13-1 profitability analysis of strategic business segments c hapter 13 prepared by douglas cloud...

Profitability Profitability Analysis of Analysis of

Strategic Business Strategic Business SegmentsSegments

Profitability Profitability Analysis of Analysis of

Strategic Business Strategic Business SegmentsSegments

CChaptehapterr

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

1. 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.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

6. 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.

ObjectivesObjectivesObjectivesObjectives

Strategic Business SegmentStrategic 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.

DecentralizationDecentralizationDecentralizationDecentralization

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.

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

CentralizationCentralizationCentralizationCentralization

Centralization exists when top

management has a wide span of

control, including direct control over all major functions of an organization.

Economies of scale Sophistication of applications Improved control

The advantages of centralization include:

Span of control Complexity Diseconomies of scale

The disadvantages of centralization include:

Organization Chart with DecentralizationOrganization Chart with Decentralization

ManagerManagerPlant 2Plant 2

DivisionDivisionControllerController

President

Executive Vice PresidentExecutive Vice President

V. P.Division A

V. P.Division B

Corporate Controller

Marketing V. P.

Other Corporate

OtherOtherStaffStaff

Production and Service Departments Area Sales Representatives

ManagerManagerPlant 1Plant 1

MarketingMarketingManagerManager

Segment Reports are income statements for a portions or

segments of a business.

Segment Reports are income statements for a portions or

segments of a business.

Segment ReportingSegment ReportingSegment ReportingSegment Reporting

They are used were companies have distinct divisions of product

lines, geographic territories, or organization units.

They are used were companies have distinct divisions of product

lines, geographic territories, or organization units.

Segment ReportingSegment ReportingSegment ReportingSegment 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

Segment ReportingSegment ReportingSegment ReportingSegment ReportingIn segment reports, costs

are recorded in four categories.

In segment reports, costs are recorded in four

categories.

Variable costsDirect fixed costsAllocated common costsUnallocated common costs

Multi-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment ReportsMulti-Level Segment Reports

Sales $100,000 $200,000 $300,000Less variable costs -55,000 -95,000 -150,000Contribution margin $ 45,000 $105,000 $150,000Less direct fixed costs -20,000 -60,000 -80,000Division margin $ 25,000 $ 45,000 $ 70,000Less allocated common costs -10,000 -25,000 -35,000Division income $ 15,000 $ 20,000 $ 30,000Less unallocated common costs -12,000Net income $ 23,000

First Level

National Accounts

Regional Accounts

Company Total

Segments (Divisions)

Sales $30,000 $70,000 $100,000Less variable costs -15,000 -40,000 -55,000Contribution margin $15,000 $30,000 $ 45,000Less direct fixed costs -9,000 -6,000 -15,000Product margin $ 6,000 $24,000 $ 30,000Less allocated division costs -5,000 -5,000 -10,000Product income $ 1,000 $19,000 $ 20,000Less unallocated common costs -5,000National Accounts Division income $ 15,000

Second Level

Fiber Optic

Twisted Pair

National Division

Segments (Products)

Sales $30,000 $70,000 $100,000Less variable costs -15,000 -40,000 -55,000Contribution margin $15,000 $30,000 $ 45,000Less direct fixed costs -9,000 -6,000 -15,000Product margin $ 6,000 $24,000 $ 30,000Less allocated division costs -5,000 -5,000 -10,000Product income $ 1,000 $19,000 $ 20,000Less unallocated common costs -5,000National Accounts Division income $ 15,000

Second Level

Fiber Optic

Twisted Pair

National Division

Segments (Products)

Sales $20,000 $10,000 $30,000Less variable costs -11,000 -4,000 -15,000Contribution margin $ 9,000 $ 6,000 $15,000Less direct fixed costs -3,000 -4,000 -7,000Territory margin $ 6,000 $ 2,000 $ 8,000Less allocated division costs -2,000 -3,000 -5,000Territory income $ 4,000 -$ 1,000 $ 3,000Less unallocated common costs -2,000Fiber Optic income $ 1,000

Third Level

Atlantic Pacific

Fiber Optic Total

Segments (Territories)

Direct Versus CommonDirect Versus CommonSegment CostsSegment Costs

The segment margin represents the amount

that a segment contributes toward the common costs of the

organization and toward profits.

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.

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.

Common segment costs are related to

more than one segment and are not

directly traceable to a particular segment.

Transfer PricingTransfer PricingTransfer PricingTransfer 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.

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.

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.

The costs associated with the two products are shown below:

Product Alpha Beta

Variable costs:Direct materials $15 $14Direct labor 5 10Variable manufacturing overhead 5 16Selling 4 0

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.

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.

Relevant Costs

Buy $52Make:

Direct materials $14Direct labor 10Variable manufacturing overhead 16 -40

Difference favors making $12

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

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

MakeBuy

Opportunity Cost

Selling price of Alpha $50Outlay costs of Alpha:

Direct materials $15Direct labor 5Variable manufacturing overhead 5Variable selling 4 -29

Opportunity cost of making Beta $21

Make:Outlay costs of Beta $40Opportunity cost of Beta 21 $61

Buy: $52The company should buy The company should buy from the outside supplier.from the outside supplier.The company should buy The company should buy from the outside supplier.from the outside supplier.

Determining Transfer PriceDetermining Transfer PriceDetermining Transfer PriceDetermining Transfer Price

Market Price Variable Costs Variable Costs plus Opportunity

Costs Absorption Cost plus Markup Negotiated Prices Dual Prices

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.

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 $14Direct labor 10Variable manufacturing overhead 16Total variable costs $40

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 $60Variable costs -40Contribution margin $20

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).

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).

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.

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.

Dual Prices

Dual prices exists when a company allows a difference in the

supplier’s and receiver’s transfer prices for the same product.

Dual prices exists when a company allows a difference in the

supplier’s and receiver’s transfer prices for the same product.

SuboptimizationSuboptimizationSuboptimizationSuboptimization

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

SuboptimizationSuboptimizationSuboptimizationSuboptimization

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.

International Transfer PricingInternational Transfer PricingInternational Transfer PricingInternational Transfer Pricing

Using Transfer Price Based onVariable Cost Full Cost Market Price (000’s) (000’s) (000’s)

Taxable income of the MercedesDivision, excluding the transfer $200,000 $200,000 $200,000

Cost of emission components toMercedes Division

Variable cost ($20 x 300,000) -6,000Full cost ($25 x 300,000) -7,500Market price ($40 x 300,000) -12,000

Taxable income $194,000 $192,500 $188,000Mercedes Division income taxes

(50%) $97,000 $96,250 $94,000ContinuedContinuedContinuedContinued

Taxable income of the ChryslerDivision, excluding the transfer $200,000 $200,000 $200,000

Cost of emission components toMercedes Division

Variable cost ($20 x 300,000) 6,000Full cost ($25 x 300,000) 7,500Market price ($40 x 300,000) 12,000

Taxable income $206,000 $207,500 $212,000Chrysler Division Income Taxes

(35%) $72,100 $72,625 $74,200ContinuedContinuedContinuedContinued

Total Daimler-Chrysler Income Taxes

($97,000 + $72,100) $169,100

($96,250 + $72,625) $168,875

($94,000 + $74,200) $168,200

Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)Return on Investment (ROI)

Investment center income Investment center asset base

orROI = Investment turnover x Return-on-sales ratio

Investment Turnover =Sales

Investment center asset base

Return-on-sales ratio =

Investment center income

Investment center income Investment center asset baseROI =

Sales Investment center income Investment center Sales asset base

xROI =

North American SteelNorth American Steel

PERFORMANCE MEASURESInvestment Return-on-Sales Turnover Ratio ROI Operating units:

Maine Division 1.50 0.12 0.18Alberta Division 2.00 0.12 0.24Missouri Division 0.67 0.33 0.22Tijuana Division 1.50 0.18 0.27

Company performance criteria:Projected minimums 1.20 0.15 0.18

Maine Division

Sales Investment center income Investment center Sales asset base

xROI =

$1,600,000 $160,000

$800,000 $1,600,000ROI = x

ROI = 0.20 x 20 percent

North American SteelNorth American Steel

Residual IncomeResidual IncomeResidual IncomeResidual Income

Division income

Less minimum return (12%)

Equals residual income

$2,000,000

-1,800,000

$ 200,000

$15,000,000 x 0.12Minimum rate of return set by management

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 IncomeResidual IncomeResidual IncomeResidual Income

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) $1,400,000Cost of capital employed ($15,000,000 - $1,800,000) x 0.10 -1,320,000Economic value-added residual income $ 80,000

Economic Value AddedEconomic Value AddedEconomic Value AddedEconomic Value Added

Why Not Just Use Financial Measures?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.

What is the Balanced Scorecard?What is the Balanced Scorecard?What is the Balanced Scorecard?What is the Balanced Scorecard?

It is a performance measurement system that includes financial

and operational measures which are

related to the organizational goals.

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.

Generally it relates resulting performance to the reward system

within each organizational unit.

• 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 Balanced Scorecard Linked to Organizational PerformanceOrganizational Performance

Balanced Scorecard for Ben’sBalanced Scorecard for Ben’sBagels for FebruaryBagels for February

Standard January February

Key financial indicatorsCash flow $25,000 -$4,000 $21,000ROI 0.18 0.22 0.19Economic value-added residual income $130,000 $133,000 $123,000Sales $4,400,000 $4,494,000 $4,342,000

ContinuedContinuedContinuedContinued

Key financial indicatorsAverage customer per hour 75 80 71Number of customer com- plaints per month 22 21 17Number of sales returns per month 10 8 5

Key operating indicatorsBagels sold/produced ratio per day 0.96 0.93 0.91Daily units lost (burnt, dropped, etc.) 25 32 34Employee turnover per

month 0.10 0.07 0.00

Key growth and innovation indicatorsNew products introduced during month 1 1 0Products discontinued during month 1 1 1Number of sales promotions 3 3 2Special offers, discounts, etc. 4 5 3

This electronic presentation was

prepared by Douglas Cloud,

Professor of Accounting, Pepperdine University

CChapter

The The EndEndThe The EndEnd

13-1 profitability analysis of strategic business segments c hapter 13 prepared by douglas cloud...

segment reportingthey

division income

assignment of direct

division margin

allocation of indirect

income statements

net income

organization units

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