PPT 10-1 ADVANCED MANAGEMENT ACCOUNTING

PPT 10-2 Decentralization and Transfer Pricing

PPT 10-3 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 10-4 Decentralization: The Major Issues l The degree of decentralization l Performance measurement l Management compensation l The setting of transfer prices

PPT 10-5 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 10-6 Decentralization in Organizations Advantages of Decentralization Advantages 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 decisions often based on better information. Lower-level decisions often based on better information. Lower level managers can respond quickly to customers. 10-6

PPT 10-7 Decentralization in Organizations Disadvantages of Decentralization 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. 10-7

PPT 10-8 Decentralization and Segment Reporting segment A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Quick Mart An Individual Store A Sales Territory A Service Center 10-8

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

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

PPT 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 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 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 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 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. Time Segment Margin 10-15

PPT Traceable and Common Costs Fixed Costs TraceableCommon Don’t allocate common costs to segments

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

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

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

PPT Levels of Segmented Statements 10-21

PPT 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 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! 10-23

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

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

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

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

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

PPT Common Costs and Segments Segment 1 Segment 3 Segment 4 Segment 2 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

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

PPT 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 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. Quick Check A common fixed cost cannot be eliminated by dropping one of the segments

PPT 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,

PPT 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 Quick Check The bar would be allocated 1 / 10 of the cost or $20,

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

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

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

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

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

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

PPT Transfer Pricing Approaches l Market price l Negotiated transfer prices l Cost-based transfer prices vFull cost vFull cost plus markup vVariable cost plus fixed fee

PPT A Transfer Pricing Problem Assume the following data for Division A: Capacity in units 50,000 Selling price to outside $15 Variable cost per unit 8 Fixed costs per unit (based on capacity) 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 A Transfer Problem Example (continued) 1.Assume division A has idle capacity in excess of 10,000 units: Minimum transfer price= Variable cost + Lost contribution margin = $8 + $0 = $8 2.Assume division A is working at capacity: Transfer Price = Variable cost + Lost contribution margin = $8 + $7 = $15 (market price) 3. 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 End of Week