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Chapter 11

Chapter 11-rsm222.docx

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Rotman Commerce
Course Code
Donna Losell

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Chapter 11: Reporting for Control DECENTRALIZATION IN ORGANIZATIONS  DO: an org in which decision making is spread throughout the org rather than being confined to a few top executives o Strongly decentralized org is one in which there are few, if any, constraints on the freedom of even the lowest level managers and employees to make decisions o Strongly centralized is lower level managers have little freedom to make decisions, most orgs fall somewhere btwn these 2 extremes Decentralization and segment reporting  Effective decen requires segment reporting to permit an analysis and evaluation of the decisions made by the segment managers  Segment: part or activity of an org for which want cost, rev, or profit data  Possible to classify segments according to managers ability to control rev, cost, and profits SEGMENT REPORTING  To uncover problems that manager may need not one but several ISs that focus on the segments of a company o Known as segmented reporting  An operating segment is a component of an enterprise o That engages in business activities o Whose operating results are regularly reviewed by CFO o For which discrete financial info is available Differing levels of segmented statements  Segmented statements can be prepared for diff levels of activity in an org and in differing formats o Divisions segmented according to their major product lines  Through this can discover opportunities and courses of action that would otherwise have remained hidden from view  Break down divisions first, then product lines, then sales territories o Bc order of breakdown depends on what info is desired (could be diff) Assigning costs to segments  SS for internal use usually prepared in Contribution format o Done the same way, except when it comes to fixed costs- those are divided into 2 parts on SS  Traceable: only these are charged to the various segments  Common: kept separate form the segments themselves  Guidelines in assigning costs to various segments under contribution approach o According to cost behaviour patterns (V and F) o According to whether the costs are directly traceable to the segments involved Sales and CM  SS give the ability to make computations (CM ratio and determine effects) on a product by product, division by division, and territory by territory basis which provides the info needed to show up areas of weakness or to capitalize on areas of strength  CM is a SR planning tool o Valuable in decisions relating to temporary uses of capacity, special orders or SR product line promotion The importance of fixed costs  Highlights the fact that after the FCs have been covered, operating income increases to the extent of the CM generated on each additional unit sold  Useful for internal planning purposes Traceable and common fixed costs  Traceable FC: FC that can be identified with a particular segment and that arise bc of the existence of the segment o Without it, the FC would not exist  Common FC: a FC that supports the operations of more than one segment but it is not traceable in whole or in part to any one segment o Even if segment was entirely eliminated, would be no change in a true common fixed cost  Not allocated to segments, whole amount is deducted to arrive at income Identifying traceable fixed costs  Only the costs that would disappear over time if the segment itself disappeared  Any allocation of common costs to segments reduces the value of the segment margin as a guide to LR segment profitability and segment performance Breakdown of traceable fixed costs  In preparing segmented ISs some like to sep the traceable FCs into discretionary and committed o Allows to make distinction btwn the performance of the segment manager and the performance of the segment as a long term investment  Amount remaining after deducting discretionary FCs is sometimes called segment performance margin  Method of assigning costs combines the strength of ABC w the power of the contribution approach and enhances the managers ability to measure the profitability and performance of segments (pg 480) Traceable costs can become common  FCs that are traceable to one segment may be common costs of another segment o Bc there are limits to how finely a cost can be separated without resorting to arbitrary allocation  The more finely segments are defined, the more costs there are that are common Segment margin  A segment margin is obtained by deducting a segment’s traceable fixed costs from the segments CM  Represents the margin available after a segment has covered all of its own costs  Best indicator of LR profitability bc it includes only those costs that are caused by the segment  Most useful in major decisions that affect capacity, like dropping a segment o While CM is useful relating to SR changes such as pricing of special orders Segment reporting for financial accounting  Under CICA handbook and IFRS need to prepare segment reports for external users that are using the same method and definitions as used for internal segmented reports  Segmented statements prepared w GAAP do not distinguish btwn fixed and var costs and btwn traceable and common costs Hindrances to proper cost assignment  Only the costs attributable to a segment should be assigned to it but companies make mistakes and omit some costs, or assign traceable fixed costs, or arbitrarily allocate common fixed costs o Omission of costs: costs assigned to a segment should include all costs attributable to that segment from the companys entire value chain  Under absorption costing, only manu costs are included in product costs so in order to maintain consistency, ppl use abs for internal and external reports- such as segmented ISs  If upstream or downstream costs are omitted in profitability analysis then the product is undercosted and mgmt. may make wrong choice  Upstream: R&D and product design  Downstream: marketing, distribution, and customer service o Inappropriate methods for assigning traceable costs among segments: may not trace fixed exps to segments even when it is feasible to do so, or may use inappro allocation bases to allocate traceable fixed exps to segments o Failure to trade costs directly: results in these costs being placed in a companywide overhead pool and then incorrectly allocated to other segments o Inappropriate allocation base: like sales dollars or COGS o Arbitrarily diving common costs among segments: practice of assigning non-traceable costs to segments  Distortion through the failure to trace costs directly to a specific segment when it is feasible to do so, the inappro use of bases for allocating costs, and the allocation of common costs to segments o Variable costing permits a clearer allocation of costs to segments bc it avoids the distortions created by the allocation of fixed manu OH that would be present w the use of absorption costing  Suggestion: use var costing for segment reports and allocated fixed MO as a period exp based on the criterion of traceability (fixed costs that will disappear over time if the segment did) RESPONSIBILITY CENTRES  Any business segment whose manager has control over cost of profit or the use of investment funds  3 primary types of responsibility centres: cost, profit, and investment  Cost centre: o A business segment whose manager has control over cost but has no control over rev or the use of investment funds o Manu facilities are considered to be cost centres o Manager expected to minimize cost while providing the level of services or production demanded by other parts of the org  Profit centre: a business segment….control over cost and rev but none over investment  Investment centre: a business…control over cost and rev and also use of investment o The cost centres are the departments and work centres that do not generate signi revs by themselves o The profit centres are business segments that generate revs and costs o Investment centre is responsible for all  Eg on pg 485 TRANSFER PRICING  The price charged when one division or segment provides goods or services to another division or segment of an org o Issue is to determine the price being sold btwn segments  The transaction has no direct effect on the companys profit bc the rev recorded for the transfer by the selling divison is exactly offset by the cost recorded by the buying divisions  3 common approaches to set transfer prices: o Allow the managers involved to negotiate their own prices o Set prices at cost, using either var cost or full absorption cost o Set prices at the market price  Goal is to motivate the managers to act in the interests of overall company  Suboptimization: overall level of profitability that is less than a segment or a company is capable of earning Negotiated transfers prices  A TP agreed on btwn buying and selling divisions  Advantages: o Preserves the autonomy of the divisions and is consistent w the spirit of decentralization o Managers of divisions are likely to have much better info about the potential costs and benefits of the transfer than others in the company  Range of acceptable transfer prices: range within which profits of both the selling and purchasing divison would increase as a result of a transfer Learning aid pg 487**  Selling divisions lowest acceptable transfer price: if the transfer has no effect on fixed costs, then from the selling divisions standpoint, the TP must over both the var cost of producing the transferred units and any opportunity costs from lost sales o Sellers perspective: transfer price >/= var cost per unit + total CM on lost sales / # of units transferred  The purchasing divisions highest acceptable transfer price: buy from the inside supplier if the price is less than the price offered by the outside supplier o Purchasers perspective: transfer price = cost of buying from outside  Selling division w idle capacity: means no lost outside sales  Selling division w no idle capacity: there are lost outside sales & transfer price must at least cover the rev on the lost sales o If no agreement on a TP and none takes place that’s fine bc its basically a way to divide any profit the entire company earns as a result of the transfer so if lose money then there will be no profit to divide up  Selling division w some idle capacity: TP that at least covers its var cost and OC and since do not have enough idle capacity to fill the entire order there are lost outside sales  No outside supplier: the highest price the purchasing div will be willing to pay depends on how much they expect to make on the transferrd units-excluding the transfer price  Evaluation of negotiated transfer prices: if a transfer within the company would result in higher overall profits for the company, there is always a range of TPs within which both the selling and purchasing div would also have higher profits if they agree to do it o When managers are dumbasses and then company needs to rely on some other means of setting the prices Transfers to the selling division at cost  Many set the price at either var cost or full abs cost incurred by the selling div  But has some defects o The use of cost – especially full- as a TP can lead to a bad decision and this suboptimization o If cost is sued as the TP, the selling div will never show a profit on any internal transfer – only one that does is the div that makes the final sale to an outside party o Do not provide incentives to control costs Transfers at market price  Best approach and designed for situation in which there is an intermediate market for the transferred product or service o IM: a market in which a transferred pro/ser is sold in its present form to outside customers  If no idle capacity, market price is perfect choice o If there is then the issue that the cost of
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