12-1

Decentralization in
Organizations
Benefits of
Top management
Decentralization
Chapter 12 Lower-level managers
gain experience in
freed to concentrate
on strategy.

decision-making. Decision-making
authority leads to
job satisfaction.
Segment Reporting Lower-level decision
often based on
better information.
and Decentralization Improves ability to
evaluate managers.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Decentralization in Decentralization and Segment

Organizations Reporting
An Individual Store
May be a lack of A segment is any Quick Mart
coordination among
autonomous part or activity of an
Lower-level managers
may make decisions
managers. organization about A Sales Territory
without seeing the which a manager
“big picture.”
Disadvantages of seeks cost,
Lower-level manager’s
Decentralization revenue, or profit
objectives may not data. A segment A Service Center
be those of the
organization.
can be . . .
May be difficult to
spread innovative ideas
in the organization.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Cost, Profit, and Investments Cost, Profit, and Investments

Centers Centers

Cost Center Profit Center

Revenues
A segment whose A segment whose Sales
manager has manager has Interest
Other
control over costs, control over both
but not over costs and Costs
Mfg. costs
revenues or revenues, Commissions
investment funds. but no control over Salaries
investment funds. Other

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-2

Cost, Profit, and Investments Cost, Profit, and Investments

Centers Centers
Corporate Headquarters
Investment Cost Profit Investment
Center Center Center Center
A segment whose
manager has
control over costs, Cost, profit,
revenues, and and investment
centers are all Responsibility
investments in
known as Center
operating assets. responsibility
centers.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Identifying Traceable Fixed

Traceable and Common Costs
Costs
Fixed Traceable costs would disappear over
Costs Don’t allocate time if the segment itself disappeared.
common costs.
No computer No computer
division means . . . division manager.
Traceable Common

A cost that supports more than one

Costs arise because
segment but that would not go
of the existence of
away if any particular segment
a particular segment
were eliminated.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Identifying Common Fixed Levels of Segmented

Costs Statements
Common costs arise because of overall Webber, Inc. has two divisions.
operation of the company and are not due to
the existence of a particular segment. Webber, Inc.
No computer We still have a
division but . . . company president.
Computer Division Television Division

Let’s look more closely at the Television

Division’s income statement.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-3

Levels of Segmented Levels of Segmented

Statements Statements
Our approach to segment reporting uses the Our approach to segment reporting uses the
contribution format. contribution format.
Income Statement Cost of goods Income Statement
Contribution Margin Format sold consists of Contribution Margin Format
Television Division variable Television Division
Sales $ 300,000 manufacturing Sales $ 300,000 Segment margin
Variable COGS 120,000 costs. Variable COGS 120,000 is Television’s
Other variable costs 30,000 Other variable costs 30,000 contribution
Total variable costs 150,000
Fixed and Total variable costs 150,000
variable costs to profits.
Contribution margin 150,000 Contribution margin 150,000
are listed in
Traceable fixed costs 90,000 Traceable fixed costs 90,000
separate
Division margin $ 60,000 Division margin $ 60,000
sections.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Levels of Segmented Levels of Segmented

Statements Statements
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Let’s see how the Television
Common costs
Division fits into Webber, Inc.
Net operating
income

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Levels of Segmented Traceable Costs Can Become

Statements Common Costs
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Fixed costs that are traceable on one
Variable costs 230,000 150,000 80,000 segmented statement can become
CM 270,000 150,000 120,000 common if the company is divided into
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
smaller segments.
Common costs 25,000
Common costs should
Let’s see how this works!
Net operating
not be allocated to the
income $ 75,000
divisions. These costs
would remain even if one
of the divisions were
eliminated.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-4

Traceable Costs Can Become Traceable Costs Can Become

Common Costs Common Costs
Income Statement
Webber’s Television Division Television

Television
Product Division Regular Big Screen

Division Lines Sales

Variable costs
$ 200,000
95,000
$ 100,000
55,000
CM 105,000 45,000
Traceable FC 45,000 35,000
Regular Big Screen
Product line margin $ 60,000 $ 10,000
Common costs
Divisional margin
U.S. Sales Foreign Sales U.S. Sales Foreign Sales

We obtained the following information from

Sales the Regular and Big Screen segments.
Territories
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Traceable Costs Can Become Traceable Costs Can Become

Common Costs Common Costs
Income Statement Income Statement
Television Television
Division Regular Big Screen Division Regular Big Screen
Sales $ 300,000 $ 200,000 $ 100,000 Sales $ 300,000 $ 200,000 $ 100,000
Variable costs 150,000 95,000 55,000 Variable costs 150,000 95,000 55,000
CM 150,000 105,000 45,000 CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000 Traceable FC 80,000 45,000 35,000
Product line margin 70,000 $ 60,000 $ 10,000 Product line margin 70,000 $ 60,000 $ 10,000
Common costs 10,000 Common costs 10,000
Divisional margin $ 60,000 Divisional margin $ 60,000

Fixed costs directly traced Of the $90,000 cost directly traced to

to the Television Division the Television Division, $45,000 is
$80,000 + $10,000 = $90,000 traceable to Regular and $35,000
traceable to Big Screen product lines.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Traceable Costs Can Become

Common Costs
Segment Margin
Income Statement
Television
Division Regular Big Screen The segment margin is the best gauge of
Sales $ 300,000 $ 200,000 $ 100,000 the long-run profitability of a segment.
Variable costs 150,000 95,000 55,000
CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000
Product line margin 70,000 $ 60,000 $ 10,000
Profits

Common costs 10,000

Divisional margin $ 60,000

The remaining $10,000 cannot be traced to

either the Regular or Big Screen product lines.
© The McGraw-Hill Companies, Inc., 2003
Time © The McGraw-Hill Companies, Inc., 2003
McGraw-Hill/Irwin McGraw-Hill/Irwin
 12-5

Hindrances to Proper Cost

Omission of Costs
Assignment

The Problems Costs assigned to a segment should include

all costs attributable to that segment from
Omission of some Assignment of costs the company’s entire value chain.
costs in the to segments that are Business Functions
assignment process. really common costs of Making Up The
the entire organization. Value Chain
Product Customer
The use of inappropriate
R&D Design Manufacturing Marketing Distribution Service
methods for allocating
costs among segments.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Inappropriate Methods of Allocating

Allocations of Common Costs
Costs Among Segments
Income Statement
Arbitrarily dividing Haglund's
common costs Lakeshore Bar Restaurant
among segments Sales $ 800,000 $ 100,000 $ 700,000
Inappropriate Variable costs 310,000 60,000 250,000
Failure to trace allocation base CM 490,000 40,000 450,000
costs directly Traceable FC 246,000 26,000 220,000
Segment margin 244,000 $ 14,000 $ 230,000
Common costs 200,000
Profit $ 44,000
Segment Segment Segment Segment
1 2 3 4

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Quick Check 9 Quick Check 9

How much of the common fixed cost of How much of the common fixed cost of
$200,000 can be avoided by eliminating the $200,000 can be avoided by eliminating the
bar? bar?
a. None of it. a. None of it.
b. Some of it. b. Some of it.
c. All of it. c. All of it.
A common fixed cost cannot be
eliminated by dropping one of
the segments.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-6

Quick Check 9 Quick Check 9

How much of the common fixed cost of How much of the common fixed cost of
$200,000 can be avoided by going out of $200,000 can be avoided by going out of
business entirely? business entirely?
a. None of it. a. None of it.
b. Some of it. b. Some of it.
c. All of it. c. All of it.
A common fixed cost can be
eliminated if all of the segments it
supports are eliminated.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Quick Check 9 Quick Check 9

Suppose square feet is used as the basis for Suppose square feet is used as the basis for
allocating the common fixed cost of $200,000. allocating the common fixed cost of $200,000.
How much would be allocated to the bar if the How much would be allocated to the bar if the
bar occupies 1,000 square feet and the bar occupies 1,000 square feet and the
restaurant 9,000 square feet? restaurant 9,000 square feet?
a. 1/10 of $200,000 a. 1/10 of $200,000 The total amount of the
b. 1/9 of $200,000 b. 1/9 of $200,000 allocation base is 10,000
c. 9/10 of $200,000 c. 9/10 of $200,000 square feet. So the bar
would be allocated 1/10 of
d. 8/9 of $200,000 d. 8/9 of $200,000
the cost.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Allocations of Common Costs Allocations of Common Costs

Income Statement Income Statement

Haglund's Haglund's
Lakeshore Bar Restaurant Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000 Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310,000 60,000 250,000 Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000 CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000 Traceable FC 246,000 26,000 220,000
Segment margin 244,000 14,000 230,000 Segment margin 244,000 14,000 230,000
Common costs 200,000 25,000 175,000 Common costs 200,000 25,000 175,000
Profit $ 44,000 $ (11,000) $ 55,000 Profit $ 44,000 $ (11,000) $ 55,000

Allocated on the basis of sales.

Hurray, now everything adds up!!! Whoops, what about the bar???
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-7

Quick Check 9 Quick Check 9

Should the bar be eliminated? Should the bar be eliminated?

a. Yes a. Yes The profit was $44,000 before
b. No b. No eliminating the bar. If we eliminate
the bar,
Income profit drops to $30,000!
Statement
Haglund's
Lakeshore Bar Restaurant
Sales $ 700,000 $ 700,000
Variable costs 250,000 250,000
CM 450,000 450,000
Traceable FC 220,000 220,000
Segment margin 230,000 230,000
Common costs 200,000 200,000
Profit $ 30,000 $ 30,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Return on Investment (ROI)

Teaching Note Formula
Income before interest
Allocating common fixed costs to the and taxes (EBIT)
segments those fixed costs support is a
recipe for disaster
Net operating income
ROI =
Average operating assets

Cash, accounts receivable, inventory,

plant and equipment, and other
productive assets.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Return on Investment (ROI) Return on Investment (ROI)

Formula Formula
Net operating income
Regal Company reports the ROI =
Average operating assets
following:
Net operating income
Net operating income $ 30,000 Margin =
Average operating assets $ 200,000 Sales
Sales $ 500,000
Turnover = Sales
Average operating assets
$30,000
ROI = = 15%
$200,000
ROI = Margin × Turnover
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Return on Investment (ROI)
Formula
ROI = Margin × Turnover
Net operating income
ROI =
Sales
ROI = $30,000 ×
$500,000
ROI = 6% × 2.5 = 15%
McGraw-Hill/Irwin
Controlling the Rate of Return
Regal’s manager was able to increase
sales to $600,000 which increased net
operating income to $42,000.
There was no change in the average
operating assets of the segment.
Let’s calculate the new ROI.
McGraw-Hill/Irwin
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
12-8
Controlling the Rate of Return
Three ways to improve ROI . . .
oReduce
Expenses
Sales nIncrease pReduce
×
Average operating assets Sales Assets
$500,000
$200,000
© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
Return on Investment (ROI)
Formula
ROI = Margin × Turnover
ROI = Net operating income
× Sales
Sales Average operating assets
ROI = $42,000 ×
$600,000
$600,000 $200,000
ROI = 7% × 3.0 = 21%
ROI increased from 15% to 21%
© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
Criticisms of ROI
As division manager at Winston, Inc., your
compensation package includes a salary plus bonus
based on your division’s ROI -- the higher your ROI,
the bigger your bonus.
The company requires an ROI of 15% on all new
investments -- your division has been producing an
ROI of 30%.
You have an opportunity to invest in a new project
that will produce an ROI of 25%.
As division manager would you
invest in this project?
© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-9

Residual Income - Another

Criticisms of ROI
Measure of Performance
Gee . . .
I thought we were As division manager,
supposed to do what I wouldn’t invest in Net operating income
that project because above some minimum
was best for the
it would lower my pay!
company! return on operating
assets

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Residual Income Residual Income

Operating
Operating assets
assets $$100,000
100,000
A division of Zepher, Inc. has average Required
Required rate
rate of
of return
return ×× 20%
20%
operating assets of $100,000 and is required Required
Required income
income $$ 20,000
20,000
to earn a return of 20% on these assets.
In the current period the division earns
$30,000. Actual
Actual income
income $$ 30,000
30,000
Required
Required income
income (20,000)
(20,000)
Residual
Residual income
income $$ 10,000
10,000
Let’s calculate residual income.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Quick Check 9 Quick Check 9

Redmond Awnings, a division of Wrapup Corp., Redmond Awnings, a division of Wrapup Corp.,
has a net operating income of $60,000 and has a net operating income of $60,000 and
average operating assets of $300,000. The average operating assets of $300,000. The
required rate of return for the company is 15%. required rate of return for the company is 15%.
What is the division’s ROI? What is the division’s ROI?
a. 25% a. 25% ROI = NOI/Average operating assets
b. 5% b. 5%
= $60,000/$300,000 = 20%
c. 15% c. 15%
d. 20% d. 20%

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
 12-10

Quick Check 9 Quick Check 9

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 © The McGraw-Hill Companies, Inc., 2003
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 division’s ROI from
20.0% down to 19.5%.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Quick Check 9 Quick Check 9

The company’s required rate of return is 15%. The company’s required rate of return is 15%.
Would the company want the manager of the Would the company want the manager of the
Redmond Awnings division to make an Redmond Awnings division to make an
investment of $100,000 that would generate investment of $100,000 that would generate
additional net operating income of $18,000 per additional net operating income of $18,000 per
year? year?
ROI = $18,000/$100,000 = 18%
a. Yes a. Yes
b. No b. No The return on the investment exceeds
the minimum required rate of return.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Quick Check 9 Quick Check 9

Redmond Awnings, a division of Wrapup Corp., Redmond Awnings, a division of Wrapup Corp.,
has a net operating income of $60,000 and has a net operating income of $60,000 and
average operating assets of $300,000. The average operating assets of $300,000. The
required rate of return for the company is 15%. required rate of return for the company is 15%.
What is the division’s residual income? What is the division’s residual income?
a. $240,000 a. $240,000
b. $ 45,000 b. $ 45,000
c. $ 15,000 c. $ 15,000
d. $ 51,000 d. $operating
Net 51,000 income $60,000
Required return (15% of $300,000) $45,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 Residual income
McGraw-Hill/Irwin $15,000
© The McGraw-Hill Companies, Inc., 2003
 12-11

Quick Check 9 Quick Check 9

If the manager of the Redmond Awnings If the manager of the Redmond Awnings
division is evaluated based on residual income, division is evaluated based on residual income,
will she want to make an investment of will she want to make an investment of
$100,000 that would generate additional net $100,000 that would generate additional net
operating income of $18,000 per year? operating income of $18,000 per year?
a. Yes a. Yes Net operating income $78,000
b. No 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 © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Motivation and Residual

End of Chapter 12
Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003