Decentralization and Segment Reporting

LEARNING OBJECTIVES
1. Differentiate between a cost centre, profit centre and investment centre and explain how performance
is measured in each.
2. Prepare a segmented income statement using the contribution format, and explain the difference
between traceable fixed costs and common fixed costs.
3. Identify three business practices that hinder proper cost assignment.
4. Analyze variances from revenue targets.
5. Analyze marketing expenses using cost drivers.
6. Compute the return on investment (ROI).
7. Show how changes in sales, expenses and assets affect an organizations ROI.
8. Compute residual income and understand the strengths and weaknesses of this method of measuring
performance.
9. Determine the range, if any, within which a negotiated transfer price should fall.

Decentralization in Organizations
Benefits of Decentralization
Top management freed to concentrate on strategy.
Lower-level managers gain experience in decision-making.
Decision-making authority leads to job satisfaction.
Lower-level decision often based on better information.
Improves ability to evaluate managers.
Disadvantages of Decentralization
May be a lack of coordination among autonomous managers
Lower-level managers may make decisions without seeing the big picture.
Lower-level managers objectives may not be those of the organization
May be difficult to spread innovative ideas in the organization

A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit
data. A segment can be An Individual Store, A Sales Territory, A Service Centre.

Responsibility Centers: Cost, Profit and Investment Centers

Traceable and Common Costs
Fixed Costs:
Traceable- Costs arise because Costs arise because of the existence of the existence of a particular
segment. Traceable costs would disappear over time if the segment itself disappeared. Example, No
computer No computer division means . . . No computer division manager.

Common- Costs arise because Costs arise because of overall operating of overall operating activities. Dont
allocate common costs. Common costs arise because of overall operation of the company and are not due
to the existence of a particular segment. Example, No computer division but We still have a We still have
a company president.

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 Cost of goods sold consists of variable manufacturing cost
Other variable costs 30,000
Total variable costs 150,000 Fixed and variable costs are listed in separate sections
Contribution margin 150,000
Traceable fixed costs 90,000
Segment margin 60,000 Segment margin is Televisions contribution to overall operations.
 Income Statement
Company Television Computer
Sales 500,000 300,000 200,000
Variable costs (230,000) (150,000) (80,000)
CM 270,000 150,000 120,000
Traceable FC (170,000) (90,000) (80,000)
Division margin 100,000 60,000 40,000
Common costs (25,000)
Ne t income 75,000

Traceable Cost- Advertising, Liability Insurance, Marketing Manager, Rent, Warehouse Costs
Common Cost-Salary of President, Others Cost & Expenses not traceable to any division

Return on Investment (ROI) Formula

Profit Margin X Asset Turnover
EBIT EBIT Sales
ROI= ------------------------------------------ or ------------------ X -------------------
Average Operating Assets* Sales Average Operating Assets

*Cash, accounts receivable, inventory, plant and equipment, and other productive assets
Three ways to improve ROI . . Increase Sales, Reduce Expenses, Reduce Assets

Residual Income - Another Measure of Performance

A 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.
Actual Return 30,000
Less: Required Return (20,000)**
Residual Income 10,000

**Operating assets of 100,000 x Required Rate of Return of 20%

Absorption & Variable Costing

Problem (Variable and absorption costing unit product costs and income statements)
ZKB company manufactures a unique device that is used by internet users to boost Wi-Fi
signals. The following data relates to the first month of operation:
Beginning inventory: 0 units
Units produced: 40,000 units
Units sold: 35,000 units
Selling price: $120 per unit
Marketing and administrative expenses:
Variable marketing and administrative expenses per unit: P4
Fixed marketing and administrative expenses per month: P1,120,000
Manufacturing costs:
Direct materials cost per unit: P30
Direct labor cost per unit: P14
Variable manufacturing overhead cost per unit: P4
Fixed manufacturing overhead cost per month: P1,280,000

Management is anxious to see the success as well as profitability of newly designed unique
booster.
Required:
1. Calculate unit product cost and prepare income statement under variable costing system
and absorption costing system.
2. Prepare income statement under two costing system.
3. Prepare a schedule to reconcile the net operating income under variable and absorption
costing system.
Solution:

(1) Calculation of unit product cost:

*$1,280,000/40,000 units

(2) Income statements:

a. Absorption costing:
b. Variable costing:

(3) Reconciliation schedule: