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Solutions Manual, Chapter 12 647
Chapter 12
Segment Reporting and Decentralization
Solutions to Questions
12-1 In a decentralized organization, deci- sion-making authority isn’t confined to a few top executives, but rather is spread throughout the organization with lower-level managers and oth- er employees empowered to make decisions.
12-2 The benefits of decentralization include: (1) by delegating day-to-day problem solving to lower-level managers, top management can concentrate on bigger issues such as overall strategy; (2) empowering lower-level managers to make decisions puts decision-making authori- ty in the hands of those who tend to have the most detailed and up-to-date information about day-to-day operations; (3) by eliminating layers of decision-making and approvals, organizations can respond more quickly to customers and to changes in the operating environment; (4) granting decision-making authority helps train lower-level managers for higher-level positions; and (5) empowering lower-level managers to make decisions can increase their motivation and job satisfaction.
12-3 A cost center manager has control over cost, but not revenue or the use of investment funds. A profit center manager has control over both cost and revenue. An investment center manager has control over cost and revenue and the use of investment funds.
12-4 A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Examples of segments include departments, operations, sales territo- ries, divisions, product lines, and so forth.
12-5 Under the contribution approach, costs are assigned to a segment if and only if the costs are traceable to the segment (i.e., could be avoided if the segment were eliminated). Common costs are not allocated to segments under the contribution approach. 12-6 A traceable cost of a segment is a cost that arises specifically because of the existence of that segment. If the segment were eliminat- ed, the cost would disappear. A common cost, by contrast, is a cost that supports more than one segment, but is not traceable in whole or in part to any one of the segments. If the depart- ments of a company are treated as segments, then examples of the traceable costs of a de- partment would include the salary of the de- partment’s supervisor, depreciation of machines used exclusively by the department, and the costs of supplies used by the department. Ex- amples of common costs would include the sala- ry of the general counsel of the entire company, the lease cost of the headquarters building, cor- porate image advertising, and periodic deprecia- tion of machines shared by several departments. 12-7 The contribution margin is the difference between sales revenue and variable expenses. The segment margin is the amount remaining after deducting traceable fixed expenses from the contribution margin. The contribution margin is useful as a planning tool for many decisions, including those in which fixed costs don’t change. The segment margin is useful in as- sessing the overall profitability of a segment. 12-8 If common costs were allocated to seg- ments, then the costs of segments would be
648 Managerial Accounting, 12th Edition
overstated and their margins would be under- stated. As a consequence, some segments may appear to be unprofitable and managers may be tempted to eliminate them. If a segment were eliminated because of the existence of arbitrarily allocated common costs, the overall profit of the company would decline by the amount of the segment margin because the common cost would remain. The common cost that had been allocated to the segment would then be reallo- cated to the remaining segments—making them appear less profitable.
12-9 There are often limits to how far down an organization a cost can be traced. Therefore, costs that are traceable to a segment may be- come common as that segment is divided into smaller segment units. For example, the costs of national TV and print advertising might be traceable to a specific product line, but be a common cost of the geographic sales territories in which that product line is sold.
12-10 Margin refers to the ratio of net operat- ing income to total sales. Turnover refers to the ratio of total sales to average operating assets. The product of the two numbers is the ROI.
12-11 Residual income is the net operating income an investment center earns above the company’s minimum required rate of return on operating assets.
12-12 If ROI is used to evaluate performance, a manager of an investment center may reject a profitable investment opportunity whose rate of return exceeds the company’s required rate of return but whose rate of return is less than the investment center’s current ROI. The residual income approach overcomes this problem since any project whose rate of return exceeds the company’s minimum required rate of return will result in an increase in residual income.
12-13 A transfer price is the price charged for a transfer of goods or services between seg- ments of the same organization, such as two departments or divisions. Transfer prices are needed for performance evaluation purposes.
The selling unit gets credit for the transfer price and the buying unit must deduct the transfer price as an expense. 12-14 If the selling division has idle capacity, any transfer price above the variable cost of producing an item for transfer will generate some additional profit. 12-15 If the selling division has no idle capaci- ty, then the transfer price would have to cover at least the division’s variable cost plus the con- tribution margin on lost sales. 12-16 Cost-based transfer prices are widely used because they are easily understood and convenient to use. Their disadvantages are that they can lead to poor decisions regarding whether transfers should be made, they provide little incentive for cost control, and the selling division makes no profit. 12-17 Using the market price as the transfer price can lead to incorrect decisions. When the selling division has idle capacity, the cost to the company of the transfer is just the variable cost of the item transferred. However, if the market price is used as the transfer price, the buying division regards the market price as the cost. This can lead to suboptimal pricing and other decisions. 12-18 Variable service department costs should be charged to operating departments using a predetermined rate applied to the actual services consumed. The predetermined rate should be based on budgeted costs and service levels. 12-19 Fixed service department costs should be charged in lump-sum amounts to the operat- ing departments in proportion to their peak- period needs or long-run average needs for the services provided by the service department. Budgeted costs, not actual costs, should be charged.
650 Managerial Accounting, 12th Edition
- (^) Net operating income Margin = Sales
$5,400, = = 30% $18,000,
- Sales Turnover = Average operating assets
$18,000, = = 0. $36,000,
- ROI = Margin × Turnover
= 30% × 0.5 = 15%
- Solutions Manual, Chapter
- Average operating assets (a) £2,200,
- Net operating income £400,
- Minimum required return: 16% × (a) 352,
- Residual income.................................... £ 48,
Solutions Manual, Chapter 12 653
- and 2.
Arbon Refinery
Beck Refinery Total Variable cost charges: $0.30 per gallon × 260,000 gallons ... $ 78, $0.30 per gallon × 140,000 gallons ... $ 42,000 $120, Fixed cost charges: 60% × $200,000 ............................. 120, 40% × $200,000 ............................. 80,000 200, Total charges ..................................... $198,000 $122,000 $320,
- Part of the $365,000 in total actual cost will not be allocated to the re- fineries, as follows: Variable Cost
Fixed Cost Total Total actual costs incurred................... $148,000 $217,000 $365, Total charges (above) ......................... 120,000 200,000 320, Spending variance .............................. $ 28,000 $ 17,000 $ 45, The overall spending variance of $45,000 represents costs incurred in excess of the budgeted $0.30 per gallon variable cost and budgeted $200,000 in fixed costs. This $45,000 in unallocated cost is the respon- sibility of the Transport Services Department.
654 Managerial Accounting, 12th Edition
Total Geographic Market Company South Central North Sales ................................ $1,500,000 $400,000 $600,000 $500, Variable expenses ............. 588,000 208,000 180,000 200, Contribution margin .......... 912,000 192,000 420,000 300, Traceable fixed expenses .. 770,000 240,000 330,000 200, Geographic market seg- ment margin .................. 142,000 $(48,000) $ 90,000 $100, Common fixed expenses not traceable to geo- graphic markets* ........... 175, Net operating income (loss)............................. $ (33,000) *$945,000 – $770,000 = $175,000.
- Incremental sales ($600,000 × 15%) ................... $90, Contribution margin ratio ($420,000 ÷ $600,000). × 70% Incremental contribution margin .......................... 63, Less incremental advertising expense ................... 25, Incremental net operating income ........................ $38, Yes, the advertising program should be initiated.
656 Managerial Accounting, 12th Edition
- Computation of ROI.
Division A:
ROI = × = 5% × 4 = 20%
Division B:
ROI = × = 9% × 2 = 18%
Division C:
ROI = × = 2.25% × 4 = 9%
- Division A Division B Division C Average operating assets ..... $1,500,000 $5,000,000 $2,000, Required rate of return ........ × 15% × 18% × 12% Required operating income .. $ 225,000 $ 900,000 $ 240, Actual operating income ...... $ 300,000 $ 900,000 $ 180, Required operating income (above) ............................ 225,000 900,000 240, Residual income .................. $ 75,000 $ 0 $ (60,000)
Solutions Manual, Chapter 12 657
Exercise 12-8 (continued)
- a. and b. Division A Division B Division C Return on investment (ROI) ... 20% 18% 9% Therefore, if the division is presented with an invest- ment opportunity yielding 17%, it probably would ....... Reject Reject Accept Minimum required return for computing residual income .. 15% 18% 12% Therefore, if the division is presented with an invest- ment opportunity yielding 17%, it probably would ....... Accept Reject Accept If performance is being measured by ROI, both Division A and Division B probably would reject the 17% investment opportunity. The reason is that these companies are presently earning a return greater than 17%; thus, the new investment would reduce the overall rate of return and place the divisional managers in a less favorable light. Division C proba- bly would accept the 17% investment opportunity, since its acceptance would increase the Division’s overall rate of return. If performance is being measured by residual income, both Division A and Division C probably would accept the 17% investment opportunity. The 17% rate of return promised by the new investment is greater than their required rates of return of 15% and 12%, respectively, and would therefore add to the total amount of their residual income. Division B would reject the opportunity, since the 17% return on the new invest- ment is less than B’s 18% required rate of return.
Solutions Manual, Chapter 12 659
- Long-Run Average Number of Employees Percentage Cutting Department ...... 600 30% Milling Department ....... 400 20% Assembly Department ... 1,000 50% Total ............................ 2,000 100%
Cutting Milling Assembly Variable cost charges: $60 per employee × 500 employees. $ 30, $60 per employee × 400 employees. $ 24, $60 per employee × 800 employees. $ 48, Fixed cost charges: 30% × $600,000 ............................. 180, 20% × $600,000 ............................. 120, 50% × $600,000 ............................. 300, Total charges ..................................... $210,000 $144,000 $348,
- Part of the total actual cost is not charged to the operating departments as shown below: Variable Cost
Fixed Cost Total Total actual costs incurred............... $105,400 $605,000 $710, Total charges ................................. 102,000 600,000 702, Spending variance .......................... $ 3,400 $ 5,000 $ 8, The overall spending variance of $8,400 represents costs incurred in ex- cess of the budgeted variable cost of $60 per employee and the budget- ed fixed cost of $600,000. This $8,400 in uncharged costs is the respon- sibility of the Medical Services Department.
660 Managerial Accounting, 12th Edition
- $75,000 × 40% CM ratio = $30,000 increased contribution margin in Dallas. Since the fixed costs in the office and in the company as a whole will not change, the entire $30,000 would result in increased net operat- ing income for the company. It is incorrect to multiply the $75,000 increase in sales by Dallas’s 25% segment margin ratio. This approach assumes that the segment’s trace- able fixed expenses increase in proportion to sales, but if they did, they would not be fixed.
- a. The segmented income statement follows:
Segments Total Company Houston Dallas Amount % Amount % Amount % Sales ................... $800,000 100.0 $200,000 100 $600,000 100 Variable expenses ........... 420,000 52.5 60,000 30 360,000 60 Contribution margin .............. 380,000 47.5 140,000 70 240,000 40 Traceable fixed expenses ........... 168,000 21.0 78,000 39 90,000 15 Office segment margin .............. 212,000 26.5 $ 62,000 31 $150,000 25 Common fixed expenses not traceable to segments .......... 120,000 15. Net operating income .............. $ 92,000 11.
b. The segment margin ratio rises and falls as sales rise and fall due to the presence of fixed costs. The fixed expenses are spread over a larger base as sales increase. In contrast to the segment ratio, the contribution margin ratio is sta- ble so long as there is no change in either variable expenses or the selling price of a unit of service.
662 Managerial Accounting, 12th Edition
- ROI computations:
Net operating income Sales ROI = × Sales Average operating assets
Perth:
× = 7% × 3 = 21%
Darwin:
× = 9% × 2 = 18%
- Perth Darwin Average operating assets (a)............... $3,000,000 $10,000, Net operating income ......................... $630,000 $1,800, Minimum required return on average operating assets—16% × (a)............ 480,000 1,600, Residual income ................................. $150,000 $ 200,
- No, the Darwin Division is simply larger than the Perth Division and for this reason one would expect that it would have a greater amount of re- sidual income. Residual income can’t be used to compare the perfor- mance of divisions of different sizes. Larger divisions will almost always look better. In fact, in the case above, Darwin does not appear to be as well managed as Perth. Note from Part (1) that Darwin has only an 18% ROI as compared to 21% for Perth.
Solutions Manual, Chapter 12 663
- (^) Net operating income Margin = Sales
$800, = = 10.00% $8,000,
Sales Turnover = Average operating assets
$8,000, = = 2. $3,200,
ROI = Margin × Turnover
= 10% × 2.50 = 25%
- (^) Net operating income Margin = Sales
$800,000(1.00 + 4.00)
$8,000,000(1.00 + 1.50)
$4,000, = = 20.00% $20,000,
Sales Turnover = Average operating assets
$8,000,000 (1.00 + 1.50)
$3,200,
$20,000,
ROI = Margin × Turnover
= 20% × 6.25 = 125%
Solutions Manual, Chapter 12 665
Company A Company B Company C Sales ......................................... $400,000 * $750,000 * $600,000 * Net operating income ................. $32,000 $45,000 * $24, Average operating assets ........... $160,000 * $250,000 $150,000 * Return on investment (ROI) ....... 20% * 18% * 16% Minimum required rate of return: Percentage ............................. 15% * 20% 12% * Dollar amount ......................... $24,000 $50,000 * $18, Residual income ........................ $8,000 ($5,000) $6,000 *
*Given.
666 Managerial Accounting, 12th Edition
- a. The lowest acceptable transfer price from the perspective of the sell- ing division, the Electrical Division, is given by the following formula: Total contribution margin Variable cost on lost sales Transfer price (^) per unit + Number of units transferred
Because there is enough idle capacity to fill the entire order from the Motor Division, there are no lost outside sales. And because the vari- able cost per unit is $21, the lowest acceptable transfer price as far as the selling division is concerned is also $21. $ Transfer price $21 + = $ 10,
b. The Motor Division can buy a similar transformer from an outside supplier for $38. Therefore, the Motor Division would be unwilling to pay more than $38 per transformer. Transfer price £Cost of buying from outside supplier = $
c. Combining the requirements of both the selling division and the buy- ing division, the acceptable range of transfer prices in this situation is: $21 £ Transfer price £$ Assuming that the managers understand their own businesses and that they are cooperative, they should be able to agree on a transfer price within this range and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take place. The cost of the transformers transferred is only $21 and the company saves the $38 cost of the transformers purchased from the outside supplier.
