Reporting for Control Chapter 11 Chapter 11: Reporting for Control

Reporting for Control Chapter 11 Chapter 11: Reporting for Control
11-1 Reporting for Control Chapter 11: Reporting for Control Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, segmented income statements, and return on investment (ROI) and residual income measures are used to help control decentralized organizations. Chapter 11

Decentralization in Organizations
11-2 Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. A decentralized organization does not confine decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages of decentralization are as follows: It enables top management to concentrate on strategy, higher-level decision- making, and coordinating activities. It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions. It enables lower-level managers to quickly respond to customers. It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions. It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance. Lower-level decisions often based on better information. Lower level managers can respond quickly to customers. LO 1

Decentralization in Organizations
11-3 Decentralization in Organizations May be a lack of coordination among autonomous managers. Lower-level managers may make decisions without seeing the “big picture.” Disadvantages of Decentralization Lower-level manager’s objectives may not be those of the organization. The disadvantages of decentralization are as follows: Lower-level managers may make decisions without fully understanding the “big picture.” There may be a lack of coordination among autonomous managers. The balanced scorecard can help reduce this problem by communicating a company’s strategy throughout the organization. Lower-level managers may have objectives that differ from those of the entire organization. This problem can be reduced by designing performance evaluation systems that motivate managers to make decisions which are in the best interests of the company. It may difficult to effectively spread innovative ideas in a strongly decentralized organization. This problem can be reduced through the effective use of intranet systems, which enable globally dispersed employees to electronically share ideas. May be difficult to spread innovative ideas in the organization. LO 1

Decentralization and Segment Reporting
11-4 Decentralization and Segment Reporting Quick Mart An Individual Store A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be . . . A Sales Territory 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. A Service Centre LO 1

Superior Foods: Geographic Regions
11-5 Superior Foods: Geographic Regions Superior Foods Corporation could segment its business by geographic regions. Superior Foods Corporation could segment its business by geographic regions. LO 1

Superior Foods: Customer Channel
11-6 Superior Foods: Customer Channel Or, Superior Foods could segment its business by customer channel. Superior Foods Corporation could segment its business by customer channel. LO 1

Keys to Segmented Income Statements
11-7 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. There are two keys to building segmented income statements. First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. LO 1

Identifying Traceable Fixed Costs
11-8 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. A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. 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 PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing. LO 1

Identifying Common Fixed Costs
11-9 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 company president. 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. Examples of common fixed costs include the following: The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Loblaws or Zehrs grocery store is a common fixed cost of the various departments – groceries, produce, and bakery. LO 1

Traceable Costs Can Become Common Costs
11-10 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. 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 a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers. LO 1

11-11 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. A segment margin is computed by subtracting the traceable fixed costs of a segment from its contribution margin. The segment margin is a valuable tool for assessing the long-run profitability of a segment. Profits Time LO 1

Traceable and Common Costs
11-12 Traceable and Common Costs Fixed Costs Don’t allocate common costs to segments. Traceable Common Part I Allocating common costs to segments reduces the value of the segment margin as a guide to long-run segment profitability. Part II As a result, common costs should not be allocated to segments. LO 1

Activity-Based Costing
11-13 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. Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments. For example, assume that three products, a 9-inch, a 12-inch, and an 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 activity-based costing can be used to trace the warehousing costs to the three products as shown. When using activity-based costing to trace fixed costs to segments, managers must still ask themselves if the traceable costs that they have identified would disappear over time, if the segment disappeared. In this example, if the warehouse was owned rather than leased, perhaps the warehousing costs assigned to a given segment would not disappear if the segment was discontinued. LO 1

Levels of Segmented Statements
11-14 Levels of Segmented Statements Webber, Inc. has two divisions. Assume that Webber, Inc. has two divisions – the Computer Division and the Television Division. Let’s look more closely at the Television Division’s income statement. LO 1

11-15 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Cost of goods sold consists of variable manufacturing costs. The contribution format income statement for the Television Division is as shown. Notice that: Cost of goods sold consists of variable manufacturing costs, and Fixed and variable costs are listed in separate sections. Fixed and variable costs are listed in separate sections. LO 1

11-16 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Contribution margin is computed by taking sales minus variable costs. Also notice that: Contribution margin is computed by subtracting variable costs from sales; and The divisional segment margin represents the Television Division’s contribution to overall company profits. Segment margin is Television’s contribution to profits. LO 1

11-17 Levels of Segmented Statements The Television Division’s results can be rolled into Webber, Inc.’s overall results as shown. Notice that the results of the Television and Computer Divisions sum to the results shown for the whole company. LO 1

11-18 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. The common costs for the company as a whole ($25,000) are not allocated to the divisions. Common costs are not allocated to segments because these costs would remain even if one of the divisions were eliminated. LO 1

11-19 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! The Television Division’s results can also be broken down into smaller segments. This enables us to see how traceable fixed costs of the Television Division can become common costs of smaller segments. LO 1

11-20 Traceable Costs Can Become Common Costs Webber’s Television Division Regular Big Screen Television Division Assume that the Television Division can be broken down into two major product lines – Regular and Big Screen. Product Lines LO 1

11-21 Traceable Costs Can Become Common Costs Assume that the segment margins for these two product lines are as shown. We obtained the following information from the Regular and Big Screen segments. LO 1

11-22 Traceable Costs Can Become Common Costs Of the $90,000 of fixed costs that were previously traceable to the Television Division, only $80,000 is traceable to the two product lines and $10,000 is a common cost. Fixed costs directly traced to the Television Division $80,000 + $10,000 = $90,000 LO 1

Segment Reporting for Financial Accounting
11-23 Segment Reporting for Financial Accounting The Accounting Standards Board now requires that companies in Canada include segmented financial data in their annual reports. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. 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. The Accounting Standards Board (CICA Handbook section 1701 and IFRS 8–Operating Segments) now requires that companies in Canada include segmented financial data in their annual reports. This ruling has implications for internal segment reporting because: It mandates that companies report segmented results to shareholders using the same methods that are used for internal segmented reports. 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. The absorption approach hinders internal decision making because it does not distinguish between fixed and variable costs or common and traceable costs. LO 1

Assignment to segments the entire organization. methods for allocating
11-24 Hindrances to Proper Cost Assignment Some Problems Omission of some costs in the assignment process. Assignment to segments of costs that are really common costs of the entire organization. Costs must be properly assigned to segments. All of the costs attributable to a segment—and only those costs—should be assigned to the segment. Unfortunately, companies often make mistakes when assigning costs to segments. They omit some costs, inappropriately assign traceable fixed costs, and arbitrarily allocate common fixed costs. Use of inappropriate methods for allocating costs among segments. LO 1

11-25 Omission of Costs Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain. Business Functions Making Up The Value Chain The costs assigned to a segment should include all the costs attributable to that segment from the company’s entire value chain. The value chain consists of all major business functions that add value to a company’s products and services. Since only manufacturing costs are included in product costs under absorption costing, those companies that choose to use absorption costing for segment reporting purposes will omit from their profitability analysis all “upstream” and “downstream” costs. “Upstream” costs include research and development and product design costs. “Downstream” costs include marketing, distribution, and customer service costs. Although these “upstream” and “downstream” costs are not manufacturing costs, they are just as essential to determining product profitability as are manufacturing costs. Omitting them from profitability analysis will result in the under-costing of products. Product Customer R&D Design Manufacturing Marketing Distribution Service LO 1

Inappropriate Methods of Allocating Costs Among Segments
11-26 Inappropriate Methods of Allocating Costs Among Segments Failure to trace costs directly Inappropriate allocation base Costs that can be traced directly to specific segments 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 of an insurance company should be charged directly against the branch office rather than included in a company-wide overhead pool and then spread throughout the company. Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments for internal decision making purposes only when the allocation base actually drives the cost being allocated. For example, sales is frequently used to allocate selling and general and administrative expenses to segments. This should only be done if sales drive these period costs. Segment 1 Segment 2 Segment 3 Segment 4 LO 1

Arbitrarily Dividing Common Costs and Segments
11-27 Arbitrarily Dividing Common Costs and Segments Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: This practice may make a profitable business segment appear to be unprofitable. Allocating common fixed costs forces managers to be held accountable for costs they cannot control. Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: First, this practice may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided. Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control. Segment 1 Segment 2 Segment 3 Segment 4 LO 1

11-28 Quick Check  Assume that Hagland's Lakeshore prepared the segmented income statement as shown. Assume that Hagland's Lakeshore prepared its segmented income statement as shown. LO 1

11-29 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. How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? LO 1

11-30 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. None of it. A common fixed cost cannot be eliminated by dropping one of the segments. A common fixed cost cannot be eliminated by dropping one of the segments. LO 1

11-31 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. $50,000 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? LO 1

The bar would be allocated 1/10 of the cost or $20,000.
11-32 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. $50,000 The bar would be allocated 1/10 of the cost or $20,000. The bar would be allocated one tenth of the cost or $20,000. LO 1

11-33 Quick Check  If Hagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? If Hagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment? LO 1

Allocations of Common Costs
11-34 Allocations of Common Costs Take a minute and review this slide. Notice that the common costs of $200,000 are allocated to the bar and restaurant. Hurray, now everything adds up!!! LO 1

Quick Check  Should the bar be eliminated? a. Yes b. No
11-35 Quick Check  Should the bar be eliminated? a. Yes b. No Should the bar be eliminated? LO 1

Quick Check  Should the bar be eliminated? a. Yes b. No
11-36 Quick Check  Should the bar be eliminated? a. Yes b. No The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000! No. The profit was $40,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000! LO 1

Cost, Profit, and Investments centres
11-37 Cost, Profit, and Investments centres Cost centre Profit centre Investment centre Cost, profit, and investment centres are all known as responsibility centres. Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions. The term responsibility centre is used for any part of an organization whose manager has control over, and is accountable for cost, profit, or investments. The three primary types of responsibility centres are cost centres, profit centres, and investment centres. Responsibility centre LO 2

Cost centre A segment whose manager has control over costs,
11-38 Cost centre A segment whose manager has control over costs, but not over revenues or investment funds. The manager of a cost centre has control over costs, but not over revenue or investment funds. Service departments such as accounting, general administration, legal, and personnel are usually classified as cost centres, as are manufacturing facilities. Standard cost variances and flexible budget variances, such as those discussed in Chapters 10 and 11, are often used to evaluate cost centre performance. LO 2

11-39 Profit centre Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries A segment whose manager has control over both costs and revenues, but no control over investment funds. The manager of a profit centre has control over both costs and revenue. Profit centre managers are often evaluated by comparing actual profit to targeted or budgeted profit. An example of a profit centre is a company’s cafeteria. LO 2

11-40 Investment centre Corporate Headquarters A segment whose manager has control over costs, revenues, and investments in operating assets. The manager of an investment centre has control over cost, revenue, and investments in operating assets. Investment centre managers are often evaluated using return on investment (ROI) or residual income (discussed later in this chapter). An example of an investment centre would be the corporate headquarters. LO 2

Responsibility centres
11-41 Responsibility centres Investment Centres Cost Centres Part I Superior Foods Corporation provides an example of the various kinds of responsibility centres that exist in an organization. Part II The President and CEO, as well as the Vice President of Operations, manage investment centres. Part III The Chief Financial Officer, General Counsel, and Vice President of Personnel all manage cost centres. Superior Foods Corporation provides an example of the various kinds of responsibility centres that exist in an organization. LO 2

11-42 Responsibility centres Profit Centres Each of the three product managers that report to the Vice President of Operations (e.g., salty snacks, beverages, and confections) manages a profit centre. Superior Foods Corporation provides an example of the various kinds of responsibility centres that exist in an organization. LO 2

11-43 Responsibility centres Cost Centres The bottling plant manager, warehouse manager, and distribution manager all manage cost centres that report to the Beverages product manager. Superior Foods Corporation provides an example of the various kinds of responsibility centres that exist in an organization. LO 2

Key Concepts/Definitions
11-44 Key Concepts/Definitions A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic transfer prices have no direct effect on the entire company’s reported profit, they can have a dramatic effect on the reported profitability of a division. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. Sub optimization occurs when managers do not act in the best interests of the overall company or even their own divisions. LO 3

Three Primary Approaches
11-45 Three Primary Approaches There are three primary approaches to setting transfer prices: Negotiated transfer prices; Transfers at the cost to the selling division; and Transfers at market price. There are three primary approaches to setting transfer prices, namely negotiated transfer prices, transfers at the cost to the selling division, and transfers at market price. LO 3

Negotiated Transfer Prices
11-46 Negotiated Transfer Prices A negotiated transfer price results from discussions between the selling and buying divisions. Upper limit is determined by the buying division. Lower limit is determined by the selling division. Range of Acceptable Transfer Prices Advantages of negotiated transfer prices: They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company. A negotiated transfer price results from discussions between the selling and buying divisions. Negotiated transfer prices have two advantages. First, they preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company. Second, the range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase. The lower limit is determined by the selling division. The upper limit is determined by the buying division. LO 3

Harrison Ltd – An Example
11-47 Harrison Ltd – An Example Assume the information as shown with respect to Cumberland Beverages and Pizza Place (both companies are owned by Harrison Ltd). Assume the information as shown with respect to Cumberland Beverages and Pizza Place (both companies are owned by Harrison Ltd). LO 3

11-48 Harrison Ltd – An Example The selling division’s (Cumberland Beverages) lowest acceptable transfer price is calculated as: Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. The buying division’s (Pizza Place) highest acceptable transfer price is calculated as: The selling division’s (Cumberland Beverages) lowest acceptable transfer price is calculated as shown. The buying division’s (Pizza Place) highest acceptable transfer price is calculated as shown. If Pizza Place had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses. Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. If an outside supplier does not exist, the highest acceptable transfer price is calculated as: LO 3

11-49 Harrison Ltd – An Example If Cumberland Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Place’s demands (2,000 barrels), without sacrificing sales to other customers, then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Buying division’s highest possible transfer price: Therefore, the range of acceptable transfer price is $8 – $18. Part I If Cumberland Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Place’s demands (2,000 barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as follows. Part II The lowest acceptable transfer price, as determined by the seller, is $8. Part III The highest acceptable transfer price, as determined by the buyer, is $18. Therefore, the range of acceptable transfer prices is $8 to $18. LO 3

11-50 Harrison Ltd – An Example If Cumberland Beverages has no idle capacity (0 barrels) and must sacrifice other customer orders (2,000 barrels) to meet Pizza Place’s demands (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Buying division’s highest possible transfer price: Therefore, there is no range of acceptable transfer prices. Part I If Cumberland Beverages has no idle capacity and must sacrifice other customer orders (2,000 barrels) to meet the demands of Pizza Place (2,000 barrels), then the lowest and highest possible transfer prices will be computed as follows. Part II The lowest acceptable transfer price, as determined by the seller, is $20. Part III The highest acceptable transfer price, as determined by the buyer, is $18. Therefore, there is no range of acceptable transfer prices. This is a desirable outcome for Harrison Ltd because it would be illogical to give up sales of $20 to save costs of $18. LO 3

11-51 Harrison Ltd – An Example If Cumberland Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet Pizza Place’s demands (2,000 barrels), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Buying division’s highest possible transfer price: Therefore, the range of acceptable transfer price is $14 – $18. Part I If Cumberland Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet the demands of Pizza Place (2,000 barrels), then the lowest and highest possible transfer prices will be computed as follows. Part II The lowest acceptable transfer price, as determined by the seller, is $14. Part III The highest acceptable transfer price, as determined by the buyer, is $18. Therefore, the range of acceptable transfer prices is $14 to $18. LO 3

Evaluation of Negotiated Transfer Prices
11-52 Evaluation of Negotiated Transfer Prices If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. If managers are pitted against each other rather than against their past performance or reasonable benchmarks, a no cooperative atmosphere is almost guaranteed. If a transfer within the company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. Nonetheless, if managers are pitted against each other rather than against their past performance or reasonable benchmarks, a no cooperative atmosphere is almost guaranteed. Thus, negotiations often break down even though it would be in both parties’ best interests to agree to a transfer price. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices. LO 3

Transfers at the Cost to the Selling Division
11-53 Transfers at the Cost to the Selling Division Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. Drawbacks of this approach include: Using full cost as a transfer price and can lead to suboptimization. The selling division will never show a profit on any internal transfer. Cost-based transfer prices do not provide incentives to control costs. Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. The drawbacks of this approach include: Using full cost as a transfer price can lead to suboptimization because it does not distinguish between variable costs, which may be relevant to the transfer pricing decision, and fixed costs, which may be irrelevant. If cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sale to an outside party. Cost-based transfer prices do not provide incentives to control costs. If the actual costs of one division are passed on to the next, there is little incentive for anyone to work on reducing costs. LO 3

Transfers at Market Price
11-54 Transfers at Market Price A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. A market price approach does not work well when the selling division has idle capacity. A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem. It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. With no idle capacity the real cost of the transfer from the company’s perspective is the opportunity cost of the lost revenue on the outside sale. It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole. LO 3

Divisional Autonomy and Sub optimization
11-55 Divisional Autonomy and Sub optimization The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally, even if this may occasionally result in suboptimal decisions. This way top management allows subordinates to control their own destiny. The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally. While subordinate managers may occasionally make suboptimal decisions, top managers should allow their subordinates to control their own destiny – even to the extent of granting subordinate managers the right to make mistakes. LO 3

International Aspects of Transfer Pricing
11-56 International Aspects of Transfer Pricing Transfer Pricing Objectives Domestic Greater divisional autonomy Greater motivation for managers Better performance evaluation Better goal congruence International Less taxes, duties, and tariffs Less foreign exchange risks Better competitive position Better governmental relations The objectives of domestic transfer pricing include: creating greater divisional autonomy; providing greater motivation for managers; enabling better performance evaluation; and establishing better goal congruence. The objectives of international transfer pricing include: lessen taxes, duties and tariffs; lessen foreign exchange risks; improve competitive position; and improve relations with foreign governments. LO 3

Return on Investment (ROI) Formula
11-57 Return on Investment (ROI) Formula Income before interest and taxes (EBIT) ROI = Operating income Average operating assets An investment centre’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as operating income divided by average operating assets. Operating income is income before taxes and is sometimes referred to as earnings before interest and taxes (EBIT). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Operating income is used in the numerator because the denominator consists only of operating assets. The operating asset base used in the formula is typically computed as the average operating assets [(beginning assets + ending assets)/2]. Cash, accounts receivable, inventory, plant and equipment, and other productive assets. LO 4

Net Book Value vs. Gross Cost
11-58 Net Book Value vs. Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets. Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets. With this approach, ROI mechanically increases over time as the accumulated depreciation increases. Replacing a fully-depreciated asset with a new asset will decrease ROI. An alternative to using net book value is the use of the gross cost of the asset, which ignores accumulated depreciation. With this approach, ROI does not grow automatically over time, rather it stays constant; thus, replacing a fully-depreciated asset does not adversely affect ROI. LO 4

Average operating assets Average operating assets
11-59 Understanding ROI ROI = Operating income Average operating assets Margin = Operating income Sales Turnover = Sales Average operating assets DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover. Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned. Turnover is computed as shown. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI. ROI = Margin  Turnover LO 4

There are three ways to increase ROI . . .
11-60 Increasing ROI There are three ways to increase ROI . . . Reduce Operating Expenses Increase Sales Reduce Operating Assets Any increase in ROI must involve at least one of the following – increased sales, reduced operating expenses, or reduced operating assets. LO 4

Increasing ROI – An Example
11-61 Increasing ROI – An Example Regal Company reports the following: Operating income $ 30,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000 What is Regal Company’s ROI? Assume that Regal Company reports operating income of $30,000; average operating assets of $200,000; sales of $500,000; and operating expenses of $470,000. What is Regal Company’s ROI? ROI = Margin  Turnover Operating income Sales Average operating assets × ROI = LO 4

Increasing ROI – An Example
11-62 Increasing ROI – An Example ROI = Margin  Turnover Operating income Sales Average operating assets × ROI = $30,000 $500,000 × $200,000 ROI = Given this information, its current ROI is 15%. 6%  2.5 = 15% ROI = LO 4

Increasing Sales Without an Increase in Operating Assets
11-63 Increasing Sales Without an Increase in Operating Assets Regal's manager was able to increase sales to $600,000, while operating expenses increased to $558,000. Regal's operating income increased to $42,000. There was no change in the average operating assets of the segment. The first way to increase ROI is to increase sales without any increase in operating assets. Assume the following. First, Regal's manager was able to increase sales to $600,000 (an increase of 20%). Second, operating expenses increased to $558,000 (an increase of 18.7%). Third, operating income increased to $42,000. Fourth, average operating assets remained unchanged. Let’s calculate the new ROI. Let’s calculate the new ROI. LO 4

Increasing Sales Without an Increase in Operating Assets
11-64 Increasing Sales Without an Increase in Operating Assets ROI = Margin  Turnover Operating income Sales Average operating assets × ROI = $42,000 $600,000 × $200,000 ROI = In this case, the ROI increases from 15% to 21%. Notice, for ROI to increase, the percentage increase in sales must exceed the percentage increase in operating expenses. 7%  3.0 = 21% ROI = ROI increased from 15% to 21%. LO 4

Let’s calculate the new ROI.
11-65 Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regal's manager was able to reduce operating expenses by $10,000, without affecting sales or operating assets. This would increase operating income to $40,000. Regal Company reports the following: Operating income $ 40,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 460,000 The second way to increase ROI is to decrease operating expenses with no change in sales or operating assets. Assume that Regal's manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets. Let’s calculate the new ROI. Let’s calculate the new ROI. LO 4

11-66 Decreasing Operating Expenses with no Change in Sales or Operating Assets ROI = Margin  Turnover Operating income Sales Average operating assets × ROI = $40,000 $500,000 × $200,000 ROI = In this case, the ROI increases from 15% to 20%. 8%  2.5 = 20% ROI = ROI increased from 15% to 20%. LO 4

Let’s calculate the new ROI.
11-67 Decreasing Operating Assets with no Change in Sales or Operating Expenses Assume that Regal's manager was able to reduce inventories by $20,000 using just-in-time techniques, without affecting sales or operating expenses. Regal Company reports the following: Operating income $ 30,000 Average operating assets $ 180,000 Sales $ 500,000 Operating expenses $ 470,000 The third way to increase ROI is to decrease operating assets with no change in sales or operating expenses. Assume that Regal's manager was able to reduce inventories by $20,000 by using just-in-time techniques without affecting sales or operating expenses. Let’s calculate the new ROI. Let’s calculate the new ROI. LO 4

11-68 Decreasing Operating Assets with no Change in Sales or Operating Expenses ROI = Margin  Turnover Operating income Sales Average operating assets × ROI = $30,000 $500,000 × $180,000 ROI = In this case, the ROI increases from 15% to 16.7%. 6%  2.78 = 16.7% ROI = ROI increased from 15% to 16.7%. LO 4

Investing in Operating Assets to Increase Sales
11-69 Investing in Operating Assets to Increase Sales Assume that Regal's manager invests in a $30,000 piece of equipment that increases sales by $35,000, while increasing operating expenses by $15,000. Regal Company reports the following: Operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000 The fourth way to increase ROI is to invest in operating assets to increase sales. Assume that Regal's manager invests $30,000 in a piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Let’s calculate the new ROI. Let’s calculate the new ROI. LO 4

Investing in Operating Assets to Increase Sales
11-70 Investing in Operating Assets to Increase Sales ROI = Margin  Turnover Operating income Sales Average operating assets × ROI = $50,000 $535,000 × $230,000 ROI = In this case, the ROI increases from 15% to 21.8%. 9.35%  2.33 = 21.8% ROI = ROI increased from 15% to 21.8%. LO 4

Criticisms of ROI In the absence of the balanced
11-71 Criticisms of ROI In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI in a manner that is consistent with the company’s strategy. This is why ROI is best used as part of a balanced scorecard. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. This may make it difficult to assess this manager relative to other managers. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager’s performance evaluation. LO 4

Residual Income - Another Measure of Performance
11-72 Residual Income - Another Measure of Performance Operating income above some minimum return on operating assets Residual income is the operating income that an investment centre earns above the minimum required return on its assets. Economic Value Added (EVA) is an adaptation of residual income. We will not distinguish between the two terms in this class. LO 5

Calculating Residual Income
11-73 Calculating Residual Income ( ) This computation differs from ROI. ROI measures operating income earned relative to the investment in average operating assets. Residual income measures operating income earned less the minimum required return on average operating assets. The equation for computing residual income is as shown. Notice that this computation differs from ROI. ROI measures operating income earned relative to the investment in average operating assets. Residual income measures operating income earned less the minimum required return on average operating assets. LO 5

Residual Income – An Example
11-74 Residual Income – An Example The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period, the division earns $30,000. Assume the information for a division of Zephyr, Inc. is as follows. The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period, the division earns $30,000. Let’s calculate residual income. Let’s calculate residual income. LO 5

Residual Income – An Example
11-75 Residual Income – An Example The residual income of $10,000 is computed by subtracting the minimum required return of $20,000 from the actual income of $30,000. LO 5

Motivation and Residual Income
11-76 Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula. Residual income motivates managers to pursue investments where the ROI associated with an investment opportunity exceeds the company’s minimum required return but is less than the ROI being earned by the division manager contemplating the investment. LO 5

11-77 Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% Redmond Awnings, a division of Wrap-up Corp., has a operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? LO 5

11-78 Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% The ROI is 20%. ROI = OI / Average operating assets = $60,000 / $300,000 = 20% LO 5

11-79 Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional operating income of $18,000 per year? a. Yes b. No If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional operating income of $80,000 per year? LO 5

This lowers the division’s ROI from 20.0% down to 19.5%.
11-80 Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional operating income of $18,000 per year? a. Yes b. No No, she would not want to invest in this project because its return is 18%, which would reduce her division’s ROI from 20% to 19.5%. ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%. LO 5

11-81 Quick Check  The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional operating income of $18,000 per year? a. Yes b. No The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional operating income of $18,000 per year? LO 5

11-82 Quick Check  The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional operating income of $18,000 per year? a. Yes b. No ROI = $18,000 / $100,000 = 18% The return on the investment exceeds the minimum required rate of return. Yes, she would want to invest in this project because the return on the investment exceeds the minimum required rate of return. LO 5

11-83 Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Review this question. What is the division’s residual income? LO 5

11-84 Quick Check  Redmond Awnings, a division of Wrap-up Corp., has an operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 The residual income is $15,000. Operating income $60,000 Required return (15% of $300,000) (45,000) Residual income $15,000 LO 5

11-85 Quick Check  If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional operating income of $18,000 per year? a. Yes b. No If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional operating income of $18,000 per year? LO 5

11-86 Quick Check  If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional operating income of $18,000 per year? a. Yes b. No Yes, she would want to invest in this project because it will increase the residual income by $3,000. Operating income $78,000 Required return (15% of $400,000) (60,000) Residual income $18,000 Yields an increase of $3,000 in the residual income. LO 5

Divisional Comparisons and Residual Income
11-87 Divisional Comparisons and Residual Income The residual income approach has one major disadvantage. It cannot be used to compare performance of divisions of different sizes. The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. LO 5

11-88 Zephyr, Inc. – Continued Recall the following information for the Retail Division of Zephyr, Inc. Assume the following information for the Wholesale Division of Zephyr, Inc. Recall that the Retail Division of Zephyr had average operating assets of $100,000, a minimum required rate of return of 20%, operating income of $30,000, and residual income of $10,000. Assume that the Wholesale Division of Zephyr had average operating assets of $1,000,000, a minimum required rate of return of 20%, operating income of $220,000, and residual income of $20,000. LO 5

11-89 Zephyr, Inc. – Continued The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division. The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division. LO 5

Criticisms of Residual Income
11-90 Criticisms of Residual Income RI is based on historical accounting data which can lead to inflated amounts for residual income in periods of rising prices (i.e.. values for capital assets). RI does not indicate what earnings should be (need comparison of external benchmark or trends). Calculating RI requires numerous adjustments to GAAP increasing the cost of preparing information. Compared to ROI, the use of residual income can lead managers to make decisions more consistent with shareholders’ objectives. Further, some claim that residual income is more closely related to shareholder returns than other metrics such as sales growth, net income or ROI. However the following criticisms of residual income, are worth noting: 1. Residual income is based on historical accounting data, which means that in particular, the accounting values used for capital assets can suffer from being out of date when costs are rising. This can lead to inflated amounts for residual income. 2. The residual income approach does not indicate what earnings should be for a particular business unit. A means of comparison is needed, which could involve using external benchmarks based on key competitors or evaluating trends in residual income over time (e.g., tracking the percentage change over several periods). 3. Calculating residual income requires numerous adjustments to financial information recorded using generally accepted accounting principles that can increase the cost of preparing the information. 4. Residual income is a financial metric that does not incorporate important leading non-financial indicators of success such as employee motivation or customer satisfaction. RI does not incorporate important leading non-financial indicators. LO 5

The Balanced Scorecard
11-91 The Balanced Scorecard Management translates its strategy into performance measures that employees understand and accept. Customers Financial Performance measures A balanced scorecard consists of an integrated set of performance measures that are derived from and support a company’s strategy. Importantly, the measures included in a company’s balanced scorecard are unique to its specific strategy. The balanced scorecard enables top management to translate its strategy into four groups of performance measures – financial, customer, internal business processes, and learning and growth – that employees can understand and influence. Learning and growth Internal business processes LO 6

The Balanced Scorecard: From Strategy to Performance Measures
11-92 Exhibit 11-4 The Balanced Scorecard: From Strategy to Performance Measures Performance Measures Financial Has our financial performance improved? What are our financial goals? What customers do we want to serve and how are we going to win and retain them? Vision and Strategy Customer Do customers recognize that we are delivering more value? Internal Business Processes Have we improved key business processes so that we can deliver more value to customers? What internal business processes are critical to providing value to customers? The premise of these four groups of measures is that learning is necessary to improve internal business processes. This in turn improves the level of customer satisfaction, thereby improving financial results. Note the emphasis on improvement, not just attaining some specific objective. Learning and Growth Are we maintaining our ability to change and improve? LO 6

The Balanced Scorecard: Non-financial Measures
11-93 The Balanced Scorecard: Non-financial Measures The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons: Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance. Top managers are ordinarily responsible for financial performance measures – not lower level managers Non-financial measures are more likely to be understood and controlled by lower level managers. The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons:  Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.  Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers. LO 6

The Balanced Scorecard for Individuals
11-94 The Balanced Scorecard for Individuals The entire organization should have an overall balanced scorecard. Each individual should have a personal balanced scorecard. While the entire organization has an overall balanced scorecard, each responsible individual should have his or her own personal scorecard as well. A personal scorecard should contain measures that can be influenced by the individual being evaluated and that support the measures in the overall balanced scorecard. A personal scorecard should contain measures that can be influenced by the individual being evaluated and that support the measures in the overall balanced scorecard. LO 6

The Balanced Scorecard
11-95 The Balanced Scorecard A balanced scorecard should have measures that are linked together on a cause-and-effect basis. If we improve one performance measure . . . Another desired performance measure will improve. Then A balanced scorecard, whether for an individual or the company as a whole, should have measures that are linked together on a cause-and-effect basis. Each link can be read as a hypothesis in the form “If we improve this performance measure, then this other performance measure should also improve.” In essence, the balanced scorecard lays out a theory of how a company can take concrete actions to attain desired outcomes. If the theory proves false or the company alters its strategy, the measures within the scorecard are subject to change. The balanced scorecard lays out concrete actions to attain desired outcomes. LO 6

The Balanced Scorecard and Compensation
11-96 The Balanced Scorecard and Compensation Incentive compensation should be linked to balanced scorecard performance measures. Incentive compensation for employees probably should be linked to balanced scorecard performance measures. However, this should only be done after the organization has been successfully managed with the scorecard for some time – perhaps a year or more. Managers must be confident that the measures are reliable, not easily manipulated, and understandable by those being evaluated with them. LO 6

The Balanced Scorecard Jaguar Example
11-97 The Balanced Scorecard Jaguar Example Profit Financial Contribution per car Number of cars sold Customer Customer satisfaction with options Assume that Jaguar pursues a strategy as shown on this slide. Examples of measures that Jaguar might select with their corresponding cause-and-effect linkages include those shown on the next four slides. Internal Business Processes Number of options available Time to install option Learning and Growth Employee skills in installing options LO 6

11-98 The Balanced Scorecard Jaguar Example Profit Contribution per car Number of cars sold Results Customer satisfaction with options Satisfaction Increases Strategies If “employee skills in installing options” increases, then the “number of options available” should increase and the “time to install an option” should decrease. If the “number of options available” increases and the “time to install an option” decreases, then “customer satisfaction with options available” should increase. Increase Options Number of options available Time to install option Time Decreases Increase Skills Employee skills in installing options LO 6

11-99 The Balanced Scorecard Jaguar Example Profit Contribution per car Results Cars sold Increase Number of cars sold Customer satisfaction with options Satisfaction Increases If the “customer satisfaction with options available” increases, then the “number of cars sold” should increase. Number of options available Time to install option Employee skills in installing options LO 6

11-100 The Balanced Scorecard Jaguar Example Profit Results Contribution per car Contribution Increases Number of cars sold Customer satisfaction with options Satisfaction Increases If the “time to install an option” decreases and the “customer satisfaction with options available” increases, then the “contribution per car” should increase. Number of options available Time to install option Time Decreases Employee skills in installing options LO 6

11-101 The Balanced Scorecard Jaguar Example Results Profit Profits Increase If number of cars sold and contribution per car increase, profits increase. Contribution per car Contribution Increases Number of cars sold Cars Sold Increases Customer satisfaction with options If the “number of cars sold” and the “contribution per car” increases, then the “profits” should increase. Number of options available Time to install option Employee skills in installing options LO 6

Advantages of Graphic Feedback
11-102 Advantages of Graphic Feedback When interpreting its performance, Jaguar will be looking for a trend of continual improvement. These trends are better identified with graphic feedback. For example: Assume that Jaguar’s “time to install an option” performance over ten weeks is as shown. It is much easier to spot trends or unusual performance if these data are presented graphically as shown. When interpreting its performance, Jaguar will look for continual improvement. It is easier to spot trends or unusual performance if these data are presented graphically. LO 6

Delivery Performance Measures
11-103 Delivery Performance Measures Order Received Production Started Goods Shipped Process Time + Inspection Time + Move Time + Queue Time Wait Time Throughput Time Delivery cycle time is the elapsed time from when a customer order is received to when the completed order is shipped. Throughput (manufacturing cycle) time is the amount of time required to turn raw materials into completed products. This includes process time, inspection time, move time, and queue time. Process time is the only value-added activity of the four times mentioned. Delivery Cycle Time Process time is the only value-added time. LO 6

Delivery Performance Measures
11-104 Delivery Performance Measures Order Received Production Started Goods Shipped Process Time + Inspection Time + Move Time + Queue Time Wait Time Throughput Time Manufacturing cycle efficiency (MCE) is computed by dividing value-added time by manufacturing cycle (throughput) time. An MCE less than one indicates that non-value-added time is present in the production process. Next, we will look at a series of questions dealing with delivery performance measures. Delivery Cycle Time Manufacturing Cycle Efficiency Value-added time Manufacturing cycle time = LO 6

Quick Check  a. 10.4 days b. 0.2 days c. 4.1 days d. 13.4 days
11-105 Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the throughput time? a days b days c days d days Here’s your first question on delivery performance measures asking for a computation of throughput time. LO 6

Quick Check  a. 10.4 days b. 0.2 days c. 4.1 days d. 13.4 days
11-106 Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the throughput time? a days b days c days d days Throughput time is the sum of process time, inspection time, move time, and queue time. The total for these four times is 10.4 days. Throughput time = Process + Inspection + Move + Queue = 0.2 days days days days = 10.4 days LO 6

11-107 Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the Manufacturing Cycle Efficiency? a. 50.0% b % c. 52.0% d % Here’s your second question on delivery performance measures asking for a computation of manufacturing cycle efficiency. LO 6

11-108 Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the Manufacturing Cycle Efficiency? a. 50.0% b % c. 52.0% d % Manufacturing cycle efficiency is found by dividing value-added time by throughput time. Process time is the only value-added time. Process time of 0.2 days divided by throughput time of 10.4 days results in a manufacturing cycle efficiency of 1.9%. MCE = Value-added time ÷ Throughput time = Process time ÷ Throughput time = 0.2 days ÷ 10.4 days = 1.9% LO 6

11-109 Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the delivery cycle time? a days b days c days d days Here’s your third question on delivery performance measures asking for a computation of delivery cycle time. LO 6

11-110 Quick Check  A TQM team at Narton Corp has recorded the following average times for production: Wait days Move days Inspection 0.4 days Queue days Process days What is the delivery cycle time? a days b days c days d days Delivery cycle time is the sum of wait time plus throughput time. The total for these two times is 13.4 days. Delivery cycle time = Wait time + Throughput time = 3.0 days days = 13.4 days LO 6

ROI and the Balanced Scorecard
11-111 ROI and the Balanced Scorecard It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI. Which internal business process should be improved? It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well-constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI. A scorecard can answer questions such as: Which internal business processes should be improved? and Which customers should be targeted and how will they be attracted and retained at a profit? Which customers should be targeted and how will they be attracted and retained at a profit? LO 6

Quality of Conformance
11-112 Quality of Conformance When the overwhelming majority of products produced conform to design specifications and are free from defects. The term quality has many meanings. Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free. In this appendix, the focus is on the presence or absence of defects. Quality of conformance is the degree to which the actual product or service meets its design specifications. Anything that does not meet design specifications is a defect and is indicative of low quality of conformance. There are four broad categories of quality costs: prevention costs, appraisal costs, internal failure costs, and external failure costs. LO 7

Prevention and Appraisal Costs
11-113 Prevention and Appraisal Costs Prevention Costs Support activities whose purpose is to reduce the number of defects Prevention costs are incurred to support activities whose purpose is to reduce the number of defects. Appraisal costs are incurred to identify defective products before the products are shipped to customers. Appraisal Costs Incurred to identify defective products before the products are shipped LO 7

Internal and External Failure Costs
11-114 Internal and External Failure Costs Internal Failure Costs Incurred as a result of identifying defects before they are shipped Internal failure costs are incurred as a result of identifying defects before they are shipped to customers. External failure costs are incurred as a result of defective products being delivered to customers. External Failure Costs Incurred as a result of defective products being delivered to customers LO 7

Examples of Quality Costs
11-115 Examples of Quality Costs Prevention Costs Quality training Quality circles Statistical process control activities Appraisal Costs Testing & inspecting incoming materials Final product testing Depreciation of testing equipment Internal Failure Costs Scrap Spoilage Rework External Failure Costs Cost of field servicing & handling complaints Warranty repairs Lost sales Here are some examples of each type of quality cost. Prevention costs include: quality training, quality circles, and statistical process control activities. Appraisal costs include: testing and inspection of incoming materials, final product testing, and depreciation of testing equipment. Internal failure costs include: scrap, spoilage, and rework. External failure costs include: the cost of field servicing and handling customer complaints, warranty repairs, and lost sales arising from reputation of poor quality. LO 7

Distribution of Quality Costs
11-116 Distribution of Quality Costs When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure. Total quality costs drop rapidly as the quality of conformance increases. Companies reduce their total quality costs by focusing their efforts on prevention and appraisal because the cost savings from reduced defects usually overwhelm the costs of additional prevention and appraisal. Here are four key concepts about the relationship between the four types of quality costs. When the quality of conformance is low, total quality cost is high and most of this cost consists of internal and external failure costs. Total quality costs drop rapidly as the quality of conformance increases. Companies reduce their total quality costs by focusing their efforts on prevention and appraisal because the cost savings from reduced defects usually overwhelm the costs of additional prevention and appraisal. Total quality costs are minimized when the quality of conformance is slightly less than 100%. This is a debatable point in the sense that some experts believe that total quality costs are not minimized until the quality of conformance is 100%. Total quality costs are minimized when the quality of conformance is slightly less than 100%. LO 7

11-117 Quality cost reports provide an estimate of the financial consequences of the company’s current defect rate. A quality cost report details the prevention, appraisal, internal failure, and external failure costs that arise from a company’s current quality control efforts. When interpreting a cost of quality report managers should look for two trends. First, increases in prevention and appraisal costs should be more than offset by decreases in internal and external failure costs. Second, the total quality costs as a percent of sales should decrease. LO 7

Quality Cost Reports in Graphic Form
11-118 Quality Cost Reports in Graphic Form Quality reports can also be prepared in graphic form. Quality cost reports can also be prepared in graphic form. Managers should still look for the same two trends whether the data are presented in a graphic or table format. LO 7

Uses of Quality Cost Information
11-119 Uses of Quality Cost Information Help managers see the financial significance of defects. Help managers identify the relative importance of the quality problems. Uses of quality cost information include the following. It helps managers see the financial significance of defects. It helps managers identify the relative importance of the quality problems faced by the company. It helps managers see whether their quality costs are poorly distributed. In general, costs should be distributed more toward prevention and to a lesser extent appraisal than toward failures. Help managers see whether their quality costs are poorly distributed. LO 7

Limitations of Quality Cost Information
11-120 Limitations of Quality Cost Information Simply measuring quality cost problems does not solve quality problems. Results usually lag behind quality improvement programs. Limitations of quality cost information include the following. Simply measuring and reporting quality cost problems does not solve quality problems. Results usually lag behind quality improvement programs. Initially, prevention and appraisal cost increases may not be offset by decreases in failure costs. The most important quality cost, lost sales arising from customer ill-will, is often omitted from quality cost reports because it is difficult to estimate. The most important quality cost, lost sales, is often omitted from quality cost reports. LO 7

11-121 ISO 9000 Standards ISO 9000 standards have become international measures of quality. To become ISO 9000 certified, a company must demonstrate: A quality control system is in use, and the system clearly defines an expected level of quality. The system is fully operational and is backed up with detailed documentation of quality control procedures. The intended level of quality is being achieved on a sustained basis. The International Organization for Standardization, based in Geneva, Switzerland, has established quality control guidelines, known as the ISO 9000 standards. For a company to become ISO 9000 certified by a certifying agency, it must demonstrate that: 1. A quality control system is in use, and the system clearly defines an expected level of quality, 2. The system is fully operational and is backed up with detailed documentation of quality control procedures, and 3. The intended level of quality is being achieved on a sustained basis. Although the ISO 9000 standards were developed in Europe, they have become widely accepted elsewhere, throughout the world, including the United States. LO 7

Profitability Analysis
11-122 Profitability Analysis Appendix 11A Appendix 11A: Profitability Analysis LO 8

Sales Variance Analysis
11-123 Sales Variance Analysis Consider the following example for CardCo: Budget Actual Sales in units Deluxe cards 14, ,000 Standard cards 6, ,000 Price per unit Deluxe cards $ $16 Standard cards $ $10 Market volume Deluxe cards 75, ,000 Standard cards 95, ,000 Variable cost per unit Deluxe cards $ $ 8 Standard cards $ $ 3 Consider the following example for CardCo and sales variances analysis. LO 8

11-124 Sales Variance Analysis CardCo Actual and Budgeted Results Actual results are based on the actual quantity sold multiplied by the actual selling price or variable cost As illustrated, CardCo’s actual results are based on the actual quantity sold multiplied by the actual selling price or variable cost. LO 8

11-125 Sales Variance Analysis CardCo Actual and Budgeted Results Flexible budget results are based on the actual quantity sold multiplied by the budgeted selling price or variable cost As illustrated, CardCo’s flexible budget results are based on the actual quantity sold multiplied by the budgeted selling price or variable cost. LO 8

11-126 Sales Variance Analysis CardCo Actual and Budgeted Results Master budget results are based on the budgeted quantity sold multiplied by the budgeted selling price or variable cost As illustrated, CardCo’s master budget (static budget) results are based on the budgeted quantity sold multiplied by the budgeted selling price or variable cost. LO 8

11-127 Sales Variance Analysis CardCo Actual and Budgeted Results CardCo’s sales price variance is the difference between the actual revenues and the flexible budget revenues. Sales Price Variance $29,000 U LO 8

11-128 Sales Variance Analysis CardCo Actual and Budgeted Results $29,000U The sales price variance for CardCo can also be calculated using the formulas. or Sales Price Variance = (Actual – Budgeted price) × Actual sales volume Deluxe = ($16–$18) × 17,000 units = $34,000 U Standard = ($10–$9) × 5,000 units = $ 5,000 F Total sales price variance = $29,000 U LO 8

11-129 Sales Variance Analysis CardCo Actual and Budgeted Results CardCo’s sales volume variance is the difference between the flexible budget contribution margin and the master budget contribution margin. Sales Volume Variance $24,000 F LO 8

CardCo Actual and Budgeted Results
11-130 Sales Variance Analysis CardCo Actual and Budgeted Results $24,000F The sales volume variance for CardCo can also be calculated using the formulas. or Sales Volume Variance= (Actual – Budgeted quantity) × Budgeted CM Deluxe = (17,000–14,000) × ($18–$8) units = $30,000 F Standard = (5,000–6,000) × ($9–$3) = $ 6,000 U Total sales volume variance = $24,000 F LO 8

11-131 Sales Variance Analysis The Sales Volume Variance can further be broken down into the: Market Volume Variance = Market Share Variance { } Actual market volume Budget market volume Expected market share % Budgeted CM per unit – × × Here are the general model equations to further break down the sales volume variance into the market volume variance and the market share variance. [ ] Actual market share – Expected market share } { Actual sales quantity Budgeted CM per unit – × LO 8

11-132 Sales Variance Analysis For CardCo, the Sales Volume Variance of $24,000 F breakdown further as follows: Market Volume Variance Deluxe = (85,000–75,000) × (14,000/75,000) × (18–8) = 18,667 F Standard = (90,000–95,000) × (6,000/95,000) × (9–3) = 1,895 U Total Market Volume Variance (1) 16,772 F Market Share Variance Deluxe = [17,000–(85,000 × 14,000/75,000)] × (18–8) = 11,333 F Standard = [5,000–(90,000 × 6,000/95,000)] × (9–3) = 4,105 U Total Market Share Variance (2) 7,228 F Sales Volume Variance = (1) + (2) = 24,000 F Let’s compute the market volume variance and the market share variance for CardCo. Notice that the sales volume variance is the sum of the market volume variance and the market share variance. LO 8

11-133 Sales Variance Analysis The Sales Volume Variance can also be broken down into the: Sales Mix Variance = Sales Quantity Variance Actual sales quantity Actual sales quantity at expected sales mix Budgeted CM per unit – { } × Here are the general model equations to further break down the sales volume variance into the sales mix variance and the sales quantity variance. Actual sales quantity at expected sales mix – Anticipated sales quantity } Budgeted CM per unit × { LO 8

11-134 Sales Variance Analysis For CardCo, the Sales Volume Variance of $24,000F is made up of: Sales Mix Variance Deluxe = [17,000–(22,000 × 14/20)] × (18–8) =16,000 F Standard = [5,000–(22,000 × 6/20)] × (9–3) = 9,600 U Total Sales Mix Variance (1) 6,400 F Sales Quantity Variance Deluxe = [(22,000 × 14/20)–14,000] × (18–8) =14,000 F Standard = [(22,000 × 6/20)–6,000] × (9–3) = 3,600 F Total Sales Quantity Variance (2) 17,600F Sales Volume Variance = (1) + (2) = 24,000F Let’s compute the market volume variance and the market share variance for CardCo. Notice that the sales volume variance is the sum of the sales mix variance and the sales volume variance. LO 8

Marketing Expense Appendix 11B Appendix 11B: Marketing Expense 11-135
LO 9

Costs Factors to Consider in a Marketing Strategy
11-136 Costs Factors to Consider in a Marketing Strategy Transport Warehousing Marketing Strategy Advertising Knowledge of the nature and behaviour of marketing expenses provides managers with information about the costs of their marketing endeavours. Such information represents a significant aspect of marketing efforts, one that is needed to complement the pricing strategy previously discussed. Transport, warehousing, selling, advertising, and credit are some of the key factors managers need to consider in their marketing strategy. Accurate cost behaviour and allocation by the accounting function can assist marketing decision makers. Selling Credit LO 9

Order Getting and Order Filling
11-137 Order Getting and Order Filling More Discretionary Accountants typically decompose marketing expense into two general categories, order-getting and order-filling. Order-getting costs are the pure marketing costs such as advertising, selling commissions, and travel. Order-filling includes the costs of warehousing, transportation, packing, and credit. Order-getting costs tend to be somewhat more discretionary than order-filling because order-filling occurs after the sale rather than to obtain the sale. Nevertheless, marketing managers need to understand the cost behaviour associated with both sets of costs so that analysis can be conducted to decide what should be done and how. LO 9

11-138 End of Chapter 11 End of Chapter 11.

Reporting for Control Chapter 11 Chapter 11: Reporting for Control

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Reporting for Control Chapter 11 Chapter 11: Reporting for Control

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