Chapter title - California State University, Northridge

Chapter title - California State University, Northridge

11th Edition Chapter 12 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Segment Reporting and Decentralization Chapter Twelve McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 decision

Lower-level decision 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Decentralization in Organizations

Lower-level Lower-level managers managers may may make make decisions decisions without without seeing seeing the the big big picture. picture. Lower-level Lower-level managers managers objectives objectives may may not not be be those those of of the

the organization. organization. McGraw-Hill/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. Copyright 2006, The McGraw-Hill Companies, Inc. Cost, Profit, and Investments Centers Cost Cost Center Center Cost, profit, and investment centers are all known as responsibility centers.

McGraw-Hill/Irwin Profit Profit Center Center Investment Investment Center Center Responsibility Responsibility Center Center Copyright 2006, The McGraw-Hill Companies, Inc. Cost, Profit, and Investments Centers Cost Center A segment whose manager has control over costs, but not over revenues

or investment funds. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Cost, Profit, and Investments Centers 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Cost, Profit, and Investments Centers Corporate Headquarters Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 e r B o ttlin g P la n t M anager B e v e ra g e s 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 rp o ra te H e a d q u a rte 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 V ic e P r e s id e n t C o n fe c tio n s P ro d u c t M a n a g e r

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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Responsibility Centers S u p e r io r F o o d s C o r p o r a tio n C o rp o ra te H e a d q u a rte rs P r e s id e n t a n d C E O 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 e r B o ttlin g P la n t M anager B e v e ra g e s

P ro d u c t M a n a g e r W a re h o u s e M anager F in a n c e C h ie f F In a n c ia l O ffic e r C o n fe c tio n s P ro d u c t M a n a g e r D is tr ib u tio n M anager Legal G e n e ra l C o u n s e l P e rs o n n e l V ic e P r e s id e n t Profit Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. Responsibility Centers S u p e r io r F o o d s C o r p o r a tio n C o rp o ra te H e a d q u a rte rs P r e s id e n t a n d C E O 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 e r B o ttlin g P la n t M anager B e v e ra g e s P ro d u c t M a n a g e r W a re h o u s e M anager 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

V ic e P r e s id e n t C o n fe c tio n s P ro d u c t M a n a g e r 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Decentralization and Segment Reporting A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A

segment can be . . . McGraw-Hill/Irwin An Individual Store Quick Mart A Sales Territory A Service Center Copyright 2006, The McGraw-Hill Companies, Inc. Superior Foods: Geographic Regions S u p e r io r F o o d s C o r p o r a tio n $ 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 lif 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Superior Foods: Customer Channel S u p e r io r F o o d s C o r p o r a tio n $ 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 le 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 r u g s to r e 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. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 . . .

McGraw-Hill/Irwin No computer division manager. Copyright 2006, The McGraw-Hill Companies, Inc. 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 . . . McGraw-Hill/Irwin We still have a company president. Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Segment Margin Profits The segment margin, 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. McGraw-Hill/Irwin

Time Copyright 2006, The McGraw-Hill Companies, Inc. Traceable and Common Costs Fixed Costs Traceable McGraw-Hill/Irwin Dont allocate common costs to segments. Common Copyright 2006, The McGraw-Hill Companies, Inc. 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

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. Levels of Segmented Statements 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 McGraw-Hill/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. Copyright 2006, The McGraw-Hill Companies, Inc. Levels of Segmented Statements 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

McGraw-Hill/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. Copyright 2006, The McGraw-Hill Companies, Inc. Levels of Segmented Statements Sales Variable costs CM Traceable FC Division margin Common costs Net operating income McGraw-Hill/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 Copyright 2006, The McGraw-Hill Companies, Inc. Levels of Segmented Statements Sales Variable costs CM Traceable FC Division margin Common costs Net operating income

McGraw-Hill/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 $ 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 75,000 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. Copyright 2006, The McGraw-Hill Companies, Inc. Traceable Costs Can Become Common Costs 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! McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Traceable Costs Can Become Common Costs Webbers Television Division Television Division Regular

Big Screen Product Lines McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Traceable Costs Can Become Common Costs 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Traceable Costs Can Become Common Costs 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 McGraw-Hill/Irwin Product Design Customer Manufacturing Marketing Distribution Service Copyright 2006, The McGraw-Hill Companies, Inc. Inappropriate Methods of Allocating Costs Among Segments Failure to trace costs directly Segment 1 McGraw-Hill/Irwin Segment

2 Inappropriate allocation base Segment 3 Segment 4 Copyright 2006, The McGraw-Hill Companies, Inc. 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

McGraw-Hill/Irwin Segment 2 Segment 3 Segment 4 Copyright 2006, The McGraw-Hill Companies, Inc. 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 $ 44,000 Restaurant $ 700,000 250,000 450,000 220,000 $ 230,000 Assume that Haglunds Lakeshore prepared the segmented income statement as shown. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 allocated b. $30,000 1/10 of the cost or $20,000. c. $40,000 d. $50,000 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check If Haglunds allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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!!! McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Should the bar be eliminated? a. Yes b. No McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Should the bar be eliminated?

a. Yes The profit was $44,000 before b. No eliminating the bar. If we eliminate Sales Variable costs CM Traceable FC Segment margin Common costs Profit McGraw-Hill/Irwin the bar, profit drops to $30,000! Income Statement Haglund's Lakeshore Bar Restaurant $ 700,000 $ 700,000 250,000

250,000 450,000 450,000 220,000 220,000 230,000 230,000 200,000 200,000 $ 30,000 $ 30,000 Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Return on Investment (ROI) Formula Net operating income ROI = Average operating assets Net operating income Margin = Sales Sales Turnover = Average operating assets Margin Turnover ROI = McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. Increasing ROI There are three ways to increase ROI . . . Increase Sales McGraw-Hill/Irwin Reduce Expenses Reduce Assets Copyright 2006, The McGraw-Hill Companies, Inc. Increasing ROI An Example Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses

$ 30,000 $ 200,000 $ 500,000 $ 470,000 What is Regal Companys ROI? Margin Turnover ROI = Sales ROI = Net operating income Sales Average operating assets McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Increasing ROI An Example Margin Turnover ROI = Sales ROI = Net operating income Sales Average operating assets

ROI = $30,000 $500,000 $500,000 $200,000 ROI =6% 2.5 = 15% McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Increasing Sales Without an Increase in Operating Assets Regals manager was able to increase sales to $600,000 while operating expenses increased to $558,000. Regals net operating income increased to $42,000. There was no change in the average operating assets of the segment. Lets calculate the new ROI. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

Increasing Sales Without an Increase in Operating Assets Margin Turnover ROI = Sales ROI = Net operating income Sales Average operating assets 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%. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regals 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. Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses $ 40,000 $ 200,000 $ 500,000 $ 460,000 Lets calculate the new ROI. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Decreasing Operating Expenses with no

Change in Sales or Operating Assets Margin Turnover ROI = Sales ROI = Net operating income Sales Average operating assets 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%. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Decreasing Operating Assets with no Change in Sales or Operating Expenses

Assume that Regals manager was able to reduce inventories by $20,000 using just-in-time techniques without affecting sales or operating expenses. Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses $ 30,000 $ 180,000 $ 500,000 $ 470,000 Lets calculate the new ROI. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Decreasing Operating Assets with no Change in Sales or Operating Expenses Margin Turnover

ROI = Sales ROI = Net operating income Sales Average operating assets ROI = $30,000 $500,000 $500,000 $180,000 ROI = 6% 2.77 = 16.7% ROI ROI increased increased from from 15% 15% to to 16.7%. 16.7%. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Investing in Operating Assets to Increase Sales Assume that Regals manager invests in a

$30,000 piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses $ 50,000 $ 230,000 $ 535,000 $ 485,000 Lets calculate the new ROI. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Investing in Operating Assets to Increase Sales Margin Turnover ROI =

Sales ROI = Net operating income 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%. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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? McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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.

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Residual Income - Another Measure of Performance Net operating income above some minimum return on operating assets McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Residual Income An Example The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to

earn a return of 20% on these assets. In the current period the division earns $30,000. Lets calculate residual income. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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% $$ 20,000 20,000 Actual Actual income income Minimum Minimum required requiredreturn return Residual Residual income income McGraw-Hill/Irwin $$ 30,000 30,000 (20,000) (20,000) $$ 10,000 10,000 Copyright 2006, The McGraw-Hill Companies, Inc.

Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Redmond Awnings, a division of Wrapup 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% McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check

Redmond Awnings, a division of Wrapup 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% ROI = NOI/Average operating assets b. 5% = $60,000/$300,000 = 20% c. 15% d. 20% McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Redmond Awnings, a division of Wrapup 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

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Redmond Awnings, a division of Wrapup 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%. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 ROI = $18,000/$100,000 = 18% b. No The return on the investment exceeds the minimum required rate of return. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Redmond Awnings, a division of Wrapup 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 residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Quick Check Redmond Awnings, a division of Wrapup 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 residual income?

a. $240,000 b. $ 45,000 Net operating income $60,000 return (15% of $300,000) $45,000 c. $ 15,000 Required Residual income $15,000 d. $ 51,000 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

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 This is an increase of $3,000 in the residual income. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Zepher, Inc. - Continued Recall the following information for the Retail Division of Zepher, Inc. Assume the following information for the Wholesale Division of Zepher, 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 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Zepher, 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

McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Transfer Pricing Appendix 12A McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin

Copyright 2006, The McGraw-Hill Companies, Inc. 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 3. Transfers at market price McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Range of Acceptable Transfer Prices Upper limit is determined by the buying division. Lower limit is determined by the selling division. Copyright 2006, The McGraw-Hill Companies, Inc. 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 McGraw-Hill/Irwin 10,000 barrels 8 per barrel 70,000 20 per barrel 18 per barrel 2,000 barrels Copyright 2006, The McGraw-Hill Companies, Inc. Harris and Louder An Example The selling divisions (Imperial Beverages) lowest acceptable transfer

price is calculated as: Variable cost Total contribution margin on lost sales Transfer Price + 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) McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Harris and Louder An Example 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: Transfer Price Cost of buying from outside supplier = 18 Therefore, the range of acceptable transfer price is 8 18. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Harris and Louder An Example 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: Selling divisions lowest possible transfer price: ( 20 - 8) 2,000 Transfer Price 8 + = 20 2,000 Buying divisions highest possible transfer price: Transfer Price Cost of buying from outside supplier = 18 Therefore, there is no range of acceptable transfer prices. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Harris and Louder An Example 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: Selling divisions lowest possible transfer price: ( 20 - 8) 1,000 Transfer Price 8 + = 14 2,000 Buying divisions highest possible transfer price: Transfer Price Cost of buying from outside supplier = 18 Therefore, the range of acceptable transfer price is 14 18. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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 noncooperative atmosphere is almost guaranteed. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. 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. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. Divisional Autonomy and Suboptimization 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 is this may occasionally result in suboptimal decisions. This way top management allows subordinates to control their own destiny. McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc. International Aspects of Transfer

Pricing Transfer Pricing Objectives Domestic Greater divisional autonomy Greater motivation for managers Better performance evaluation Better goal congruence McGraw-Hill/Irwin International Less taxes, duties, and tariffs Less foreign exchange risks Better competitive position Better governmental relations Copyright 2006, The McGraw-Hill Companies, Inc. End of Chapter 12 McGraw-Hill/Irwin Copyright 2006, The McGraw-Hill Companies, Inc.

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