13-1 Profitability Analysis of Strategic Business Segments C hapter 13 Prepared by Douglas Cloud Pepperdine University

Recognize a strategic business segment. 2.Discuss centralized and decentralized organization structures. 3.Understand the development and use of segment reports. 4.Evaluate transfer pricing alternatives, including international transfers. 5.Discuss the issues that cause difficulty in evaluating decentralized operations. ObjectivesObjectives After studying this chapter, you should be able to:

Calculate, explain, and compare return on investment, residual income and economic value-added residual income measures for divisional performance 7.Understand the concept of performance measurement when financial and nonfinancial concepts are integrated. ObjectivesObjectives

13-4 Strategic Business Segment  A strategic business segment is generally one that has its own mission and set of goals to be achieved.  The mission of the segment influences the decisions that its top managers make in both short-run and long-run situations.

13-5DecentralizationDecentralization Decentralization is the delegation of decision- making authority to successively lower management levels in an organization. The lower in the organization that authority is delegated, the greater the decentralization.

13-6DecentralizationDecentralization  Firsthand decision making  Timely decisions  Specialization  Motivation  Focus  Frees up higher level management’s time The advantages of decentralization include:

The disadvantages of decentralization include:  Compatible performance measurements  Suboptimization  Duplication  Lack of competent personnel DecentralizationDecentralization

13-8CentralizationCentralization Centralization exists when top management has a wide span of control, including direct control over all major functions of an organization.

13-9CentralizationCentralization Economies of scale Sophistication of applications Improved control The advantages of centralization include:

13-10 Span of control Complexity Diseconomies of scale The disadvantages of centralization include: CentralizationCentralization

13-11 Organization Chart with Decentralization Manager Plant 2 DivisionController President Executive Vice President V. P. Division A V. P. Division B Corporate Controller Marketing V. P. Other Corporate Staff OtherStaff Production and Service DepartmentsArea Sales Representatives Manager Plant 1 MarketingManager

13-12 Segment Reports are income statements for a portions or segments of a business. Segment Reporting They are used were companies have distinct divisions of product lines, geographic territories, or organization units.

13-13 Segment Reporting Three steps basic to the preparation of all segment reports: 1.Identification of the segments 2.Assignment of direct costs to the segments 3.Allocation of indirect costs to the segments

13-14 Segment Reporting In segment reports, costs are recorded in four categories. Variable costs Direct fixed costs Allocated common costs Unallocated common costs

13-15 Multi-Level Segment Reports Sales$100,000$200,000$300,000 Less variable costs -55, , ,000 Contribution margin$ 45,000$105,000$150,000 Less direct fixed costs -20, , ,000 Division margin$ 25,000$ 45,000$ 70,000 Less allocated common costs -10, , ,000 Division income$ 15,000$ 20,000$ 30,000 Less unallocated common costs -12,000 Net income$ 23,000 First Level National Accounts Regional Accounts Company Total Segments (Divisions)

13-16 Multi-Level Segment Reports Sales$30,000$70,000$100,000 Less variable costs -15, , ,000 Contribution margin$15,000$30,000$ 45,000 Less direct fixed costs -9,000 -6, ,000 Product margin$ 6,000$24,000$ 30,000 Less allocated division costs -5,000 -5, ,000 Product income$ 1,000$19,000$ 20,000 Less unallocated common costs -5,000 National Accounts Division income$ 15,000 Second Level Fiber Optic Twisted Pair National Division Total Segments (Products)

13-17 Multi-Level Segment Reports Sales$30,000$70,000$100,000 Less variable costs -15, , ,000 Contribution margin$15,000$30,000$ 45,000 Less direct fixed costs -9,000 -6, ,000 Product margin$ 6,000$24,000$ 30,000 Less allocated division costs -5,000 -5, ,000 Product income$ 1,000$19,000$ 20,000 Less unallocated common costs -5,000 National Accounts Division income$ 15,000 Second Level Fiber Optic Twisted Pair National Division Total Segments (Products)

13-18 Multi-Level Segment Reports Sales$20,000$10,000$30,000 Less variable costs -11,000 -4, ,000 Contribution margin$ 9,000$ 6,000$15,000 Less direct fixed costs -3,000 -4,000 -7,000 Territory margin$ 6,000$ 2,000$ 8,000 Less allocated division costs -2,000 -3,000 -5,000 Territory income$ 4,000-$ 1,000$ 3,000 Less unallocated common costs -2,000 Fiber Optic income$ 1,000 Third Level AtlanticPacific Fiber Optic Total Segments (Territories)

13-19 Direct Versus Common Segment Costs The segment margin represents the amount that a segment contributes toward the common costs of the organization and toward profits. Direct segment costs are costs that would not be incurred if the segment being evaluated were to be discontinued. Common segment costs are related to more than one segment and are not directly traceable to a particular segment.

13-20 Transfer Pricing  A transfer price is the internal value assigned a product or service that one division provides to another.  Transfer pricing transactions normally occur between profit or investment centers.  The objective of transfer pricing is to transmit financial data between departments or divisions of a company.  Transfer pricing systems are normally used in decentralized operations to determine whether organizational objectives are being achieved in each division.

13-21 OmniTech, Inc. has five divisions, some of which transfer products and product components to other OmniTech divisions. The BioTech Division manufactures two products, Alpha and Beta. Alpha is sold externally for $50 per unit, and Beta is transferred to the GenTech Division for $60 per unit. Transfer Pricing

13-22 Transfer Pricing The costs associated with the two products are shown below: Product Alpha Beta Variable costs: Direct materials$15$14 Direct labor510 Variable manufacturing overhead516 Selling40 Fixed costs: Fixed manufacturing overhead 6 15 Total$35$55

A proposal has been received from an external company to supply the GenTech Division with a substitute product similar to Beta at a price of $52. Transfer Pricing Relevant Costs Buy$52 Make: Direct materials$14 Direct labor10 Variable manufacturing overhead Difference favors making$12

13-24 Transfer Pricing The BioTech Division can sell all the Alpha that it can produce (it is operating at capacity) and there is no external market for Beta. The outlay cost for Beta is $40 ($14 + $10 + $16) Opportunity Cost

13-25 Transfer Pricing If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s opportunity cost is the net benefit forgone. Opportunity Cost Make Buy

13-26 Transfer Pricing If the limited capacity of the BioTech Division is used to produce Beta rather than Alpha, Beta’s opportunity cost is the net benefit forgone. Opportunity Cost Selling price of Alpha$50 Outlay costs of Alpha: Direct materials$15 Direct labor5 Variable manufacturing overhead5 Variable selling 4-29 Opportunity cost of making Beta$21 Make: Outlay costs of Beta$40 Opportunity cost of Beta 21$61 Buy:$52 The company should buy from the outside supplier.

13-27 Determining Transfer Price  Market Price  Variable Costs  Variable Costs plus Opportunity Costs  Absorption Cost plus Markup  Negotiated Prices  Dual Prices

13-28 Determining Transfer Price Market Price Product Alpha of the BioTech Division can be sold competitively at $50 per unit or transferred to a third division, the Quantum Division for additional processing. The BioTech Division will never sell Alpha for less than $50, and the Quantum Division will never pay more than $50 for it. However, because variable selling expenses of $4 per unit can be eliminated in interdepartment transfers, the price probably will be between $46 and $50.

13-29 Determining Transfer Price Variable Costs If Beta could be sold externally for $60, the BioTech Division would not want to transfer Beta to GenTech Division for a $40 transfer price based on the following variable costs: Direct materials$14 Direct labor10 Variable manufacturing overhead 16 Total variable costs$40

13-30 Determining Transfer Price Variable Costs The BioTech Division would much rather sell outside the company for $60, which covers variable costs and provide for a profit contribution margin of $20. Selling price of Beta$60 Variable costs-40 Contribution margin$20

13-31 Determining Transfer Price Variable Costs Plus Opportunity Costs If the BioTech Division had excess capacity, the transfer price of Beta would be set at Beta’s variable costs of $40 per unit. If BioTech Division cannot sell Beta externally, but can sell all the Alpha it can produce, and it is operating at capacity, the transfer price per unit would be set at $61, the sum of Beta’s variable and opportunity cost ($40 + $21).

13-32 Determining Transfer Price Absorption Cost Plus Markup Absorption cost plus markup provides the supplying division with a contribution toward unallocated costs. In “cost-plus” transfer pricing, “cost” should be defined as standard cost rather than as actual cost.

13-33 Determining Transfer Price Negotiated Price Negotiated transfer prices are used when the supplying and buying divisions independently agree on a price. Negotiated transfer prices are believed to preserve divisional autonomy.

13-34 Determining Transfer Price Dual Prices Dual prices exists when a company allows a difference in the supplier’s and receiver’s transfer prices for the same product.

13-35SuboptimizationSuboptimization Suboptimization is a transfer pricing problem that exists when divisions, acting in their own best interest, set transfer prices or make decisions based on transfer prices that are not in the best interest of the organization as a whole

13-36SuboptimizationSuboptimization A potential transfer pricing problem exists when divisions exchange goods or services when there is no established market. In the interest of maintaining a strong profit center philosophy, top management may decide to suboptimize by allowing profit centers to profit services of themselves.

13-37 International Transfer Pricing Using Transfer Price Based on Variable Cost Full Cost Market Price (000’s) (000’s) (000’s) Taxable income of the Mercedes Division, excluding the transfer$200,000$200,000$200,000 Cost of emission components to Mercedes Division Variable cost ($20 x 300,000)-6,000 Full cost ($25 x 300,000)-7,500 Market price ($40 x 300,000) -12,000 Taxable income$194,000$192,500$188,000 Mercedes Division income taxes (50%)$97,000$96,250$94,000 ContinuedContinued

13-38 International Transfer Pricing Using Transfer Price Based on Variable Cost Full Cost Market Price (000’s) (000’s) (000’s) Taxable income of the Chrysler Division, excluding the transfer$200,000$200,000$200,000 Cost of emission components to Mercedes Division Variable cost ($20 x 300,000)6,000 Full cost ($25 x 300,000)7,500 Market price ($40 x 300,000) 12,000 Taxable income$206,000$207,500$212,000 Chrysler Division Income Taxes (35%)$72,100$72,625$74,200 ContinuedContinued

13-39 International Transfer Pricing Using Transfer Price Based on Variable Cost Full Cost Market Price (000’s) (000’s) (000’s) Total Daimler-Chrysler Income Taxes ($97,000 + $72,100)$169,100 ($96,250 + $72,625)$168,875 ($94,000 + $74,200)$168,200

13-40 Return on Investment (ROI) Investment center income Investment center asset base ROI = or ROI = Investment turnover x Return-on-sales ratio

13-41 Investment Turnover = Sales Investment center asset base Return-on-sales ratio = Investment center income Sales Return on Investment (ROI)

Investment center income Investment center asset base ROI = Sales Investment center income Investment center Sales asset base x ROI = Return on Investment (ROI)

13-43 North American Steel PERFORMANCE MEASURES Investment Return-on-Sales Turnover Ratio ROI Operating units: Maine Division Alberta Division Missouri Division Tijuana Division Company performance criteria: Projected minimums x=

13-44 Maine Division Sales Investment center income Investment center Sales asset base x ROI = $1,600,000 $160,000 $800,000 $1,600,000 ROI = x 0.20 x 20 percent North American Steel

13-45 Residual Income Division income Less minimum return (12%) Equals residual income $2,000,000 -1,800,000 $ 200,000 $15,000,000 x 0.12 Minimum rate of return set by management

13-46 The primary disadvantage of the residual income method is that it measures performance in dollars. It cannot be used to compare the performance of divisions of different sizes Residual Income

13-47 A firm has a cost of capital of 10 percent, $1,800,000 in current liabilities and a 30 percent tax rate. Division income after taxes ($2,000,000 x 0.70) $1,400,000 Cost of capital employed ($15,000,000 - $1,800,000) x ,320,000 Economic value-added residual income$ 80,000 Economic Value Added

13-48 Why Not Just Use Financial Measures? 1.There is no single financial measure that captures all performance aspects of an organization. 2.Financial measures have reporting time lags that may hinder timely decision making. 3.The financial measures may not accurately capture information needed for current decision making.

13-49 What is the Balanced Scorecard? It is a performance measurement system that includes financial and operational measures which are related to the organizational goals. Generally it relates resulting performance to the reward system within each organizational unit.

13-50 Financial Perspective Customer Perspective Internal Perspective Innovation and Learning Perspective The most commonly used key performance indicators found in a survey are-- Balanced Scorecard Linked to Organizational Performance

13-51 Balanced Scorecard for Ben’s Bagels for February Standard January February Key financial indicators Cash flow$25,000-$4,000$21,000 ROI Economic value-added residual income$130,000$133,000$123,000 Sales$4,400,000$4,494,000$4,342,000 ContinuedContinued

13-52 Standard January February Key financial indicators Average customer per hour Number of customer com- plaints per month Number of sales returns per month1085 Balanced Scorecard for Ben’s Bagels for February ContinuedContinued

13-53 Standard January February Key operating indicators Bagels sold/produced ratio per day Daily units lost (burnt, dropped, etc.) Employee turnover per month Balanced Scorecard for Ben’s Bagels for February ContinuedContinued

13-54 Standard January February Key growth and innovation indicators New products introduced during month110 Products discontinued during month111 Number of sales promotions332 Special offers, discounts, etc.453 Balanced Scorecard for Ben’s Bagels for February

13-55 This electronic presentation was prepared by Douglas Cloud, Professor of Accounting, Pepperdine University

13-56C hapter 13 The End

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