Essay Example: Segment Reporting and Decentralization

. [pic] Subject: Cost and Management Accounting Prepare a segmented income statement using the contribution format, and explain the difference between traceable fixed costs and common fixed cost. Segment reporting and Profitability Analysis A different kind of income statement is required for evaluating the performance of a profit or investment center, something that emphasizes segments rather than the performance of the company as a whole.

A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be an individual store, a sales territory and a service center. 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. Levels of Segmented Statements Webber, Inc. Divisions Webber’s defined as Divisions Webber’s segments defined as Television Division Webber’s Segments Defined as Sales Channels for One Product Line, Big Screen, of the Television Division |Income Statement | | Big Screen |Retail Stores |Catalog Sales | |Sales |100,000 |70,000 |30,000 | |Variable Costs |55,000 |42,000 |13,000 | |CM |45,000 |28,000 |17,000 | |Traceable FC |16,000 |10,000 |6,000 | |Sales Channel margin |29,000 |18,000 |11,000 | |Common costs |7,000 | | | |Product Line Margin |$ 22,000 | | | Identifying Traceable and Common Fixed Costs Traceable fixed cost: A traceable fixed cost is a fixed cost that is incurred because of the existence of a segment. If the segment had never existed, the fixed cost would have not been incurred; and if the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include the following: • The salary of the Fritos product manager at Pepsi CO. s traceable fixed cost of the Fritos business segment of Pepsi Co. • The liability insurance at Disney World is a traceable fixed cost of the Disney World business segment of the Disney Corporation Common fixed cost: A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Even if a segment were entirely eliminated, there would be no change in true common fixed cost. Examples: Example of common fixed cost include the following: • The salary of general manager who controls all the segments. The salary of CEO at general motors is also an example of common fixed cost.

No single segment can be regarded as the sole reason of this cost. • The salary of receptionist at an office shared by a number of doctors is a common fixed cost of the doctors. The cost is traceable to the office, but not to any one of the doctors individually. Identifying traceable and common fixed costs is crucial in segment reporting, since the traceable fixed costs are charged to the segments and common fixed costs are not charged to segments. In actual situations, it is some times 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.

Traceable cost can become common cost: Fixed cost that is traceable to one segment can become a common cost for another segment. For example, an air line might want a segmented income statement that shows the segment margin for a particular flight from Loss Angeles to Paris further broken down into first class, business class and economy class segment margins. The airline must pay a landing fee Charles DeGaulle air port in Paris. This fixed landing fee is a trace able fixed cost of the flight, but it is a common fixed cost of first class, business class and economy class segments. Even the first class cabinet is empty the entire landing fee must be paid.

So the landing fee is not a traceable cost of the first class segment. But on the other hand paying the landing fee is necessary in order to have any first, business and economy class passengers. So the landing fee is common cost for these three classes of passengers and is a traceable cost for the flight as a whole. Segment Margin: The segment margin is obtained by deducting the traceable fixed costs of a segment from contribution margin. It represents the margin that is available after a segment has covered all of its own costs. The segment margin is the best gauge of the long-run profitability of a segment, since it includes only those costs that are caused by the segment.

If a segment cannot cover is own costs, then that segment probably should not be retained (unless it has an important side effects on other segments). From a decision making point of view, the segment margin is most useful in major decisions that effect capacity such as dropping a segment. By contrast, the contribution margin is most useful in decisions relating to short-run changes in volume, such as pricing special orders that involve utilization of existing capacity Determine the range, if any, within which a negotiated transfer price should fall. Transfer Pricing. A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.

Transfer prices are necessary to calculate costs and revenues in cost, profit, and investment centers. Clearly, the division that is selling the good or service would prefer a high transfer price while the division that is buying would prefer a low transfer price. 1. Do transfer prices matter? From the standpoint of the company as a whole, the transfer price has no effect on aggregate income (other than perhaps from tax effects when divisions are in different states or countries). What is counted as revenue to one division is a cost to the other and is eliminated in the consolidation process. From an economic perspective, it is like taking money out of one pocket and putting it into the other.

What does matter is how the transfer price affects the decisions made by the segment managers. In companies in which decentralization is really practiced, segment managers are given a lot of latitude in dealing with each other. Based on the transfer price, a division manager will decide whether to sell a service on the outside market or sell it internally to another division, or whether to buy a part from an outside supplier or internally from another division. 2. Negotiated transfer prices. In principle, if managers understand their own businesses and are cooperative, negotiated transfer prices should work quite well. a. If a transfer is in the best interests of the entire company, the profits of the entire company should increase.

It is always possible in such a situation (barring externalities) to find a transfer price that would increase each participating division’s profits. A pie analogy is helpful to explain this principle. The profits of the entire company are the pie. By cooperating in a transfer, the division managers can make the pie bigger. With a bigger pie, it is always possible to divide it in such a way that everyone gets a bigger piece. And transfer prices provide a means for dividing up the pie. b. While negotiated transfer prices can work quite well under the right conditions, if managers are uncooperative and highly competitive, negotiations may go nowhere. 3. The lowest acceptable transfer price for the selling division.

Clearly, the selling division would like for the transfer price to be as high as possible, but how low would the manager of the selling division be willing to go? The answer is that a manager will not agree to a transfer price that is less than his or her “cost. ” But what cost? If the manager is rational and fixed costs are unaffected by the decision, then the manager should realize that any transfer price that covers variable cost plus opportunity cost will result in an increase in segment profits. The opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer. Therefore, the lowest acceptable transfer price as far as the selling division is concerned is: [pic]

When there is idle capacity, there are no lost sales and so the total contribution margin of lost sales is zero. 4. Highest transfer price the buying division is willing to pay. In the book and in problems, we generally consider only the situation in which the buying division can buy the transferred item from an outside supplier. In that case, the buying division clearly would not voluntarily agree to a transfer unless: Transfer price ? Cost of buying from outside supplier 5. The range of acceptable negotiated transfer prices. Combining the selling and buying divisions’ perspectives, we can find the range within which a negotiated transfer price will lie. Two situations should be considered. a.

A transfer makes sense from the standpoint of the company if the item can be made inside the company (including opportunity costs) for less that it costs to buy the item from the outside. In algebraic form: [pic]. In this case, any transfer price within the following range will increase the profits of both divisions: [pic]. b. A transfer does not make sense from the standpoint of the company if the item can be purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs). In algebraic form: [pic]. In this case, it is impossible to satisfy both the selling division and the buying division and no transfer will be made voluntarily.

And, of course, no transfer should be forced on the managers since a transfer would not be in the best interests of the entire company. 6. Alternative approaches to transfer pricing. If managers understand their own businesses and are cooperative, negotiated transfer prices should work very well. But, if managers do not understand their own businesses or are uncooperative, negotiations are likely to be fruitless. As a consequence, most companies rely on either cost-based or market price-based transfer prices. a. Cost-based transfer prices. In many companies, transfers are recorded at variable cost, at full cost, or at variable or full cost plus some arbitrary mark-up. These transfer pricing systems are easy to administer, but suffer from serious limitations. Cost-based transfer prices can easily lead to bad decisions. If variable costs are used, the transfer price will be too low when there is no idle capacity. If full cost is used, the transfer price will never be correct for decision-making purposes—it will always indicate to the buying division that the cost of the transfer is something other than what it really is to the entire company. • If there is no profit margin built into the transfer price, then the selling division has no incentive to cooperate in the transfer. • If the costs of one division are simply passed on to the next division, then there is little incentive for cost control anywhere in the organization.

If transfer prices are to be based on cost, then standard cost rather than actual cost should be used. b. Market-based transfer prices. When there is a competitive outside market for the good or service transferred between the divisions, the market price is often used as a transfer price. This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity. However, when there is idle capacity in the selling division, the transfer price will be too high and the buying division may inappropriately purchase from an outside supplier or cut back on volume. ———————– [pic] [pic] Regular Big Screen Retail Stores Catalog Sales