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Chapter 11

Chapter 11 - ACTG 2020.docx

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York University
ACTG 2020
Sylvia Hsingwen Hsu

Chapter 11 - Feedback of actual results, comparison to other orgs, other periods, mgers attempt to ensure orgs moves in planned direction -> performance assessment or control - Segment reporting, responsibility centre reporting, investment performance, and profitability analysis are four commonly used reporting structures that provide somewhat different types of information o Each represent a different aspect of organizational control - Increasingly, companies are using non-financial indicators of performance such as scrap levels, rework efforts, market share, employee morale, pollutant discharges, and customer satisfaction. Decentralization in Organizations - In a decentralized organization, decision making is spread throughout the organization, rather than being confined to a few top executives Decentralization and Segment Reporting - Segment reporting is key for analyzing and evaluating decisions made by segment managers - Need reports for each segment o A segment is defined as a part or activity of an organization about which managers would like cost, revenue, or profit data.  E.g. geographic segments for grocery chain Segment Reporting - Company-wide statements do not contain enough detail to allow the manager or investor to detect problems that may exist in the organization. o E.g. some lines may be unprofitable and others may not - Segment is a component of the enterprise o Engages in business activities from which it may incur revenues and expenses o Whose operating results are regularly reviewed by enterprises COO to make decisions about resource to be allocated to that segment and assess its performance o For which discrete financial info is available Differing Levels of Segmented Statements - As we go from one segmented statement to another, we are looking at smaller and smaller pieces of the company o The order of breakdown depends on what information is desired - By carefully examining trends and results in each segment, the manager can gain considerable insight into the company as a whole, and perhaps discover opportunities and courses of action that would otherwise have remained hidden from view. - The order of the breakdown should not affect the numbers, but it can alter what appears on a given report and the ease of review. Assigning costs to segments - Segmented statements for internal use are typically prepared in contribution format - One exception: fixed costs labelled traceable are charged to the various segments. If a fixed cost is not traceable directly to some segment, then it is treated as a common cost and kept separate from the segments themselves. o Under the contribution approach, a cost is never arbitrarily assigned to a segment of an organization - Two guideline followed in assigning costs to various segments of a company: o 1) According to cost behaviour (variable or fixed) o 2) Whether the cost is directly traceable to the segments involved or not Sales and CM - Usefulness of CM – compute CM ratio and if SP/FC are unchanged, then can use to see direct increase in net income caused by increase in sales - Segmented statements give the manager the ability to make such computations on a product-by-product, division-by-division, or territory-by-territory basis, thereby providing the information needed to show up areas of weakness or to capitalize on areas of strength - CM is a SHORT-RUN PLANNING TOOL – good for decisions relative to uses of capacity, special orders, short-run product-line promotion o Decisions involve: VC, SALES - By monitoring each segment’s CM and segment ratios, mger is able to make SR decisions that maximize each segments contribution to overall profitability Importance of FC - FC/VC differences must be kept clearly in mind for both short-run and long-run planning - Grouping of FC under CM approach highlights the fact that after FC have been covered, income increases based on CM generated per additional unit sold o Useful for internal planning purposes Traceable and Common FC - Traceable: fixed costs that can be identified with a particular segment and that arise because of the existence of the segment o If segment never existed, costs would not be incurred and if segment were to be eliminated, then the cost would disappear o Only traceable costs charged to segments; if not traceable then cost not charged  E.g. salary of Frito-lay product manager for PepsiCo - Common: fixed cost that supports the operations of more than one segment but is not traceable in whole or in part to any one segment; cost would be incurred regardless of segment’s existence o Company’s CEO is a common fixed cost for all divisions o Receptionist’s salary for multiple doctors - The total amount is deducted to arrive at the income for the company as a whole - Any attempt to allocate common fixed costs among segments may result in misleading data or may obscure important relationships between segment revenues and segment earnings o May lead to segment looking unprofitable and may lead to undue elimination of a segment which then further reduces profitability of the company - Firms may however allocate common costs for a number of reasons o E.g. want to know the “benefits” EACH SEGMENT rec’d from headquarters Identifying Traceable Fixed Costs - Traceable costs -> charge to segments, common -> deduct at end - Hard to determine whether a cost should be classified as traceable or common* - The general guideline is to treat as traceable costs only those costs that would disappear over time if the segment itself disappeared. o E.g. if a division were to be shut down then why pay that division managers salary - - traceable  But the co’s president would still need to be paid - - so this is common - Depreciation is a common cost as well** - Any allocation of common costs to segments reduces the value of the segment margin as a guide to long- run segment profitability and segment Breakdown of traceable FC - Might separate traceable FC into two classes: discretionary and committed - Discretionary fixed costs are under the immediate control of the manager, whereas committed fixed costs are not o Breakdown allows co to make a distinction between the performance of the segment manager and the performance of the segment as a long-term investment - The amount remaining after deducting the discretionary fixed costs, sometimes called a segment performance margin should be used to judge a manager’s performance (in the case he/she operates in a function with large committed cost) ABC - This method of assigning costs combines the strength of activity-based costing with the power of the contribution approach and greatly enhances the manager's ability to measure the profitability and performance of segments - But mgers still must ask themselves if the costs would in fact disappear over time if the segment did as well; Traceable costs can become common - Fixed costs that are traceable to one segment may be common costs of another segment. - This is because 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. o E.g. when the segments are divisions, there is greater traceable exp; but when you further analyze the divisions into product lines, there is less traceable exp b/c the salary of the product lines is now a common fixed expense BUT ONLY FOR THE PRODUCT line  This salary is a traceable cost of the division as a whole, but is a common cost of the division's product lines.  Would be incurred even if one of the segments were eliminated Segment Margin - Obtained by deducting a segment's traceable fixed costs from the segment's contribution margin. - Is margin avlbl after segment has covered its own costs - Best gauge of LT profitability of a segment b/c it includes costs only caused by the segment; if segment cannot cover its own costs, it should probably be dropped (unless essential to other sales) - The segment margin is most useful in major decisions that affect capacity, such as dropping a segment o CM more useful for SR changes and orders involving temporary use of existing capacity Segment Reporting for Financial Accounting - Companies are not ordinarily required to report the same data to external users that are reported internally for decision-making purposes. - CICA, however, requires that segmented reports prepared for external users use same methods and definitions used for internal segmented reports o Drawbacks:  1) Segmented data are often sensitive and cos are reluctant to release to public (competitors threat  2) Segmented statements prepared in accordance w/ GAAP don’t distinguish b/w fixed and variable costs and b/w traceable and common Hindrances to proper cot assignment - Costs must be properly assigned to segments. All of the costs attributable to a segment—and only those costs—should be assigned to the segment - Common errors include: omitting costs, assigning traceable fixed costs, and allocating common costs Omission of cost - Costs assigned to segment include all costs attributable to segment (all functions: R/D, design, manufacturing, marketing, distribution, customer service) o But only manufacturing costs are included in product costs under absorption costing; regarded as required for financial reporting  As a result, co’s use absorption costing for internal reports (segmented income statements)  Omit “upstream” costs in the value chain, which consist of research and development and product design, and the “downstream” costs, which consist of marketing, distribution, and customer service  SGA expenses o BUT must be included in the profitability analysis b/c they can represent > ½ or more of total costs of an orgs o Product may end up being undercosted and mgmt may continue developing products that may not even be profitable Inappropriate Methods for Assigning traceable costs among segments - Co’s do not correctly handle fixed expenses on segmented income statements; do not trace fixed expenses when feasible to do so and may use inappropriate allocation bases to allocate traceable fixed expenses to segments Failure to trace costs directly - Failure to trace these costs directly results in these costs being placed in a companywide overhead pool o E.g. rent for branch office of an insurance co should be charged directly to branch rather than be included in company overhead pool Inappropriate allocation base - 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) - The allocation base should be the cost driver* Arbitrarily dividing common costs among segments - There is no cause-and-effect relationship between the cost of the corporate headquarters building and the existence of any one product – cannot allocate cost of corporate HQ to one product - The common practice of arbitrarily allocating these costs to segments is often justified on the grounds that “someone” has to “cover the common costs.” - Adding a share of common costs to the real costs of a segment may make an otherwise profitable segment appear to be unprofitable - Additionally, common fixed costs are not manageable by the manager to whom they are arbitrarily allocated; they are the responsibility of higher-level managers - When common fixed costs are allocated to managers, they are held responsible for those costs even though they cannot control them. Summary - The way co’s handle segment reporting causes cost distortion – three main practices cause this: failure to trace costs directly to specific segment when its feasible to do so, the use of inappropriate bases for allocating costs, and the allocation of common costs to segments. - Variable costing permits a clearer allocation of costs to segments because it avoids the distortions created by the allocation of fixed manufacturing overhead that would be present with the use of absorption costing. - Use variable costing for segment reports and allocate fixed manufacturing overhead as a period expense based on the criterion of traceability; that is, fixed costs that will disappear over time if the segment itself disappears. Responsibility Centres - Any part of orgs hose mger has control over and is accountable for profit, investments, or cost - Three primary types: cost centres, profit centres, investments centres Cost Centre - Business segment whose manager has control over costs but not over revenue or investment funds - Service departments like accounting, finance, administration, legal, personnel etc are usually considered to be cost centres - Mfting facilities are often considered to be cost centres - Mgers expected to minimize cost while providing level of services or amt of product demanded by other parts of organization - Standard cost variances and flexible budget variances used to evaluate performance of this centre - Mgers should not be held accountable for controlling common costs arbitrarily allocated to their segment Profit centre - Any business segment whose manager has control over both cost and revenue. - Profit centre manager generally does not have control over investment funds - Evaluated by comparing actual profit to targeted or budgeted profit. Investment centre - Is any segment of an organization whose manager has control over cost, revenue, and investments in operating assets - Investment centre managers are usually evaluated using return on investment or residual income measures, as discussed later in the chapter. - Transfer Pricing - Some issues arise when segments of the same company (often referred to as divisions) supply goods and services to each other. The issue is determining the transfer price of the goods or services being sold between segments. - Transfer price is the price charged when one segment sells goods or services to another segment of the same company Three common approaches are used to set transfer prices: 1. Allow the managers involved in the transfers to negotiate their own transfer prices. 2. Set transfer prices at cost, using either variable cost or full absorption cost. 3. Set transfer prices at the market price. - The fundamental objective in setting transfer prices is to motivate the managers to act in the best interests of the overall company o BUT: suboptimization occurs when managers do not act in the best interests of the overall company or even in the best interests of their own segment Negotiated Price Transfers - Is transfer price agreed on b/w selling and purchasing segments/divisions - Advantages: preserves the autonomy of divisions and consistent w/ spirit of decentralization; mgers have better info abt costs and benefits of transfers than others in the company - The selling division will agree to transfer only if the profits of the selling division increase as a result of ransfer - Purchasing division will agree if their profits increase as well - The transfer price has both a lower limit (determined by the situation of the selling division) and an upper limit (determined by the situation of the purchasing division). o Determine the range of acceptable transfer prices - within which the profits of both divisions participating in a transfer would increase. - Selling division (lowest acceptable transfer price): - Purchasing division’s highest acceptable transfer price: - Selling Division with Idle Capacity: (because the numerator = 0 w/ idle capacity) - Selling Division w/ no Idle capacity: selling at full capacity and then required to divert sales from customers in order to meet the intercompany transaction** o o The selling division’s minimum price is > than buying division’s max price so the transaction will not happen!  This is b/c the transfer price is a mechanism for dividing b/w two divisions any profit the entire co earns as a result of the transfer - - if co loses money on transfer, then no profit to divide - Selling Division w/ some idle capacity – same steps as before – - No outside supplier: o the highest price the purchasing division would be willing to pay depends on how much the purchasing division expects to make on the transferred units—excluding the transfer price - Evaluation of Negotiated Transfer Prices: o if the managers understand their own businesses and are cooperative, then they should always be able to agree on a transfer price if it is in the best interests of the company that they do so o Sometimes negotiations break down if self-interests come in the way; might be b/c of the way they are being evaluated (i.e. NOT encouraged to cooperate) o Due to problems w/ negotiation, most companies rely on some other mean of setting transfer prices – which too have their own drawbacks Transfers to selling division at cost - Set prices either at VC or absorption cost incurred by selling division - Use of cost can lead t bad decisions and suboptimization* o If the transfer price was bureaucratically set at full cost, then Pizza Place would never want to
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