Segment Reporting and Decentralization

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Segment Reporting and Decentralization

• Chapter Twelve

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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.
Lower level managers can respond quickly to
customers.
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Decentralization in Organizations
May be a lack of coordination among autonomous man
agers.
Lower-level managers may make decisions without
seeing the big picture.
Disadvantages of Decentralization
Lower-level managers objectives may not be those
of the organization.
May be difficult to spread innovative ideas in
the organization.
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Decentralization and Segment Reporting
An Individual Store
A segment is any part or activity of an
organization about which a manager seeks cost,
revenue, or profit data. A segment can be . . .
Quick Mart
A Sales Territory
A Department
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Cost, Profit, and Investments Centers
Cost Center
Profit Center
Investment Center
Cost, profit, and investment centers are
all known as responsibility centers.
Responsibility Center
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Measuring Managers Performance
Evaluation Tool
Cost Center
Standard Cost/Flexible Budget Variances
Profit Center
Budgeted income statement
Investment Center
Return on investment or residual income
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Return on Investment (ROI) Formula
Income before interest and taxes (EBIT)
Cash, accounts receivable, inventory, plant and
equipment, and other productive assets.
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Return on Investment (ROI) Formula
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Improving R0I

• Decrease
• Expenses

• Increase
• Sales

• Reduce
• Operating Assets

• Three ways to improve ROI

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Improving ROI An Example

• Regal Company reports the following
• Net operating income 30,000
• Average operating assets 200,000
• Sales
  500,000
• Operating expenses 470,000

What is Regal Companys ROI?
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Increasing Sales Without an Increase in Operating
Assets

• Regals manager was able to increase sales to
  600,000 while operating expenses increased to
  558,000.
• Regals net operating income increased to
  42,000.
• There was no change in the average operating
  assets of the segment.

Lets calculate the new ROI.
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Decreasing Operating Expenses with no Change in
Sales or Operating Assets
Assume that Regals manager was able to reduce
operating expenses by 10,000 without affecting
sales or operating assets. This would increase
net operating income to 40,000.
Regal Company reports the following Net
operating income 40,000 Average
operating assets 200,000 Sales
500,000 Operating
expenses 460,000
Lets calculate the new ROI.
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Decreasing Operating Assets with no Change in
Sales or Operating Expenses
Assume that Regals manager was able to reduce
inventories by 20,000 using just-in-time
techniques without affecting sales or operating
expenses.
Regal Company reports the following Net
operating income 30,000 Average
operating assets 180,000 Sales
500,000 Operating
expenses 470,000
Lets calculate the new ROI.
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Investing in Operating Assets to Increase Sales
Assume that Regals manager invests in a 30,000
piece of equipment that increases sales by
35,000 while increasing operating expenses by
15,000.
Regal Company reports the following Net
operating income 50,000 Average
operating assets 230,000 Sales
535,000 Operating
expenses 485,000
Lets calculate the new ROI.
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Pop Quiz

• Applebaum Enterprises had a margin of 8, sales
  of 3,000,000, and average operating assets of
  2,000,000. The company's ROI was
• A. 5.33.
• B. 7.00.
• C. 12.00.
• D. 20.00.
• E. some other figure.

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Pop Quiz

• The Brookshire Company had a 12 return on a
  50,000 investment in new equipment. The
  investment resulted in increased sales, and the
  resultant increase in income amounted to 4 of
  the increase in sales. Brookshires turnover was
• A) 1
• B) 1.5
• C) 2
• D) 3

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ROI - A Major Drawback

• As division manager at Winston, Inc., your
  compensation package includes a salary plus bonus
  based on your divisions ROI -- i.e., 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?
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Residual Income - Another Measure of Performance
Net operating income that an investment center
earns above the minimum required return on its
operating assets
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Calculating Residual Income
(
)
Residual income measures net operating income
earned less the minimum required return on
average operating assets.
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Residual Income An Example

• The Retail Division of Zepher, Inc. has average
  operating assets of 100,000 and is required to
  earn a return of 20 on these assets.
• In the current period the division earns 30,000.

Lets calculate residual income.
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Quick Check ?

• Redmond Awnings, a division of Wrapup Corp.,
  has a net operating income of 60,000 and average
  operating assets of 300,000. The required rate
  of return for the company is 15. What is the
  divisions ROI?
• a. 25
• b. 5
• c. 15
• d. 20

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Quick Check ?

• Redmond Awnings, a division of Wrapup Corp.,
  has a net operating income of 60,000 and average
  operating assets of 300,000. If the manager of
  the division is evaluated based on ROI, will she
  want to make an investment of 100,000 that would
  generate additional net operating income of
  18,000 per year?
• a. Yes
• b. No

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Quick Check ?

• The companys required rate of return is 15.
  Would the company want the manager of the Redmond
  Awnings division to make an investment of
  100,000 that would generate additional net
  operating income of 18,000 per year?
• a. Yes
• b. No

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Quick Check ?

• Redmond Awnings, a division of Wrapup Corp.,
  has a net operating income of 60,000 and average
  operating assets of 300,000. The required rate
  of return for the company is 15. What is the
  divisions residual income?
• a. 240,000
• b. 45,000
• c. 15,000
• d. 51,000

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Quick Check ?

• If the manager of the Redmond Awnings division
  is evaluated based on residual income, will she
  want to make an investment of 100,000 that would
  generate additional net operating income of
  18,000 per year?
• a. Yes
• b. No

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Divisional Comparisons and Residual Income
The residual income approach has one major
disadvantage. It cannot be used to compare
performance of divisions of different sizes.
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Zepher, Inc.Is Wholesale performing better than
Retail?
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Practice

• At Pittsburgh Pipe Fittings the required rate of
  return on invested capital is 8.

Div A






Sales Revenue

10,000,000



2,000,000
Operating Income


2,500,000
Average Assets


Margin


Turnover


ROI


Residual Income



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Practice, continued

• At Pittsburgh Pipe Fittings the required rate of
  return on invested capital is 8.

Div B





Sales Revenue



400,000
Operating Income



Average Assets



Margin


20
Turnover


1
ROI


Residual Income



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Quick Check ?

• Johanssen Company reported the following
  information for 2007
• Sales 787,000
• Average Operating Assets 375,000
• Minimum Required Rate of Return 9
• Residual Income 11,250
• The company's operating income for 2007 was
• A) 37,080
• B) 33,750
• C) 45,000
• D) 363,750

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Pop Quiz

• Extron Division reported a residual income of
  200,000 for the year just ended. The division
  had 8,000,000 of average assets and 1,000,000
  of operating income. On the basis of this
  information, the minimum required rate of return
  was
• A. 2.5.
• B. 10.0.
• C. 12.5.
• D. 20.0.
• E. some other figure.

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Pop Quiz

• Hasty Corporation minimum required rate of
  return of 12. Division C, which is part of
  Hasty, had average operating assets of 800,000
  and an ROI of 15. On the basis of this
  information, C's residual income was
• A. (24,000).
• B. 24,000.
• C. 96,000.
• D. 120,000.
• E. some other amount.