Getting the Try 2 data back. Huge curve on the Try 2, apparently. Picked up .3 of a point on it, not enough to push my grade up to an A. Oh, well. The huge carves seem to be characteristic of this class. Not terribly impressed with that.
Chapter 12: Segment Reporting and Decentralization
Cost, Profit, and Investment Centers
Companies can be divided into responsibility centers. A responsibility center is any part of an organization whose manager had control over and is accountable for cost, profit, or investment for the company.
Cost centers have control over costs, but not revenue or investment funds. Service departments and manufacturing facilities are generally cost centers. Cost centers act to minimize costs while providing the required production or service level.
Profit centers have control over revenue and costs, but not investment funds. Often the profit-center level or an organization is management for an entire division or branch.
Investment centers have control over cost, revenue, and investment. Generally the investment is the primary concern. This is often the highest level of management in the company.
A segment is any part or activity of a company about which one seeks cost or revenue data. This may be divisions, functions, geographic areas, or even individual employees. In segment reporting, one divides the whole organization into segments and determines what costs and revenues each segment is responsible for. This includes all costs, even sales and administrative costs which are not product costs.
In segment reporting, rather than caring about product or period costs, or about fixed or variable costs, we care about traceable costs and common costs.
Traceable costs are any costs which can be assigned to a single segment. If you eliminated the segment, the traceable costs associated with that segment are also eliminated; likewise the revenues from that segment.
Common cost cannot be traced to any one segment. They are shared by some or all segments in an indivisible fashion. Rent is often, but not always, a common cost. Shared equipment may be a common cost. Common costs must not be allocated to individual segments. Doing so skews the appearance of each segment’s profitability.
The income statement will be similar to a variable reporting income statement, but with additional columns breaking out segment expenses.
Return on Investment
Investment centers are often evaluated based on their return on investment. ROI is computed as Net Operating Income divided by Average Operating Assets.
Alternately, ROI can be calculated as Margin * Turnover, where Margin is Net Operating Income / Sales, and Turnover is Sales / Average Operating Assets. Mathematically, it works out the same. If I use this method on a test, it needs to be run to four decimal places.
To increase ROI, three things work:
- Increase sales
- Reduce expenses
- Reduce operating assets
Residual Income is the net operating income that an investment center earns above the minimum rate of return on its operating assets. It’s possible for a division or company to generate lower residual income even though it has a higher ROI. The inverse is also true. ROI is good, but it’s not the only important metric.
Transfer Pricing
A transfer price is the price one segment charges another segment when it provides goods or services within the company.
Transfer prices are necessary to calculate costs in a cost, profit, or investment center. The buying segment will normally and naturally want the lowest possible transfer price. The selling segment will naturally want the highest possible transfer price. As far as the whole organization is concerned, the money is all staying in-house. It’s just moving from area to area internally.
Three general approaches are used to set transfer prices:
- Negotiated Price
- Cost-based pricing
- Variable cost
- Full or Absorption cost
- Market Price
For negotiated prices, the buyer will not pay more that he could pay to get equivalent goods/services from another vendor. The seller will not accept less than he could make selling to an outside vendor. Those two characteristics, then, set the possible negotiating range. This only applies when the seller could, in fact, sell the goods in question elsewhere, and the buyer could, in actuality, buy the goods elsewhere. Therefore, it assumes the seller is operating at capacity.
It is possible that costs will be lower for internal transfers than for outside sales. This will influence the transfer price. For instance, internal transfers may not be subject to sales commissions or delivery expenses.
If the seller is not operating at capacity, he should be willing to sell for any price that meets his variable expenses.
Cost-Based transfer prices are easy to understand and convenient to use. They can lead to bad decisions, however, because they may not include opportunity costs from lost sales or similar issues. Intermediate divisions will not show profit in the transaction. No incentive exists to control costs unless transfers are made at standard cost.
Market-Based Transfer Prices are only suitable when the selling division is operating at capacity. If idle capacity exists, the price will likely be overstated and may lead the buying manager to make poor decisions.