Chapter 11
Chapter 11 -
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Feedback of actual results, comparison to other orgs, other periods, mgers attempt to ensure orgs moves in planned direction -> performance assessment or control Segment reporting, responsibility centre reporting, investment performance, and profitability analysis are four commonly used reporting structures that provide somewhat different types of information o Each represent a different aspect of organizational control Increasingly, companies are using non-financial indicators of performance such as scrap levels, rework efforts, market share, employee morale, pollutant discharges, and customer satisfaction.
Decentralization in Organizations -
In a decentralized organization, decision making is spread throughout the organization, rather than being confined to a few top executives
Decentralization and Segment Reporting -
Segment reporting is key for analyzing and evaluating decisions made by segment managers Need reports for each segment o A segment is defined as a part or activity of an organization about which managers would like cost, revenue, or profit data. E.g. geographic segments for grocery chain
Segment Reporting -
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Company-wide statements do not contain enough detail to allow the manager or investor to detect problems that may exist in the organization. o E.g. some lines may be unprofitable and others may not Segment is a component of the enterprise o Engages in business activities from which it may incur revenues and expenses o Whose operating results are regularly reviewed by enterprises COO to make decisions about resource to be allocated to that segment and assess its performance o For which discrete financial info is available
Differing Levels of Segmented Statements -
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As we go from one segmented statement to another, we are looking at smaller and smaller pieces of the company o The order of breakdown depends on what information is desired By carefully examining trends and results in each segment, the manager can gain considerable insight into the company as a whole, and perhaps discover opportunities and courses of action that would otherwise have remained hidden from view. The order of the breakdown should not affect the numbers, but it can alter what appears on a given report and the ease of review.
Assigning costs to segments -
Segmented statements for internal use are typically prepared in contribution format
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One exception: fixed costs labelled traceable are charged to the various segments. If a fixed cost is not traceable directly to some segment, then it is treated as a common cost and kept separate from the segments themselves. o Under the contribution approach, a cost is never arbitrarily assigned to a segment of an organization Two guideline followed in assigning costs to various segments of a company: o 1) According to cost behaviour (variable or fixed) o 2) Whether the cost is directly traceable to the segments involved or not
Sales and CM -
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Usefulness of CM – compute CM ratio and if SP/FC are unchanged, then can use to see direct increase in net income caused by increase in sales Segmented statements give the manager the ability to make such computations on a product-by-product, division-by-division, or territory-by-territory basis, thereby providing the information needed to show up areas of weakness or to capitalize on areas of strength CM is a SHORT-RUN PLANNING TOOL – good for decisions relative to uses of capacity, special orders, short-run product-line promotion o Decisions involve: VC, SALES By monitoring each segment’s CM and segment ratios, mger is able to make SR decisions that maximize each segments contribution to overall profitability
Importance of FC -
FC/VC differences must be kept clearly in mind for both short-run and long-run planning Grouping of FC under CM approach highlights the fact that after FC have been covered, income increases based on CM generated per additional unit sold o Useful for internal planning purposes
Traceable and Common FC -
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Traceable: fixed costs that can be identified with a particular segment and that arise because of the existence of the segment o If segment never existed, costs would not be incurred and if segment were to be eliminated, then the cost would disappear o Only traceable costs charged to segments; if not traceable then cost not charged E.g. salary of Frito-lay product manager for PepsiCo Common: fixed cost that supports the operations of more than one segment but is not traceable in whole or in part to any one segment; cost would be incurred regardless of segment’s existence o Company’s CEO is a common fixed cost for all divisions o Receptionist’s salary for multiple doctors The total amount is deducted to arrive at the income for the company as a whole Any attempt to allocate common fixed costs among segments may result in misleading data or may obscure important relationships between segment revenues and segment earnings o May lead to segment looking unprofitable and may lead to undue elimination of a segment which then further reduces profitability of the company Firms may however allocate common costs for a number of reasons o E.g. want to know the “benefits” EACH SEGMENT rec’d from headquarters
Identifying Traceable Fixed Costs -
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Traceable costs -> charge to segments, common -> deduct at end Hard to determine whether a cost should be classified as traceable or common* The general guideline is to treat as traceable costs only those costs that would disappear over time if the segment itself disappeared. o E.g. if a division were to be shut down then why pay that division managers salary - - traceable But the co’s president would still need to be paid - - so this is common Depreciation is a common cost as well** Any allocation of common costs to segments reduces the value of the segment margin as a guide to longrun segment profitability and segment
Breakdown of traceable FC -
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Might separate traceable FC into two classes: discretionary and committed Discretionary fixed costs are under the immediate control of the manager, whereas committed fixed costs are not o Breakdown allows co to make a distinction between the performance of the segment manager and the performance of the segment as a long-term investment The amount remaining after deducting the discretionary fixed costs, sometimes called a segment performance margin should be used to judge a manager’s performance (in the case he/she operates in a function with large committed cost)
ABC -
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This method of assigning costs combines the strength of activity-based costing with the power of the contribution approach and greatly enhances the manager's ability to measure the profitability and performance of segments But mgers still must ask themselves if the costs would in fact disappear over time if the segment did as well;
Traceable costs can become common -
Fixed costs that are traceable to one segment may be common costs of another segment. This is because there are limits to how finely a cost can be separated without resorting to arbitrary allocation. The more finely segments are defined, the more costs there are that are common. o E.g. when the segments are divisions, there is greater traceable exp; but when you further analyze the divisions into product lines, there is less traceable exp b/c the salary of the product lines is now a common fixed expense BUT ONLY FOR THE PRODUCT line This salary is a traceable cost of the division as a whole, but is a common cost of the division's product lines. Would be incurred even if one of the segments were eliminated
Segment Margin -
Obtained by deducting a segment's traceable fixed costs from the segment's contribution margin. Is margin avlbl after segment has covered its own costs Best gauge of LT profitability of a segment b/c it includes costs only caused by the segment; if segment cannot cover its own costs, it should probably be dropped (unless essential to other sales)
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The segment margin is most useful in major decisions that affect capacity, such as dropping a segment o CM more useful for SR changes and orders involving temporary use of existing capacity
Segment Reporting for Financial Accounting -
Companies are not ordinarily required to report the same data to external users that are reported internally for decision-making purposes. CICA, however, requires that segmented reports prepared for external users use same methods and definitions used for internal segmented reports o Drawbacks: 1) Segmented data are often sensitive and cos are reluctant to release to public (competitors threat 2) Segmented statements prepared in accordance w/ GAAP don’t distinguish b/w fixed and variable costs and b/w traceable and common
Hindrances to proper cot assignment -
Costs must be properly assigned to segments. All of the costs attributable to a segment—and only those costs—should be assigned to the segment Common errors include: omitting costs, assigning traceable fixed costs, and allocating common costs
Omission of cost -
Costs assigned to segment include all costs attributable to segment (all functions: R/D, design, manufacturing, marketing, distribution, customer service) o But only manufacturing costs are included in product costs under absorption costing; regarded as required for financial reporting As a result, co’s use absorption costing for internal reports (segmented income statements) Omit “upstream” costs in the value chain, which consist of research and development and product design, and the “downstream” costs, which consist of marketing, distribution, and customer service SGA expenses o BUT must be included in the profitability analysis b/c they can represent > ½ or more of total costs of an orgs o Product may end up being undercosted and mgmt may continue developing products that may not even be profitable
Inappropriate Methods for Assigning traceable costs among segments -
Co’s do not correctly handle fixed expenses on segmented income statements; do not trace fixed expenses when feasible to do so and may use inappropriate allocation bases to allocate traceable fixed expenses to segments
Failure to trace costs directly -
Failure to trace these costs directly results in these costs being placed in a companywide overhead pool o E.g. rent for branch office of an insurance co should be charged directly to branch rather than be included in company overhead pool
Inappropriate allocation base -
Costs should be allocated to segments for internal decision-making purposes only when the allocation base actually drives the cost being allocated (or is very highly correlated with the real cost driver) The allocation base should be the cost driver*
Arbitrarily dividing common costs among segments -
There is no cause-and-effect relationship between the cost of the corporate headquarters building and the existence of any one product – cannot allocate cost of corporate HQ to one product The common practice of arbitrarily allocating these costs to segments is often justified on the grounds that “someone” has to “cover the common costs.” Adding a share of common costs to the real costs of a segment may make an otherwise profitable segment appear to be unprofitable Additionally, common fixed costs are not manageable by the manager to whom they are arbitrarily allocated; they are the responsibility of higher-level managers When common fixed costs are allocated to managers, they are held responsible for those costs even though they cannot control them.
Summary -
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The way co’s handle segment reporting causes cost distortion – three main practices cause this: failure to trace costs directly to specific segment when its feasible to do so, the use of inappropriate bases for allocating costs, and the allocation of common costs to segments. Variable costing permits a clearer allocation of costs to segments because it avoids the distortions created by the allocation of fixed manufacturing overhead that would be present with the use of absorption costing. Use variable costing for segment reports and allocate fixed manufacturing overhead as a period expense based on the criterion of traceability; that is, fixed costs that will disappear over time if the segment itself disappears.
Responsibility Centres -
Any part of orgs hose mger has control over and is accountable for profit, investments, or cost Three primary types: cost centres, profit centres, investments centres
Cost Centre -
Business segment whose manager has control over costs but not over revenue or investment funds Service departments like accounting, finance, administration, legal, personnel etc are usually considered to be cost centres Mfting facilities are often considered to be cost centres Mgers expected to minimize cost while providing level of services or amt of product demanded by other parts of organization Standard cost variances and flexible budget variances used to evaluate performance of this centre Mgers should not be held accountable for controlling common costs arbitrarily allocated to their segment
Profit centre -
Any business segment whose manager has control over both cost and revenue.
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Profit centre manager generally does not have control over investment funds Evaluated by comparing actual profit to targeted or budgeted profit.
Investment centre -
Is any segment of an organization whose manager has control over cost, revenue, and investments in operating assets Investment centre managers are usually evaluated using return on investment or residual income measures, as discussed later in the chapter.
Transfer Pricing -
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Some issues arise when segments of the same company (often referred to as divisions) supply goods and services to each other. The issue is determining the transfer price of the goods or services being sold between segments. Transfer price is the price charged when one segment sells goods or services to another segment of the same company
Three common approaches are used to set transfer prices: 1. 2. 3.
Allow the managers involved in the transfers to negotiate their own transfer prices. Set transfer prices at cost, using either variable cost or full absorption cost. Set transfer prices at the market price.
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The fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company o BUT: suboptimization occurs when managers do not act in the best interests of the overall company or even in the best interests of their own segment
Negotiated Price Transfers -
Is transfer price agreed on b/w selling and purchasing segments/divisions Advantages: preserves the autonomy of divisions and consistent w/ spirit of decentralization; mgers have better info abt costs and benefits of transfers than others in the company The selling division will agree to transfer only if the profits of the selling division increase as a result of ransfer
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Purchasing division will agree if their profits increase as well The transfer price has both a lower limit (determined by the situation of the selling division) and an upper limit (determined by the situation of the purchasing division). o Determine the range of acceptable transfer prices - within which the profits of both divisions participating in a transfer would increase. Selling division (lowest acceptable transfer price):
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Purchasing division’s highest acceptable transfer price:
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Selling Division with Idle Capacity: (because the numerator = 0 w/ idle capacity) Selling Division w/ no Idle capacity: selling at full capacity and then required to divert sales from customers in order to meet the intercompany transaction**
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The selling division’s minimum price is > than buying division’s max price so the transaction will not happen! This is b/c the transfer price is a mechanism for dividing b/w two divisions any profit the entire co earns as a result of the transfer - - if co loses money on transfer, then no profit to divide Selling Division w/ some idle capacity – same steps as before – No outside supplier: o the highest price the purchasing division would be willing to pay depends on how much the purchasing division expects to make on the transferred units—excluding the transfer price Evaluation of Negotiated Transfer Prices: o if the managers understand their own businesses and are cooperative, then they should always be able to agree on a transfer price if it is in the best interests of the company that they do so o Sometimes negotiations break down if self-interests come in the way; might be b/c of the way they are being evaluated (i.e. NOT encouraged to cooperate) o Due to problems w/ negotiation, most companies rely on some other mean of setting transfer prices – which too have their own drawbacks
Transfers to selling division at cost -
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Set prices either at VC or absorption cost incurred by selling division Use of cost can lead t bad decisions and suboptimization* o If the transfer price was bureaucratically set at full cost, then Pizza Place would never want to buy ginger beer from Cumberland Beverages, since it could buy its ginger beer from the outside supplier at less cost But from company standpoint, the internal transfer should happen (especially if the selling division has idle capacity) because the transfer price will be very cheap (taking into account the opportunity cost) If cost is used as transfer price, selling division will never show PROFIT on any internal transfer Third problem is that there is no incentive to control costs; if the costs of one division are simply passed on to the next, then there is little incentive for anyone to work to reduce costs.
Transfers at market price -
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Market price: price charged for item in open market is regarded as BEST approach to transfer pricing problem o Designed for situations in which there is intermediate market for transferred product or service o Intermediate market: means a market in which the product or service is sold in its present form to outside customers. Price in this market is perfect to transfer at if selling division has no idle capacity More profitable to sell to the outside market than to transfer internally At the market price with no idle capacity, difficulties occur when the selling division has idle capacity;
Divisional Autonomy and Suboptimization -
In line with decentralization, co’s should grant mgers autonomy to set transfer price and decide whether to sell internally or externally It may be hard for top mgers to accept this principle when their subordinate managers are about to make a suboptimal decision If top managers wish to create a culture of autonomy and independent profit responsibility, they must allow their subordinate managers to control their own destiny—even to the extent of granting their managers the right to make mistakes.
International Aspects of Transfer Pricing -
Transfer pricing used worldwide to control flow of g/s among segments of orgs
Transfer Pricing Objectives Domestic International Greater divisional autonomy Lower taxes, duties, and tariffs Greater motivation for managersFewer foreign exchange risks Better performance evaluation Better competitive position Better goal congruence Better governmental relationships Domestic objectives are always desirable, but become secondary when international transfers are involved*** Managers need to be sensitive to legal rules in establishing transfer prices Evaluating Investment Centre Performance – ROI -
Transfer prices and assigning costs to responsibility centres are important for cost and profit centres 2 methods of evaluating investment centre’s performance: ROI, and residual income
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The higher it is, the greater profit generated per $ invested
ROI
OI and OA -
OI = EBIT (earnings b4 interest and taxes) Use OI b/c in OA (denominator), no debt is included and interest expense is paid for by the profits of OA
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OA: cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization and/or the investment centre o Stuff that wouldn’t be included in OA category (non-op assets, for ex) include land and investments in other companies – FUTURE use assets o Average of OA = b+e/2 One major issue is what $ value to include in OA for equipment and plant; (i.e. NBV or GROSS VALUE) NBV GROSS Consistent w/ balance sheet Eliminates age and method of Consistent w/ computation of ROI depreciation (b/c under NBV, ROI will increase as NBV ↓ due to depreciation) Doesn’t discourage replacement (replacement for NBV will (-) impact) WE GONNA USE NBV APPROACH DAWG
Understanding ROI
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Margin – measure of mgmt’s ability to control operating expenses in relation to sales o Lower the expense, higher the margin o Improve by increasing sales or decreasing expenses Turnover – measures sales generated for each dollar invested in OA o Excess funds tied up in inactive assets depress turnover and as a result, lower ROI ROI can be compared to returns of other investment centres in the orgs, in returns of other cos in the industry and to the past returns of the investment centre itself
Any increase in ROI must involve at least one of the following: 1. 2. 3.
Increased sales Reduced operating expenses Reduced operating assets
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1) If the percentage increase in sales exceeds the percentage increase in operating expenses, ROI will always improve - - is for a increase in sales without increase in operating assets
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o 2) Decreased expenses w/ no change in sales or assets - - - leads to increased ROI but must be careful to cut discretionary expenses and not something that will cause decreased sales, low morale, etc
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o 3) Investing in assets - - - proportionate increase in operating assets AND sales/net income
o Criticisms of ROI -
1) ROI may not be enough; don’t know how exactly to increase it (may take actions that are good in SHORT-TERM like cutting costs) – need to stay consistent with co’s strategy 2) A mger who takes over a bus segment typically inherits many committed costs over which mger has no control - - - these costs may make it hard to assess the performance off the manager 3) Mger who is evaluated based on ROI may reject profitable investment opportunities
Residual Income -
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Is the operating income that an investment centre earns above the minimum required return on its operating assets.
When residual income is used to measure performance, the purpose is to maximize the total amount of residual income not to maximize overall ROI If residual income method adopted at a division, then the manager SHOULD BE evaluated based on growth from yr to yr
Motivation and Residual Income -
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One primary reason why controller would want to switch from ROI to residual income is b/c residual income encourages investments that are profitable for the entire company but would be rejected if evaluated by ROI
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Is rejected b/c the 18% ($4.5k/25k) return on the new machine is below the current ROI of 20% A manager who is evaluated based on ROI will want to reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the minimum required rate of return for the entire company. BUT: it’s in best interests for the co to accept any project w/ return > minimum so managers evaluated on residual income will make better investment decisions than those evaluated on ROI
Divisional Comparison and Residual Income -
ONE MAJOR ADVANTAGE OF “ “: cannot be used to compare divisions w/ diff sizes Larger firms, in general, will have more residual income (b/c they are bigger, not necessarily better)
Criticisms of RI -
RI based on historical actg data; actg values used for cap assets can suffer from being out of date when costs are rising; can lead to inflated RI NO standard income to compare to; should use external benchmarks or overall trend (i.e. RI growing over years, etc) Calculating RI requires numerous adjustments to financial info – increases cost of preparing info Doesn’t incorporate NON-FINANCIAL INDICATORS of success like employee motivation or customer satisfaction
Balanced Scorecard -
Consists of an integrated set of performance measures that is derived from the company's strategy and that supports the company's strategy throughout the organization 3 generic approaches to outperforming competitors o Cost Leadership: by maintaining low cost through efficiency, co will be able to make superior profits at current industry prices Low costs can also be a barrier for other competitors o Differentiation: Customers will pay premium for unique products; higher profits – can’t be too high though-lose brand loyalty o Focus/niche: achieve superiority by serving narrow target market more effectively
Common Characteristics of Balanced Scorecards
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Four groups: financial, internal business processes, customer, learning/growth Strong emphasis on continual improvement** - if orgs doesn’t improve, it’ll lose out to competitors who do Ultimately, most cos exist to provide financial rewards to owners Financial performance measures alone aren’t enough though, should be integrated with non-financial measures in a well-designed balanced scorecard o Financial measures are lag indicators, report on results of PAST ACTIONS o Non-financial measures of key success drivers like customer satisfaction are leading indicators of FUTURE FINANCIAL PERFORMANCE Second, top mgers are responsible for financial performance measures NOT lower-level mgers Selecting performance measures: o 1) should be consistent with and follow from, co’s strategy o 2) don’t have too many measures – causes confusion and lack of focus Each individual has a personal scorecard as well – consists of items individual can influence in relation to the company’s scorecard
Company’s strategy and the Balanced Scorecard -
Company must decide which customers to target and what internal business processes are crucial to attracting and retaining those customers
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Performance measures must be tailored to the specific strategy of each company. Balanced scorecard illustrates a theory of how the company can attain its desired outcomes (financial, in this case) by taking concrete actions One advantage is that it can be used to continually test the theories underlying mgmt strategy; if strategy not working, it becomes obvious when some of the predictions don’t come true o Without this feedback, mgmt may keep drifting on faulty assumptions!
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Tying Compensation to Balanced Scoreboard -
Incentives for workers must be tied to the scorecard performance measures
Advantage of timely feedback
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Any performance measures used should be reported on frequent and timely basis E.g. data on defects is reported immediately Focus on trends in performance measures over time; emphasis on improvement
Some measures of Internal Business Process Performance -
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Provide feedback needed for improving these processes o Info essential for cost and quality improvements -> leads to greater profitability and customer satisfaction 3 performances in particular are key: o Delivery Cycle Time - amount of time from when an order is received from a customer to o
when the completed order is shipped is called; best to keep as short as possible Throughput (MFTING CYCLE) time - amount of time required to turn raw materials into completed products; made up of process time, inspection time, move time, and queue time Process time: amt of time in which work is actually done on product Inspection time: time spent ensuring that the product is not defective. Move time is the time required to move materials or partially completed products from workstation to workstation. Queue time is the amount of time a product spends waiting to be worked on, to be moved, to be inspected, or in storage waiting to be shipped.
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ONLY process time adds value, the other three should be eliminated
Manufacturing Cycle Efficiency (MCE):
If MCE < 1 - - non-value-added time is present in the production process
Some Final Observations -
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Balanced scorecard should be tailored to co’s strategy - - each co’s should be unique Balanced “ reflects strategy or theory abt how co can further its objectives by taking specific actions; theory should be tentative and subject to changes - - if it doesn’t work obv - - if theory changes, then the performance measures change on the balanced scorecard and should also change Balanced scorecard isn’t only piece – other info should also be used – doesn’t replace the need for regular preparation and use of detailed reports on key operating activities
Cost of Quality -
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A company may have a product with a high-quality design that uses high-quality components, but if the product is poorly assembled or has other defects, the company will have high warranty repair costs and dissatisfied customers The objective is to have high quality of conformance.
Quality of Conformance -
Product which meets or exceeds design specifications and is free of defects that mark its appearance or degrade its performance = = quality of conformance
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Preventing, detecting, and dealing with defects cause costs that are called quality costs or the cost of quality. Quality cost refers to all of the costs that are incurred to prevent defects or that are incurred as a result of defects occurring. o 4 groups: 2 are prevention costs and appraisal costs -- incurred in an effort to keep defective product from reaching customers o Internal/external failure costs are incurred b/c defects are produced despite efforts to prevent them Quality costs do not just relate to manufacturing; they relate to all of the activities in a company from initial research and development through customer service # of costs associated with quality is very large; can be high unless mgmt gives this area attention
Prevention costs -
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Avoid having quality problems
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Feedback of actual results, comparison to other orgs, other periods, mgers attempt to ensure orgs moves in planned direction -> performance assessment or control Segment reporting, responsibility centre reporting, investment performance, and profitability analysis are four commonly used reporting structures that provide somewhat different types of information o Each represent a different aspect of organizational control Increasingly, companies are using non-financial indicators of performance such as scrap levels, rework efforts, market share, employee morale, pollutant discharges, and customer satisfaction.
Decentralization in Organizations -
In a decentralized organization, decision making is spread throughout the organization, rather than being confined to a few top executives
Decentralization and Segment Reporting -
Segment reporting is key for analyzing and evaluating decisions made by segment managers Need reports for each segment o A segment is defined as a part or activity of an organization about which managers would like cost, revenue, or profit data. E.g. geographic segments for grocery chain
Segment Reporting -
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Company-wide statements do not contain enough detail to allow the manager or investor to detect problems that may exist in the organization. o E.g. some lines may be unprofitable and others may not Segment is a component of the enterprise o Engages in business activities from which it may incur revenues and expenses o Whose operating results are regularly reviewed by enterprises COO to make decisions about resource to be allocated to that segment and assess its performance o For which discrete financial info is available
Differing Levels of Segmented Statements -
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As we go from one segmented statement to another, we are looking at smaller and smaller pieces of the company o The order of breakdown depends on what information is desired By carefully examining trends and results in each segment, the manager can gain considerable insight into the company as a whole, and perhaps discover opportunities and courses of action that would otherwise have remained hidden from view. The order of the breakdown should not affect the numbers, but it can alter what appears on a given report and the ease of review.
Assigning costs to segments -
Segmented statements for internal use are typically prepared in contribution format
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One exception: fixed costs labelled traceable are charged to the various segments. If a fixed cost is not traceable directly to some segment, then it is treated as a common cost and kept separate from the segments themselves. o Under the contribution approach, a cost is never arbitrarily assigned to a segment of an organization Two guideline followed in assigning costs to various segments of a company: o 1) According to cost behaviour (variable or fixed) o 2) Whether the cost is directly traceable to the segments involved or not
Sales and CM -
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Usefulness of CM – compute CM ratio and if SP/FC are unchanged, then can use to see direct increase in net income caused by increase in sales Segmented statements give the manager the ability to make such computations on a product-by-product, division-by-division, or territory-by-territory basis, thereby providing the information needed to show up areas of weakness or to capitalize on areas of strength CM is a SHORT-RUN PLANNING TOOL – good for decisions relative to uses of capacity, special orders, short-run product-line promotion o Decisions involve: VC, SALES By monitoring each segment’s CM and segment ratios, mger is able to make SR decisions that maximize each segments contribution to overall profitability
Importance of FC -
FC/VC differences must be kept clearly in mind for both short-run and long-run planning Grouping of FC under CM approach highlights the fact that after FC have been covered, income increases based on CM generated per additional unit sold o Useful for internal planning purposes
Traceable and Common FC -
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Traceable: fixed costs that can be identified with a particular segment and that arise because of the existence of the segment o If segment never existed, costs would not be incurred and if segment were to be eliminated, then the cost would disappear o Only traceable costs charged to segments; if not traceable then cost not charged E.g. salary of Frito-lay product manager for PepsiCo Common: fixed cost that supports the operations of more than one segment but is not traceable in whole or in part to any one segment; cost would be incurred regardless of segment’s existence o Company’s CEO is a common fixed cost for all divisions o Receptionist’s salary for multiple doctors The total amount is deducted to arrive at the income for the company as a whole Any attempt to allocate common fixed costs among segments may result in misleading data or may obscure important relationships between segment revenues and segment earnings o May lead to segment looking unprofitable and may lead to undue elimination of a segment which then further reduces profitability of the company Firms may however allocate common costs for a number of reasons o E.g. want to know the “benefits” EACH SEGMENT rec’d from headquarters
Identifying Traceable Fixed Costs -
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Traceable costs -> charge to segments, common -> deduct at end Hard to determine whether a cost should be classified as traceable or common* The general guideline is to treat as traceable costs only those costs that would disappear over time if the segment itself disappeared. o E.g. if a division were to be shut down then why pay that division managers salary - - traceable But the co’s president would still need to be paid - - so this is common Depreciation is a common cost as well** Any allocation of common costs to segments reduces the value of the segment margin as a guide to longrun segment profitability and segment
Breakdown of traceable FC -
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Might separate traceable FC into two classes: discretionary and committed Discretionary fixed costs are under the immediate control of the manager, whereas committed fixed costs are not o Breakdown allows co to make a distinction between the performance of the segment manager and the performance of the segment as a long-term investment The amount remaining after deducting the discretionary fixed costs, sometimes called a segment performance margin should be used to judge a manager’s performance (in the case he/she operates in a function with large committed cost)
ABC -
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This method of assigning costs combines the strength of activity-based costing with the power of the contribution approach and greatly enhances the manager's ability to measure the profitability and performance of segments But mgers still must ask themselves if the costs would in fact disappear over time if the segment did as well;
Traceable costs can become common -
Fixed costs that are traceable to one segment may be common costs of another segment. This is because there are limits to how finely a cost can be separated without resorting to arbitrary allocation. The more finely segments are defined, the more costs there are that are common. o E.g. when the segments are divisions, there is greater traceable exp; but when you further analyze the divisions into product lines, there is less traceable exp b/c the salary of the product lines is now a common fixed expense BUT ONLY FOR THE PRODUCT line This salary is a traceable cost of the division as a whole, but is a common cost of the division's product lines. Would be incurred even if one of the segments were eliminated
Segment Margin -
Obtained by deducting a segment's traceable fixed costs from the segment's contribution margin. Is margin avlbl after segment has covered its own costs Best gauge of LT profitability of a segment b/c it includes costs only caused by the segment; if segment cannot cover its own costs, it should probably be dropped (unless essential to other sales)
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The segment margin is most useful in major decisions that affect capacity, such as dropping a segment o CM more useful for SR changes and orders involving temporary use of existing capacity
Segment Reporting for Financial Accounting -
Companies are not ordinarily required to report the same data to external users that are reported internally for decision-making purposes. CICA, however, requires that segmented reports prepared for external users use same methods and definitions used for internal segmented reports o Drawbacks: 1) Segmented data are often sensitive and cos are reluctant to release to public (competitors threat 2) Segmented statements prepared in accordance w/ GAAP don’t distinguish b/w fixed and variable costs and b/w traceable and common
Hindrances to proper cot assignment -
Costs must be properly assigned to segments. All of the costs attributable to a segment—and only those costs—should be assigned to the segment Common errors include: omitting costs, assigning traceable fixed costs, and allocating common costs
Omission of cost -
Costs assigned to segment include all costs attributable to segment (all functions: R/D, design, manufacturing, marketing, distribution, customer service) o But only manufacturing costs are included in product costs under absorption costing; regarded as required for financial reporting As a result, co’s use absorption costing for internal reports (segmented income statements) Omit “upstream” costs in the value chain, which consist of research and development and product design, and the “downstream” costs, which consist of marketing, distribution, and customer service SGA expenses o BUT must be included in the profitability analysis b/c they can represent > ½ or more of total costs of an orgs o Product may end up being undercosted and mgmt may continue developing products that may not even be profitable
Inappropriate Methods for Assigning traceable costs among segments -
Co’s do not correctly handle fixed expenses on segmented income statements; do not trace fixed expenses when feasible to do so and may use inappropriate allocation bases to allocate traceable fixed expenses to segments
Failure to trace costs directly -
Failure to trace these costs directly results in these costs being placed in a companywide overhead pool o E.g. rent for branch office of an insurance co should be charged directly to branch rather than be included in company overhead pool
Inappropriate allocation base -
Costs should be allocated to segments for internal decision-making purposes only when the allocation base actually drives the cost being allocated (or is very highly correlated with the real cost driver) The allocation base should be the cost driver*
Arbitrarily dividing common costs among segments -
There is no cause-and-effect relationship between the cost of the corporate headquarters building and the existence of any one product – cannot allocate cost of corporate HQ to one product The common practice of arbitrarily allocating these costs to segments is often justified on the grounds that “someone” has to “cover the common costs.” Adding a share of common costs to the real costs of a segment may make an otherwise profitable segment appear to be unprofitable Additionally, common fixed costs are not manageable by the manager to whom they are arbitrarily allocated; they are the responsibility of higher-level managers When common fixed costs are allocated to managers, they are held responsible for those costs even though they cannot control them.
Summary -
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The way co’s handle segment reporting causes cost distortion – three main practices cause this: failure to trace costs directly to specific segment when its feasible to do so, the use of inappropriate bases for allocating costs, and the allocation of common costs to segments. Variable costing permits a clearer allocation of costs to segments because it avoids the distortions created by the allocation of fixed manufacturing overhead that would be present with the use of absorption costing. Use variable costing for segment reports and allocate fixed manufacturing overhead as a period expense based on the criterion of traceability; that is, fixed costs that will disappear over time if the segment itself disappears.
Responsibility Centres -
Any part of orgs hose mger has control over and is accountable for profit, investments, or cost Three primary types: cost centres, profit centres, investments centres
Cost Centre -
Business segment whose manager has control over costs but not over revenue or investment funds Service departments like accounting, finance, administration, legal, personnel etc are usually considered to be cost centres Mfting facilities are often considered to be cost centres Mgers expected to minimize cost while providing level of services or amt of product demanded by other parts of organization Standard cost variances and flexible budget variances used to evaluate performance of this centre Mgers should not be held accountable for controlling common costs arbitrarily allocated to their segment
Profit centre -
Any business segment whose manager has control over both cost and revenue.
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Profit centre manager generally does not have control over investment funds Evaluated by comparing actual profit to targeted or budgeted profit.
Investment centre -
Is any segment of an organization whose manager has control over cost, revenue, and investments in operating assets Investment centre managers are usually evaluated using return on investment or residual income measures, as discussed later in the chapter.
Transfer Pricing -
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Some issues arise when segments of the same company (often referred to as divisions) supply goods and services to each other. The issue is determining the transfer price of the goods or services being sold between segments. Transfer price is the price charged when one segment sells goods or services to another segment of the same company
Three common approaches are used to set transfer prices: 1. 2. 3.
Allow the managers involved in the transfers to negotiate their own transfer prices. Set transfer prices at cost, using either variable cost or full absorption cost. Set transfer prices at the market price.
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The fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company o BUT: suboptimization occurs when managers do not act in the best interests of the overall company or even in the best interests of their own segment
Negotiated Price Transfers -
Is transfer price agreed on b/w selling and purchasing segments/divisions Advantages: preserves the autonomy of divisions and consistent w/ spirit of decentralization; mgers have better info abt costs and benefits of transfers than others in the company The selling division will agree to transfer only if the profits of the selling division increase as a result of ransfer
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Purchasing division will agree if their profits increase as well The transfer price has both a lower limit (determined by the situation of the selling division) and an upper limit (determined by the situation of the purchasing division). o Determine the range of acceptable transfer prices - within which the profits of both divisions participating in a transfer would increase. Selling division (lowest acceptable transfer price):
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Purchasing division’s highest acceptable transfer price:
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Selling Division with Idle Capacity: (because the numerator = 0 w/ idle capacity) Selling Division w/ no Idle capacity: selling at full capacity and then required to divert sales from customers in order to meet the intercompany transaction**
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o o
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The selling division’s minimum price is > than buying division’s max price so the transaction will not happen! This is b/c the transfer price is a mechanism for dividing b/w two divisions any profit the entire co earns as a result of the transfer - - if co loses money on transfer, then no profit to divide Selling Division w/ some idle capacity – same steps as before – No outside supplier: o the highest price the purchasing division would be willing to pay depends on how much the purchasing division expects to make on the transferred units—excluding the transfer price Evaluation of Negotiated Transfer Prices: o if the managers understand their own businesses and are cooperative, then they should always be able to agree on a transfer price if it is in the best interests of the company that they do so o Sometimes negotiations break down if self-interests come in the way; might be b/c of the way they are being evaluated (i.e. NOT encouraged to cooperate) o Due to problems w/ negotiation, most companies rely on some other mean of setting transfer prices – which too have their own drawbacks
Transfers to selling division at cost -
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Set prices either at VC or absorption cost incurred by selling division Use of cost can lead t bad decisions and suboptimization* o If the transfer price was bureaucratically set at full cost, then Pizza Place would never want to buy ginger beer from Cumberland Beverages, since it could buy its ginger beer from the outside supplier at less cost But from company standpoint, the internal transfer should happen (especially if the selling division has idle capacity) because the transfer price will be very cheap (taking into account the opportunity cost) If cost is used as transfer price, selling division will never show PROFIT on any internal transfer Third problem is that there is no incentive to control costs; if the costs of one division are simply passed on to the next, then there is little incentive for anyone to work to reduce costs.
Transfers at market price -
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Market price: price charged for item in open market is regarded as BEST approach to transfer pricing problem o Designed for situations in which there is intermediate market for transferred product or service o Intermediate market: means a market in which the product or service is sold in its present form to outside customers. Price in this market is perfect to transfer at if selling division has no idle capacity More profitable to sell to the outside market than to transfer internally At the market price with no idle capacity, difficulties occur when the selling division has idle capacity;
Divisional Autonomy and Suboptimization -
In line with decentralization, co’s should grant mgers autonomy to set transfer price and decide whether to sell internally or externally It may be hard for top mgers to accept this principle when their subordinate managers are about to make a suboptimal decision If top managers wish to create a culture of autonomy and independent profit responsibility, they must allow their subordinate managers to control their own destiny—even to the extent of granting their managers the right to make mistakes.
International Aspects of Transfer Pricing -
Transfer pricing used worldwide to control flow of g/s among segments of orgs
Transfer Pricing Objectives Domestic International Greater divisional autonomy Lower taxes, duties, and tariffs Greater motivation for managersFewer foreign exchange risks Better performance evaluation Better competitive position Better goal congruence Better governmental relationships Domestic objectives are always desirable, but become secondary when international transfers are involved*** Managers need to be sensitive to legal rules in establishing transfer prices Evaluating Investment Centre Performance – ROI -
Transfer prices and assigning costs to responsibility centres are important for cost and profit centres 2 methods of evaluating investment centre’s performance: ROI, and residual income
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The higher it is, the greater profit generated per $ invested
ROI
OI and OA -
OI = EBIT (earnings b4 interest and taxes) Use OI b/c in OA (denominator), no debt is included and interest expense is paid for by the profits of OA
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OA: cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization and/or the investment centre o Stuff that wouldn’t be included in OA category (non-op assets, for ex) include land and investments in other companies – FUTURE use assets o Average of OA = b+e/2 One major issue is what $ value to include in OA for equipment and plant; (i.e. NBV or GROSS VALUE) NBV GROSS Consistent w/ balance sheet Eliminates age and method of Consistent w/ computation of ROI depreciation (b/c under NBV, ROI will increase as NBV ↓ due to depreciation) Doesn’t discourage replacement (replacement for NBV will (-) impact) WE GONNA USE NBV APPROACH DAWG
Understanding ROI
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Margin – measure of mgmt’s ability to control operating expenses in relation to sales o Lower the expense, higher the margin o Improve by increasing sales or decreasing expenses Turnover – measures sales generated for each dollar invested in OA o Excess funds tied up in inactive assets depress turnover and as a result, lower ROI ROI can be compared to returns of other investment centres in the orgs, in returns of other cos in the industry and to the past returns of the investment centre itself
Any increase in ROI must involve at least one of the following: 1. 2. 3.
Increased sales Reduced operating expenses Reduced operating assets
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1) If the percentage increase in sales exceeds the percentage increase in operating expenses, ROI will always improve - - is for a increase in sales without increase in operating assets
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o 2) Decreased expenses w/ no change in sales or assets - - - leads to increased ROI but must be careful to cut discretionary expenses and not something that will cause decreased sales, low morale, etc
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o 3) Investing in assets - - - proportionate increase in operating assets AND sales/net income
o Criticisms of ROI -
1) ROI may not be enough; don’t know how exactly to increase it (may take actions that are good in SHORT-TERM like cutting costs) – need to stay consistent with co’s strategy 2) A mger who takes over a bus segment typically inherits many committed costs over which mger has no control - - - these costs may make it hard to assess the performance off the manager 3) Mger who is evaluated based on ROI may reject profitable investment opportunities
Residual Income -
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Is the operating income that an investment centre earns above the minimum required return on its operating assets.
When residual income is used to measure performance, the purpose is to maximize the total amount of residual income not to maximize overall ROI If residual income method adopted at a division, then the manager SHOULD BE evaluated based on growth from yr to yr
Motivation and Residual Income -
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One primary reason why controller would want to switch from ROI to residual income is b/c residual income encourages investments that are profitable for the entire company but would be rejected if evaluated by ROI
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Is rejected b/c the 18% ($4.5k/25k) return on the new machine is below the current ROI of 20% A manager who is evaluated based on ROI will want to reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the minimum required rate of return for the entire company. BUT: it’s in best interests for the co to accept any project w/ return > minimum so managers evaluated on residual income will make better investment decisions than those evaluated on ROI
Divisional Comparison and Residual Income -
ONE MAJOR ADVANTAGE OF “ “: cannot be used to compare divisions w/ diff sizes Larger firms, in general, will have more residual income (b/c they are bigger, not necessarily better)
Criticisms of RI -
RI based on historical actg data; actg values used for cap assets can suffer from being out of date when costs are rising; can lead to inflated RI NO standard income to compare to; should use external benchmarks or overall trend (i.e. RI growing over years, etc) Calculating RI requires numerous adjustments to financial info – increases cost of preparing info Doesn’t incorporate NON-FINANCIAL INDICATORS of success like employee motivation or customer satisfaction
Balanced Scorecard -
Consists of an integrated set of performance measures that is derived from the company's strategy and that supports the company's strategy throughout the organization 3 generic approaches to outperforming competitors o Cost Leadership: by maintaining low cost through efficiency, co will be able to make superior profits at current industry prices Low costs can also be a barrier for other competitors o Differentiation: Customers will pay premium for unique products; higher profits – can’t be too high though-lose brand loyalty o Focus/niche: achieve superiority by serving narrow target market more effectively
Common Characteristics of Balanced Scorecards
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Four groups: financial, internal business processes, customer, learning/growth Strong emphasis on continual improvement** - if orgs doesn’t improve, it’ll lose out to competitors who do Ultimately, most cos exist to provide financial rewards to owners Financial performance measures alone aren’t enough though, should be integrated with non-financial measures in a well-designed balanced scorecard o Financial measures are lag indicators, report on results of PAST ACTIONS o Non-financial measures of key success drivers like customer satisfaction are leading indicators of FUTURE FINANCIAL PERFORMANCE Second, top mgers are responsible for financial performance measures NOT lower-level mgers Selecting performance measures: o 1) should be consistent with and follow from, co’s strategy o 2) don’t have too many measures – causes confusion and lack of focus Each individual has a personal scorecard as well – consists of items individual can influence in relation to the company’s scorecard
Company’s strategy and the Balanced Scorecard -
Company must decide which customers to target and what internal business processes are crucial to attracting and retaining those customers
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Performance measures must be tailored to the specific strategy of each company. Balanced scorecard illustrates a theory of how the company can attain its desired outcomes (financial, in this case) by taking concrete actions One advantage is that it can be used to continually test the theories underlying mgmt strategy; if strategy not working, it becomes obvious when some of the predictions don’t come true o Without this feedback, mgmt may keep drifting on faulty assumptions!
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Tying Compensation to Balanced Scoreboard -
Incentives for workers must be tied to the scorecard performance measures
Advantage of timely feedback
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Any performance measures used should be reported on frequent and timely basis E.g. data on defects is reported immediately Focus on trends in performance measures over time; emphasis on improvement
Some measures of Internal Business Process Performance -
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Provide feedback needed for improving these processes o Info essential for cost and quality improvements -> leads to greater profitability and customer satisfaction 3 performances in particular are key: o Delivery Cycle Time - amount of time from when an order is received from a customer to o
when the completed order is shipped is called; best to keep as short as possible Throughput (MFTING CYCLE) time - amount of time required to turn raw materials into completed products; made up of process time, inspection time, move time, and queue time Process time: amt of time in which work is actually done on product Inspection time: time spent ensuring that the product is not defective. Move time is the time required to move materials or partially completed products from workstation to workstation. Queue time is the amount of time a product spends waiting to be worked on, to be moved, to be inspected, or in storage waiting to be shipped.
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ONLY process time adds value, the other three should be eliminated
Manufacturing Cycle Efficiency (MCE):
If MCE < 1 - - non-value-added time is present in the production process
Some Final Observations -
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Balanced scorecard should be tailored to co’s strategy - - each co’s should be unique Balanced “ reflects strategy or theory abt how co can further its objectives by taking specific actions; theory should be tentative and subject to changes - - if it doesn’t work obv - - if theory changes, then the performance measures change on the balanced scorecard and should also change Balanced scorecard isn’t only piece – other info should also be used – doesn’t replace the need for regular preparation and use of detailed reports on key operating activities
Cost of Quality -
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A company may have a product with a high-quality design that uses high-quality components, but if the product is poorly assembled or has other defects, the company will have high warranty repair costs and dissatisfied customers The objective is to have high quality of conformance.
Quality of Conformance -
Product which meets or exceeds design specifications and is free of defects that mark its appearance or degrade its performance = = quality of conformance
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Preventing, detecting, and dealing with defects cause costs that are called quality costs or the cost of quality. Quality cost refers to all of the costs that are incurred to prevent defects or that are incurred as a result of defects occurring. o 4 groups: 2 are prevention costs and appraisal costs -- incurred in an effort to keep defective product from reaching customers o Internal/external failure costs are incurred b/c defects are produced despite efforts to prevent them Quality costs do not just relate to manufacturing; they relate to all of the activities in a company from initial research and development through customer service # of costs associated with quality is very large; can be high unless mgmt gives this area attention
Prevention costs -
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Avoid having quality problems
