Segment Reporting and Decentralization Chapter Twelve

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

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

Decentralization and Segment Reporting 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 An Individual Store A Sales Territory A Department

Cost, Profit, and Investments Centers Responsibility Center Responsibility Center Cost Center Cost Center Profit Center Profit Center Investment Center Investment Center Cost, profit, and investment centers are all known as responsibility centers.

Measuring Managers Performance Cost Center Standard Cost/Flexible Budget Variances Profit Center Budgeted income statement Investment Center Return on investment or residual income Evaluation Tool

Return on Investment (ROI) Formula ROI = Net operating income Average operating assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. Cash, accounts receivable, inventory, plant and equipment, and other productive assets. Income before interest and taxes (EBIT) Income before interest and taxes (EBIT)

Return on Investment (ROI) Formula ROI = Net operating income Average operating assets Margin = Net operating income Sales Turnover = Sales Average operating assets ROI = Margin  Turnover

Improving R0I Three ways to improve ROI Increase Sales Decrease Expenses Reduce Operating Assets

Improving ROI – An Example Regal Company reports the following: Net operating income $ 30,000 Net operating income $ 30,000 Average operating assets $ 200,000 Average operating assets $ 200,000 Sales $ 500,000 Sales $ 500,000 Operating expenses $ 470,000 Operating expenses $ 470,000 ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI = What is Regal Company’s ROI?

Increasing Sales Without an Increase in Operating Assets Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000. Regal’s net operating income increased to $42,000. There was no change in the average operating assets of the segment. Let’s calculate the new ROI.

Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regal’s 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. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 40,000 Net operating income $ 40,000 Average operating assets $ 200,000 Average operating assets $ 200,000 Sales $ 500,000 Sales $ 500,000 Operating expenses $ 460,000 Operating expenses $ 460,000

Decreasing Operating Assets with no Change in Sales or Operating Expenses Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time techniques without affecting sales or operating expenses. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 30,000 Net operating income $ 30,000 Average operating assets $ 180,000 Average operating assets $ 180,000 Sales $ 500,000 Sales $ 500,000 Operating expenses $ 470,000 Operating expenses $ 470,000

Investing in Operating Assets to Increase Sales Assume that Regal’s manager invests in a $30,000 piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 50,000 Net operating income $ 50,000 Average operating assets $ 230,000 Average operating assets $ 230,000 Sales $ 535,000 Sales $ 535,000 Operating expenses $ 485,000 Operating expenses $ 485,000

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.

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. Brookshire’s turnover was: A)1 B)1.5 C)2 D)3

ROI - A Major Drawback As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s 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?

Residual Income - Another Measure of Performance Net operating income that an investment center earns above the minimum required return on its operating assets

Calculating Residual Income () Residual income measures net operating income earned less the minimum required return on average operating assets.

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. Let’s calculate residual income.

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 division’s ROI? a. 25% b. 5% c. 15% d. 20%

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

Quick Check The company’s 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

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 division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000

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

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.

Zepher, Inc. Is Wholesale performing better than Retail? Recall the following information for the Retail Division of Zepher, Inc. Assume the following information for the Wholesale Division of Zepher, Inc.

Practice At Pittsburgh Pipe Fittings the required rate of return on invested capital is 8%. Div A Sales Revenue $10,000,000 Operating Income $ 2,000,000 Average Assets $ 2,500,000 Margin Turnover ROI Residual Income

Practice, continued At Pittsburgh Pipe Fittings the required rate of return on invested capital is 8%. Div B Sales Revenue Operating Income $400,000 Average Assets Margin 20% Turnover 1 ROI Residual Income

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

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.

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.