Measure of
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Performance
Net operating incomeabove some minimum
return on operatingassets
Calculating Residual Income
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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 relativeto the investment in average operating assets.
Residual income measures net operating incomeearned less the minimum required return on average
operating assets.
Residual Income An Example
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Residual Income An Example
The Retail Division of Zepher, Inc. has averageoperating assets of $100,000 and is required toearn a return of 20% on these assets.
In the current period the division earns $30,000.
Lets calculate residual income.Lets calculate residual income.
Residual Income An Example
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Residual Income An Example
Operating assets 100,000$
Required rate of return 20%
Minimum required return 20,000$
Actua l incom e 30,000$
Minim um required return (20,000)
Re sidua l incom e 10,000$
Motivation and Residual Income
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Motivation and Residual Income
Residual income encourages managers toResidual income encourages managers tomake profitable investments that wouldmake profitable investments that would
be rejected by managers using ROI.be rejected by managers using ROI.
Quick Check
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Quick Check
Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of
$300,000. The required rate of return for thecompany is 15%. What is the divisions ROI?
a. 25%
b. 5%c. 15%
d. 20%
Quick Check
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Quick Check
Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of
$300,000. The required rate of return for thecompany is 15%. What is the divisions ROI?
a. 25%
b. 5%c. 15%
d. 20%
ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%
Quick Check
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Quick Check
Redmond Awnings, a division of Wrapup Corp., hasa net operating income of $60,000 and averageoperating assets of $300,000. If the manager of thedivision is evaluated based on ROI, will she want to
make an investment of $100,000 that wouldgenerate additional net operating income of$18,000 per year?
a. Yesb. No
Quick Check
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Quick Check
Redmond Awnings, a division of Wrapup Corp., hasa net operating income of $60,000 and averageoperating assets of $300,000. If the manager of thedivision is evaluated based on ROI, will she want to
make an investment of $100,000 that wouldgenerate additional net operating income of$18,000 per year?
a. Yesb. NoROI = $78,000/$400,000 = 19.5%
This lowers the divisions ROI from
20.0% down to 19.5%.
Quick Check
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Quick Check
The companys required rate of return is 15%.Would the company want the manager of theRedmond Awnings division to make an investmentof $100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No
Quick Check
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Quick Check
The companys required rate of return is 15%.Would the company want the manager of theRedmond Awnings division to make an investmentof $100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No ROI = $18,000/$100,000 = 18%
The return on the investment exceedsthe minimum required rate of return.
Quick Check
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Quick Check
Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of$300,000. The required rate of return for thecompany is 15%. What is the divisionsresidual income?
a. $240,000
b. $ 45,000c. $ 15,000
d. $ 51,000
Quick Check
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Quick Check
Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of$300,000. The required rate of return for thecompany is 15%. What is the divisionsresidual income?
a. $240,000
b. $ 45,000c. $ 15,000
d. $ 51,000
Net operating income $60,000Required return (15% of $300,000) $45,000
Residual income $15,000
Quick Check
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Quick Check
If the manager of the Redmond Awnings division isevaluated based on residual income, will she wantto make an investment of $100,000 that wouldgenerate additional net operating income of
$18,000 per year?
a. Yes
b. No
Quick Check
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Quick Check
If the manager of the Redmond Awnings division isevaluated based on residual income, will she wantto make an investment of $100,000 that wouldgenerate additional net operating income of
$18,000 per year?
a. Yes
b. No Net operating income $78,000
Required return (15% of $400,000) $60,000
Residual income $18,000This is an increase of $3,000 in the residual
income.
Divisional Comparisons and ResidualI
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Income
The residualincome approach
has one major
disadvantage.
It cannot be used tocompare
performance ofdivisions ofdifferent sizes.
Zepher, Inc. - Continued
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Zepher, Inc. Continued
Retail Wholesale
Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%
Minimum required return 20,000$ 200,000$
Retail Wholesale
Actual income 30,000$ 220,000$Minimum required return (20,000) (200,000)
Residual income 10,000$ 20,000$
Recall the followinginformation for the RetailDivision of Zepher, Inc.
Assume the followinginformation for the Wholesale
Division of Zepher, Inc.
Zepher, Inc. - Continued
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ep e , c Co t ued
Retail Wholesale
Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%
Minimum required return 20,000$ 200,000$
Retail Wholesale
Actual income 30,000$ 220,000$Minimum required return (20,000) (200,000)
Residual income 10,000$ 20,000$
The residual income numbers suggest that the Wholesale Division outperformed
the Retail Division because its residual income is $10,000 higher. However, theRetail Division earned an ROI of 30% compared to an ROI of 22% for the
Wholesale Division. The Wholesale Divisions residual income is larger than theRetail Division simply because it is a bigger division.
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Transfer Pricing
Appendix 12A
Key Concepts/Definitions
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y p
A transfer price is the pricecharged when one segment ofa company provides goods orservices to another segment of
the company.
The fundamental objective in
setting transfer prices is tomotivate managers to act in thebest interests of the overall
company.
Three Primary Approaches
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y pp
There are three primaryapproaches to setting
transfer prices:
1. Negotiated transfer prices
2. Transfers at the cost to theselling division
3. Transfers at market price
Negotiated Transfer Prices
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g
A negotiated transfer price results from discussionsbetween the selling and buying divisions.
Advantages of negotiated transfer prices:
1. They preserve the autonomy of thedivisions, which is consistent withthe spirit of decentralization.
2. The managers negotiating thetransfer price are likely to have muchbetter information about the potentialcosts and benefits of the transferthan others in the company.
Upper limit isdetermined by thebuying division.
Lower limit isdetermined by theselling division.
Range of AcceptableTransfer Prices
Harris and Louder An Example
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p
Imperial Beverages:
Ginger beer production capactiy per month 10,000 barrels
Variable cost per barrel of ginger beer 8 per barrel
Fixed costs per month 70,000
Selling price of Imperial Beverages ginger be
on the outside market 20 per barrel
Pizza Maven:
Purchase price of regular brand of ginger beer 18 per barrel
Monthly comsumption of ginger beer 2,000 barrels
Assume the information as shown with respectto Imperial Beverages and Pizza Maven (bothcompanies are owned by Harris and Louder).
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p
The selling divisions (Imperial Beverages) lowest acceptable transferprice is calculated as:
Variable cost Total contribution margin on lost sales
per unit Number of units transferredTransfer Price +
Transfer Price Cost of buying from outside supplier
The buying divisions (Pizza Maven) highest acceptable transfer price iscalculated as:
Lets calculate the lowest and highest acceptabletransfer prices under three scenarios.
Transfer Price Profit to be earned per unit sold (not including the transfer price)
If an outside supplier does not exist, the highest acceptable transfer priceis calculated as:
Harris and Louder An Example
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p
If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfyPizza Mavens demands (2,000 barrels) without sacrificing sales to other
customers, then the lowest and highest possible transfer prices arecomputed as follows:
02,000
= 8Transfer Price +8Selling divisions lowest possible transfer price:
Transfer Price Cost of buying from outside supplier = 18Buying divisions highest possible transfer price:
Therefore, the range of acceptabletransfer price is 8 18.
Harris and Louder An Example
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p
If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice othercustomer orders (2,000 barrels) to meet Pizza Mavens demands (2,000
barrels), then the lowest and highest possible transfer prices are computedas follows:
( 20 - 8) 2,0002,000
= 20Tra nsfe r P r i +8
Selling divisions lowest possible transfer price:
Transfer Price Cost of buying from outside supplier = 18Buying divisions highest possible transfer price:
Therefore, there is no range ofacceptable transfer prices.
Harris and Louder An Example
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p
If Imperial Beverages has some idle capacity (1,000 barrels) and mustsacrifice other customer orders (1,000 barrels) to meet Pizza Mavens
demands (2,000 barrels), then the lowest and highest possible transfer pricesare computed as follows:
Transfer Price Cost of buying from outside supplier = 18Buying divisions highest possible transfer price:
Therefore, the range of acceptabletransfer price is 14 18.
Selling divisions lowest possible transfer price:
( 20 - 8) 1,0002,000
= 14Tra nsfe r P r i +8
Evaluation of Negotiated TransferPrices
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Prices
If a transfer within a company would result in
higher overall profits for the company, there isalways a range of transfer prices within whichboth the selling and buying divisions would
have higher profits if they agree to thetransfer.
If managers are pitted against each otherrather than against their past performance orreasonable benchmarks, a noncooperative
atmosphere is almost guaranteed.
Given the disputes that often accompany thenegotiation process, most companies rely onsome other means of setting transfer prices.
Transfers at the Cost to the SellingDivision
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Division
Many companies set transfer prices at eitherthe 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 tosuboptimization.
2. The selling division will nevershow a profit on any internaltransfer.
3. Cost-based transfer prices donot provide incentives to control
costs.
Transfers at Market Price
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A market price (i.e., the price charged for anitem on the open market) is often regarded as
the best approach to the transfer pricingproblem.
1. A market price approach worksbest when the product or serviceis sold in its present form tooutside customers and the
selling division has no idlecapacity.
2. A market price approach doesnot work well when the sellingdivision has idle capacity.
Divisional Autonomy andSuboptimization
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Suboptimization
The principles ofdecentralization suggestthat companies should
grant managers autonomyto set transfer prices and
to decide whether to sellinternally or externally,
even is this mayoccasionally result in
suboptimal decisions.This way top management
allows subordinates tocontrol their own destiny.
International Aspects of TransferPricing
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Pricing
Transfer PricingObjectives
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
End of Chapter 12
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