ADM 2341 Chapter Notes - Chapter 11: Management Accounting, Financial Statement, Cost Accounting
16 Dec 2016
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Chapter 11: Reporting for Control (6 pages)
Decentralization in Organizations
- Managers use performance assessment/control to try to ensure the organization moves in the planned direction
- Decentralized organization: decision making is spread throughout the organization rather than being confined to a few top execs –
extreme version: few, if any, constraints on even lowest-level managers & employees to make decisions vs. extreme opposite – most
organizations fall between the 2
Decentralization & segment reporting
- Effective decentralization requires segment reporting to permit analysis & evaluation of decisions made by segment managers
- Segment: a part/activity of an organization about which managers would like cost, revenue, or profit data (eg: geographical region,
individual store, nature of merchandise, brand name) – can classify segments by manager’s ability to control revenues, costs & profits
Segment Reporting
- Segment reporting: preparing several income statements that focus on the segments of a company
Operating segment for financial accounting purposes is a component of an enterprise:
- That engages in business activities from which it may earn revenues & incur expenses
- Whose operating results are regularly reviewed by the COO to make decisions about resources to be allocated to the segment & assess
its performance
- For which discrete financial information is available
Different levels of segmented statements:
- Segmented statements can be prepared for different levels of activity
in an organization & in different formats
- Segmented income statements can be prepared for activities at many
levels in the company
- Many benefits accruing to the manager from a series of statements
like these – gain considerable insight into the company as a whole &
opportunities/courses of action that would’ve otherwise remained
hidden from view (by carefully examining trends & results in each
segment)
- The order of breakdown (eg: division, then product line, then
territory) depends on what info is desired, what management wants
to learn & the types of comparisons desired – but shouldn’t affect
numbers, just alter what appears on a report & ease of review
Assigning costs to segments:
- Segmented statements for internal use typically prepared in CM
format – on exception
- Fixed costs divided into 2 parts on a segmented statement:
1. Traceable (charged to the various segments)
2. Common (not traceable directly to a segment, kept separate
from segments themselves)
- 2 guidelines to assign costs for various segments of a company
under contribution approach:
1. 1st according to cost behavior pattern (variable & fixed)
2. 2nd according to if the costs are directly traceable to the
segments involved
Sales & CM:
- The prepared segmented statements for management purposes, must
keep records of sales by individual statement & in total for the
organization – can compute CM for each segment
- Segmented statements give managers ability to compute how sales
fluctuations affect operating income (unit CM x sales price) on a
product-by-product, division-by-division, or territory-by-territory
basis – highlight areas of weakness or capitalize on areas of strength
Importance of fixed costs:
- Different costs are needed for different purposes – variable costs &
revenues alone may be adequate for 1 purpose, but may need fixed
costs too for another purpose
- Breaking apart fixed & variable costs emphasizes to management
that costs are controlled differently & the differences must be kept
clearly in mid for ST & LT planning
- Grouping fixed costs under contribution approach highlights the fact
that affect fixed costs have been covered, operating income increases
to the extent of the CM generated on each additional u sold
Exhibit 1-1:
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Traceable & common fixed costs:
- Traceable fixed costs: can be identified with a
particular segment & that arise because of the
existence of the segment (eg: salary of Frito-Lay
product manager at PepsiCo)
- Common fixed costs: supports the operations of
more than 1 segment, but is not traceable in
whole/in part to any 1 segment (eg: salary of CEO
at PepsiCo)
- Many believe not useful to allocate common costs
among segments – draws attention away from
traceable costs to a segment; may result in
misleading data; may obscure important
relationships b/n segment revenues & earnings; may
result in segment appearing unprofitable; unwise
elimination of a segment
- Managers may use common cost allocation as a
form of cost price or as a signal about the benefits
received from HQs & thus modify their actions for
the common good of the organization
- Some do allocate common costs to segments –
analysis of the treatment of uncontrollable costs &
allocated common costs suggests there may be some
benefit to charge managers with uncontrollable
costs/allocating common costs to segments
Breakdown of traceable fixed costs:
Some managements like to separate the traceable fixed costs into 2 classes:
1. Discretionary fixed costs: under immediate control of the manager
2. Committed fixed costs: not under immediate control of the manager
- Separating allows to distinguish b/n performance of the segment manager
& performance of the segment as a LT investment
- Segment performance margin: amount remaining after deducting the
discretionary fixed costs – used as a basis for evaluating the segment
manager’s performance – represents the margin generated by the segment
after deducting all costs controllable by segment manager
- Activity-based costing (ABC approach)
- Harder to identify traceable costs when a building/machine/other
resource is shared by 2+ segments
Eg: Holt Corp. has 3 products (9-inch pipe, 12-inch pipe, 18-inch pipe)
- Lease cost of warehouse space: $10/square meter/year – 9-inch pipe:
400sq-m of space; 12-inch pipe: 1,600sq-m of space; 18-inch pipe:
2,000sq-m of space
- Order-processing department incurred $150,000 in order-processing
costs – 2,500 orders placed: 9-inch pipe: 1,200 orders; 12-inch pipe:
800 orders; 18-inch pipe: 500 orders
- Give these data, following costs would be assigned to each product
using the ABC approach:
- This method of assigning costs combines strengths of ABC with the
power of the contribution approach & greatly engages the manager’s
ability to measure the profitability & performance of segments
- Managers must still ask themselves if the costs would in fact
disappear over time if the segment itself disappeared
Identifying traceable fixed costs:
- **Treat as traceable costs only those that would
disappear over time if segment itself disappeared
- Always be some costs that fall b/n traceable &
common – considerable care & good judgment
needed for their proper classification
- Resist temptation to allocate costs (eg: depreciation
of corporate facilities) that are clearly common
- **Any allocation of common costs to segments
reduces the value fo the segment margin as a guide
to LT segment profitability & segment performance
Traceable costs can become common:
- Fixed costs traceable to 1 segment may be common of another
segment since there are limits to how finely a cost can be
separated without resorting to arbitrary allocation – more finely
the segments are defined, more costs they have in common
- Consumer Product Division has $80,000 in traceable fixed costs:
- $70,000 remains traceable when narrow down definition to that of
the product lines ($30,000 adv. animation + $40,000 adv. games)
- $10,000 becomes a common cost of these product lines because
it’s the monthly salary of the manager of the CPD (traceable cost
of the division as a whole, but common cost of the division’s
product lines since if 1 product line was dropped, salary would
stay same)
Segment margin: obtained by deducing a segment’s traceable
fixed costs from the segment’s CM
- Represents the margin available aster a segment has covered
all of its own costs
- Best gauge of the long-run profitability of a segment since it
includes only those costs that are caused by the segment
- Most useful in major decisions affecting capacity, like
dropping a segment (CM most useful in decisions from
short-run changes)
- Exhibit 1-1: retail stores sales has negative segment margin
– not generate enough revenue to cover its own costs
Segment reporting for financial accounting:
- IFRS (Int’l Financial Accounting Standards) requires
segmented reports prepared for external users use the same
methods & definitions used for internal segmented reports
prepared to aid in making operating decisions – unusual
- 1st: segmented data are often highly sensitive, so companies
are reluctant to release such data to the public since their
competitors would have access to the data
- 2nd: segmented statements prepared according to GAAP
don’t distinguish b/n fixed/variable & traceable/common
- To avoid complications of reconciling non-GAAP segment
earnings with CAAP consolidated earnings, some managers
may construct their segmented financial statements to
conform to GAAP, results in more problems, discussed next
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Hindrances to proper cost assignment:
- Omission of costs:
- Costs assigned to a segment should include all costs
attributable to that segment from the company’s entire
value chain
- Absorption costing: only manufacturing costs
included in product costs (notably for financial
reporting)
- Many companies use absorption costing for internal
reports too, such as segmented income statements –
result in omitted part/all of the upstream costs in the
value chain (R&D, product design) and downstream
costs (marketing, distribution, customer service) from
their profitability analysis – the costs are usually
included in S&A expenses – if omitted, the product is
under-costed & management may unwittingly develop
& maintain products that result in losses in long run
- Inappropriate methods for assigning traceable costs
among segments:
- Companies may not trace fixed expenses to segments
even when feasible to do so
- Companies pay use inappropriate allocation bases to
allocate traceable fixed expenses to segments
- Failure to trace costs directly:
- Results in these costs being placed in a companywide
overhead pool – a portion would be allocated to the
segment generating the costs, but the rest would be
incorrectly allocated to other segments
- Inappropriate allocation base:
- Some companies allocate costs to segments using arbitrary
bases like sales dollars/COGS (eg: if a segment generates 20%
of the company’s sales, it’s allocated 20% if the company’s
S&A expenses as it’s “fair share”)
- 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) (eg: sales should be used to allocate S&A
expenses only if 10% increase in sales will result in 10%
increase in S&A expense)
- To the extent that eg: S&A expenses aren’t driven by sales
volume, these expenses will be improperly allocated –
disproportionately high % of S&A expenses assigned to the
segments with the largest sales
- Arbitrarily dividing common costs among segments:
- Assigning non-traceable costs to segments (eg: allocating costs
of corporate HQs building to products on segment reports)
- There’s no cause-and-effect relationship b/n the cost of
corporate HQs building & the existence of any 1 product
- Some justify the allocation since “someone” has to “cover
common costs”; they’re necessary to have functioning company
- Allocating common costs to segments may make a profitable
segment appear unprofitable
- Common costs don’t disappear when a segment is removed;
aren’t manageable by the manager to whom they are arbitrarily
allocated; they’re the higher-level managers’ responsibility
- Variable costing permits a clearer allocation of costs to segments since it avoids the distortions created by allocating fixed MO that
would be present with using absorption costing
- Suggest to use variable costing for segment reports & allocated fixed MO as a period expense based on criterion of traceability: fixed
costs will disappear over time if the segment itself disappears
Responsibility Centres
- Responsibility centre: any business segment whose manager has control over cost or profit or the use of investment funds
3 main types:
1. Cost centre: business segment whose manager has control over cost
but no control over revenue or use of investment funds
- Eg: service department like accounting, finance, S&A, legal,
personnel; manufacturing facilities
- Managers expected to min. cost while providing level of
services/amount of product demanded by other parts of company
- Managers’ performance often evaluated using flexible budget
variances & standard cost variables (but shouldn’t be held
accountable for controlling common costs arbitrarily allocated to
their segment)
2. Profit centre: business segment whose manager has control over
cost & revenue but no control over use of investment funds
- Eg: manager of 6 resorts responsible for revenues & costs
(profits) of the resort, but may not have control over major
investments
- Managers’ performance often evaluated by comparing actual
profit to targeted/budgeted profit
3. Investment centre: business segment whose manager has control
over cost, revenue & use of investment funds
- Eg: president of Genera Motors Canada has great deal of
discretion over investments in division of GM company
- Managers’ performance often evaluated using ROI or residual
income measures
Chart shows how various business segments are classified in
terms of responsibility
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Document Summary
Managers use performance assessment/control to try to ensure the organization moves in the planned direction. Effective decentralization requires segment reporting to permit analysis & evaluation of decisions made by segment managers. Segment: a part/activity of an organization about which managers would like cost, revenue, or profit data (eg: geographical region, individual store, nature of merchandise, brand name) can classify segments by manager"s ability to control revenues, costs & profits. Segment reporting: preparing several income statements that focus on the segments of a company. Operating segment for financial accounting purposes is a component of an enterprise: Whose operating results are regularly reviewed by the coo to make decisions about resources to be allocated to the segment & assess. That engages in business activities from which it may earn revenues & incur expenses. Segmented statements can be prepared for different levels of activity in an organization & in different formats.
