ADVANCED MANAGEMENT ACCOUNTING PPT 10 1 Decentralization and

ADVANCED MANAGEMENT ACCOUNTING PPT 10 -1

Decentralization and Transfer Pricing PPT 10 -2

Learning Objectives l Explain why firms choose to decentralize l Explain the role of transfer pricing in a decentralized firm. l Discuss the methods of setting transfer prices. PPT 10 -3

Decentralization: The Major Issues l The degree of decentralization l Performance measurement l Management compensation l The setting of transfer prices PPT 10 -4

Reasons for Decentralization There are many reasons to explain why firms decide to decentralize, including: 1. better access to local information 2. cognitive limitations 3. more timely response 4. focusing of central management 5. training and evaluation 6. motivation 7. enhanced competition PPT 10 -5

10 -6 Decentralization in Organizations Advantages of Decentralization Lower-level managers gain experience in decision-making. Top management freed to concentrate on strategy. Decision-making authority leads to job satisfaction. Lower-level decisions often based on better information. Lower level managers can respond quickly PPT 10 -6 to customers.

10 -7 Decentralization in Organizations Lower-level managers may make decisions without seeing the “big picture. ” Lower-level manager’s objectives may not be those of the organization. May be a lack of coordination among autonomous managers. Disadvantages of Decentralization May be difficult to spread innovative ideas in the organization. PPT 10 -7

10 -8 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. Quick Mart A Sales Territory A Service Center PPT 10 -8

10 -9 Superior Foods: Segmented by Geographic Regions Superior Foods Corporation could segment its business PPT 10 -9 by geographic region.

10 -10 Superior Foods: Segmented by Customer Channel Superior Foods Corporation could segment its business by customer channel. PPT 10 -10

10 -11 Keys to Segmented Income Statements There are two keys to building segmented income statements: A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. PPT 10 -11

10 -12 Identifying Traceable Fixed Costs Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer division means. . . No computer division manager. PPT 10 -12

10 -13 Identifying Common Fixed Costs Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but. . . We still have a CEO. PPT 10 -13

10 -14 Traceable Costs Can Become Common Costs It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers. PPT 10 -14

Segment Margin The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Segment Margin 10 -15 Time PPT 10 -15

10 -16 Traceable and Common Costs Fixed Costs Traceable Don’t allocate common costs to segments. Common PPT 10 -16

10 -17 Activity-Based Costing Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments. Assume that three products, 9 -inch, 12 -inch, and 18 -inch pipe, share 10, 000 square feet of warehousing space, which is leased at a price of $4 per square foot. If the 9 -inch, 12 -inch, and 18 -inch pipes occupy 1, 000, 4, 000, and 5, 000 square feet, respectively, then ABC can be used to trace the warehousing costs to the three products as shown. PPT 10 -17

10 -18 Levels of Segmented Statements Webber, Inc. has two divisions. Webber, Inc. Computer Division Television Division Let’s look more closely at the Television Division’s income statement. PPT 10 -18

10 -19 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate PPT 10 -19 sections.

10 -20 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Contribution margin is computed by taking sales minus variable costs. Segment margin is Television’s contribution to profits. PPT 10 -20

10 -21 Levels of Segmented Statements PPT 10 -21

10 -22 Levels of Segmented Statements Common costs should not be allocated to the divisions. These costs would remain even if one of the divisions were eliminated. PPT 10 -22

10 -23 Traceable Costs Can Become Common Costs As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into smaller segments. Let’s see how this works using the Webber, Inc. example! PPT 10 -23

10 -24 Traceable Costs Can Become Common Costs Webber’s Television Division LCD Plasma Product Lines PPT 10 -24

10 -25 Traceable Costs Can Become Common Costs We obtained the following information from PPT 10 -25 the LCD and Plasma segments.

10 -26 Traceable Costs Can Become Common Costs Fixed costs directly traced to the Television Division PPT 10 -26 $80, 000 + $10, 000 = $90, 000

10 -27 External Reports The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports. 1. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. 2. Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP. PPT 10 -27

10 -28 Omission of Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain Business Functions Making Up The Value Chain R&D Product Design Customer Manufacturing Marketing Distribution Service PPT 10 -28

10 -29 Inappropriate Methods of Allocating Costs Among Segments Failure to trace costs directly Segment 1 Segment 2 Inappropriate allocation base Segment 3 Segment 4 PPT 10 -29

10 -30 Common Costs and Segments Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: 1. This practice may make a profitable business segment appear to be unprofitable. 2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control. Segment 1 Segment 2 Segment 3 Segment 4 PPT 10 -30

10 -31 Quick Check Assume that Hoagland's Lakeshore prepared its segmented income statement as shown. PPT 10 -31

10 -32 Quick Check How much of the common fixed cost of $200, 000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it. PPT 10 -32

10 -33 Quick Check How much of the common fixed cost of $200, 000 can be avoided by eliminating the bar? a. None of it. b. Some of it. A common fixed cost c. All of it. cannot be eliminated by dropping one of the segments. PPT 10 -33

10 -34 Quick Check Suppose square feet is used as the basis for allocating the common fixed cost of $200, 000. How much would be allocated to the bar if the bar occupies 1, 000 square feet and the restaurant 9, 000 square feet? a. $20, 000 b. $30, 000 c. $40, 000 d. $50, 000 PPT 10 -34

10 -35 Quick Check Suppose square feet is used as the basis for allocating the common fixed cost of $200, 000. How much would be allocated to the bar if the bar occupies 1, 000 square feet and the restaurant 9, 000 square feet? a. $20, 000 The bar would be b. $30, 000 1/ allocated 10 of the cost c. $40, 000 or $20, 000. d. $50, 000 PPT 10 -35

10 -36 Quick Check If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? PPT 10 -36

10 -37 Allocations of Common Costs Hurray, now everything adds up!!! PPT 10 -37

10 -38 Quick Check Should the bar be eliminated? a. Yes b. No PPT 10 -38

10 -39 Quick Check Should the bar be eliminated? a. Yes The profit was $44, 000 before b. No eliminating the bar. If we eliminate the bar, profit drops to $30, 000! PPT 10 -39

Transfer Pricing The transferred good is revenue to the selling division and cost to the buying division. This value is called transfer pricing. PPT 10 -40

Transfer Pricing: General Concerns Some Major Issues l Impact on divisional performance measures l Impact on firm wide profits l Impact on divisional autonomy PPT 10 -41

Transfer Pricing Approaches l Market price l Negotiated transfer prices l Cost-based transfer prices v Full cost plus markup v Variable cost plus fixed fee PPT 10 -42

A Transfer Pricing Problem Assume the following data for Division A: Capacity in units Selling price to outside Variable cost per unit Fixed costs per unit (based on capacity) 50, 000 $15 8 5 Division B would like to purchase units for Division A. Division B is currently purchasing 5, 000 units per year from an outside source at a cost of $14. PPT 10 -43

A Transfer Problem Example (continued) 1. 2. 3. Assume division A has idle capacity in excess of 10, 000 units: Minimum transfer price = Variable cost + Lost contribution margin = $8 + $0 = $8 Assume division A is working at capacity: Transfer Price = Variable cost + Lost contribution margin = $8 + $7 = $15 (market price) Assume division A is working at capacity, but a negotiated $2 in variable costs can be avoided on intercompany sales. Transfer Price = Variable cost + Lost contribution margin = $6 + $7 = $13 (negotiated price) PPT 10 -44

End of Week PPT 10 -45