Planning and Control in Decentralization Operation

LUO, YAN.

Outline

• Definition of decentralization

• Decentralization in organization

• Decentralization & segment reporting

• Segmented reporting & profitability analysis• Hindrance in proper cast assignment in

segmented reporting• Segmented financial information on external

reports

Definition of Decentralization

• Decentralization (or decentralisation) is the process of redistributing or dispersing functions, powers, people or things away from a central location or authority.

—— Wikipedia

Definition of Decentralization

• A decentralized organization is one in which decision making is not confined to a few top executives but rather is throughout the organization, with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity.

Decentralization in organization

• In a decentralized company, managers of separate divisions or units are delegated operating responsibility. The division (unit) managers are responsible for planning and controlling the operations of their divisions.

Advantages of Decentralization Relieves the Top Executives of Excessive Workload. Managerial Development Increase in morale of employees Quicker and better decisions Improvement in Industrial Relations Expansion of Market Increase in Initiative Reduces problem of Communication

Disadvantages of Decentralization

Dependence on the ability of subordinatesLack of cooperationLack of uniformity of decisiondifficult to effectively spread innovative ideas.Costly set- upLack of control

Decentralization & Segment Reporting

• What is the segment?

A segment is a part or activity of an organization about which managers would like cost, revenue or profit data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers and product lines.

Decentralization & Segment Reporting

• Categorization of business segment

cost centers

profit centers

investment centers

responsibility centers

Decentralization & Segment Reporting

• Relationship of D&SR Effective decentralization requires segment reporting. In

addition to the companywide income statement, reports are needed for individual segments of the organizations. These segmented income statements are useful in analyzing the profitability of segments and measuring the performance of segment managers.

Traceable and common fixed costs

• The most puzzling aspect of segmented income statements is probably the treatment of fixed costs. While preparing segmented income statements the fixed cost is divided into two parts one is traceable fixed cost and other is common fixed cost. Only traceable fixed costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments. Following paragraphs define explain these two types of fixed costs.

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.

Traceable and common fixed costs

• Examples of Traceable fixed cost 1. The salary of the Fritos product manager at Pepsi CO. is traceable

fixed cost of the Fritos business segment of Pepsi Co.

2. The liability insurance at Disney World is a traceable fixed cost of the Disney World business segment of the Disney Corporation

Traceable and common fixed costs

• 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.

Traceable and common fixed costs

• Example of Common fixed cost:• 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.

Traceable and common fixed costs

• 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 and common fixed costs• 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 traceable 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 class of passengers and is a traceable cost for the flight as a whole.

Segment Reporting and Profitability Analysis-Segmented Income Statements• How are segmented income statements prepared?

A different kind of income statement is required for evaluating the performance of a profit or investment center. This income statement should emphasize on the segment rather than the performance of the company as a whole. A contribution margin format income statement is used to evaluate the performance of different segments. In a contribution margin format income statement cost of goods sold consists only of the variable manufacturing costs. This point has been discussed in detail on our cost volume profit CVP relationship page. To prepare an income statement for a particular segment variable costs are deducted from the sales revenue to yield contribution margin. Fixed costs are broken down further into traceable and common fixed costs. Traceable fixed are assigned to the segments but non-traceable or common fixed costs are not assigned to segments. For detailed study about traceable and common fixed costs see traceable and common fixed cost page.

Segment Reporting and Profitability Analysis-Segmented Income Statements• 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.

Segment Reporting and Profitability Analysis-Segmented Income Statements

• Example: 1• As an example, a portion of the segmented report is shown below.

In this report segments have been defined as divisions. Report also have a column of total company performance for the period. We can see that divisional segment margin is $60,000 for business product division and $40,000 for the consumer product division. This report is very useful for company's divisional managers They may want to know how much each of their divisions is contributing to the company's profit.

Segments defined as divisions

Segment Reporting and Profitability Analysis-Segmented Income Statements• Example: 2• Segmented income statements can be prepared for activities at

many levels in a company. To provide more information to the company's divisional managers the divisions can be further segmented according to their major product lines. In the consumer product division the product lines are clip art and computer games. This concept is further explained by the following example.

Segments defined as product lines of the consumer product division

Segments defined as product lines of the consumer product division• Conclusion of example 2• Total traceable cost ($80,000) of consumer product division include

10,000 of divisional manager's salary. This cost now is a common fixed cost for clip art and computer games. Because non of these products is solely responsible for this salary of manager.

• Going even further , we can segment each of the product lines according to how they are sold--in retail computer stores or by catalog sales.

Segments defined as sales channels for one product line, computer games, of the consumer products division

Segments defined as sales channels for one product line, computer games, of the consumer products division

• Substantial benefits are received from a series of statements of such as those above. By carefully examining trends and results in each segment, a manager is able to gain considerable insight into the company's operations viewed from many different angles. And advanced computer-based information systems are making it easier and easier to construct such statements and to keep them continuously current.

Hindrances/Problems to Proper Cost Assignment in Segmented Reporting

• Omission of costs

• Arbitrarily dividing common costs among segments

• Inappropriate methods for allocating costs among segmentsa. Failure to trace cost directly

b. Inappropriate Allocation Base

Omission of costs

• The costs assigned to a segment should include all costs attributable to that segment from the company's entire value chain. The value chain consists of major business functions that add value to a company's products and services. All of these functions, from research and development, through product design, manufacturing, marketing, distribution, and customer service, are required to bring a product or service to the customer and generate revenues. However only manufacturing costs are included in product costs for financial reporting purposes, some companies deduct only manufacturing costs from product revenues.

Omission of costs• As a result such companies omit from their profitability

analysis part or all or the "upstream costs“ in the value chain which consist of research and development and product design, and "down stream costs“ which consist of marketing, distribution and customer service. Yet these non manufacturing costs are just as essential in determining the product profitability as are the manufacturing costs. These upstream and downstream costs, which are usually titled selling, general and administrative (SG&A) on the income statement, can represent half or more of the total costs of an organization. If either the upstream or downstream costs are omitted in profitability analysis, then the product is under-costed and management may unwillingly develop and maintain products that in the long run result in losses rather than profits for the company.

Arbitrarily dividing common costs among segments

• The third business practice that leads to distorted segment costs is the practice of assigning non-traceable costs to segments. For example, some companies allocate the costs of the corporate headquarters building to products on segment reports. However, in a multiproducts company, no single product is likely to be responsible for any significant amount of this cost. Even if a product were eliminated entirely, there would usually be no significant effect on any of the costs of the corporate headquarters building. In short, there is nocause and effectrelation between the cost of the corporate headquarters building and the existence of any one product. As a consequence, any allocation of the cost of the corporate headquarters building to the products must be arbitrary.

Arbitrarily dividing common costs among segments• Common costs like the costs of corporate headquarters building are necessary, of

course, to have a functioning organization. The common practice of arbitrarily allocating these costs to segments is often justified on the grounds that "someone" has to "cover the common costs." While it is undeniably true that the common costs must be covered, arbitrarily allocating common costs to segments does not ensure that this will happen. In fact, adding a share of common costs to the real costs of a segment make an otherwise profitable segment appear to be unprofitable. If a manager erroneously eliminates the segment, the revenues will be lost, the real costs of a segment will behaved, but the common cost will still be there. The net effect will be to reduce the profit of the company as a whole and make it even more difficult to "cover the common costs." In sum, the way many companies handle segment reporting results in cost distortion. This distortion results from three practices--the failure to trace costs directly to specific segment when it is feasible to do so, the use of inappropriate bases for allocating costs, and the allocation of common costs to segments. These practices are widespread. One study found that 60% of the companies surveyed made no attempt to assign SG&A costs to segments on a cause and effect basis.

Inappropriate methods for allocating costs among segments

• Cross-subsidization, or cost distortion, occurs when costs are improperly assigned among a company's segment. Cross-subsidization can occur in two ways; first, when companies fail to trace costs directly to segments in those situations where it is a feasible to do so; and second, when companies use inappropriate bases to allocate costs.

Failure to trace cost directly

• Costs that can be traced directly to a specific segment of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example, the rent for a branch office should be charged directly against the branch office rather than included in a company wide overhead pool and then spread throughout the company.

Inappropriate Allocation Base

• Some companies allocate costs to segments using arbitrary bases such as sales dollars or cost of goods sold. For example, under the sales dollars approach, costs are allocated to the various segments according to the percentage of company sales generated by each segment. If a segment generates 20% of total company sales, it would be allocated 20% of the company's SG&A expenses as its fair share. This same basic procedure is followed if cost of goods sold or some other measure is used as the allocation base. For this approach to be valid, the allocation base must actually drive the overhead cost. Or at least the allocation base should be highly correlated with the cost driver of the overhead cost. For example, when sales dollars is used as the allocation based for SG&A expense, it is implicitly assumed that SG&A expense change in proportion to change in total sales. If that is not true, the SG&A expenses allocated to segments will be misleading.

Segmented Financial Information on External Reports The Financial Accounting Standards Board (FASB) now requires that companies in

the united states include segmented financial and other data in their annual reports and that the segmented reports prepared for external users must use the same method and definitions that the companies use in internal segmented reports that are prepared to aid in making operating decisions. This is a very usual requirement. Companies are not ordinarily required to report the same data to external users that are reported internally for decision making purposes. This may seem like a reasonable requirement for the FASB to make, but it has some serious drawbacks. First segmented data are often highly sensitive and companies are reluctant to release such data to the public for the simple reason that their competitors will then have access to the data. Second companies must reconcile their segmented financial statements, which need not be prepared under Generally Accepted Accounting Principles (GAAP). It is important to realize that the segmented income statement prepared on Segment reporting and profitability analysis-segmented income statements page does not conform to GAAP. For example statements prepared in accordance with GAAP do not distinguish between fixed and variable costs and between traceable and common costs. To avoid the complications of the reconciliations between non-GAAP segment earnings and GAAP consolidated earnings, it is likely that at least some managers will choose to construct their segmented financial statements so as to be within GAAP. This will result in more occurrences of the problems.

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