copyright © 2012 mcgraw-hill ryerson limited 11-1 powerpoint author: robert g. ducharme, macc, ca...

Copyright © 2012 McGraw-Hill Ryerson Limited

11-1

PowerPoint Author:

Robert G. Ducharme, MAcc, CAUniversity of Waterloo, School of Accounting and Finance

MANAGERIALACCOUNTINGNinth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB, LIBBY

MANAGERIALACCOUNTINGNinth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB, LIBBY

Reporting for Control

Chapter 11

11-2


Decentralization in Organizations

Benefits ofDecentralization Top management

freed to concentrateon strategy.

Top managementfreed to concentrate

on strategy.Lower-level managers

gain experience indecision-making.

Lower-level managersgain experience indecision-making. Decision-making

authority leads tojob satisfaction.

Decision-makingauthority leads tojob satisfaction.

Lower-level decisionsoften based on

better information.

Lower-level decisionsoften based on

better information.Lower level managers can respond quickly

to customers.

Lower level managers can respond quickly

to customers.LO 1

11-3


Decentralization in Organizations

Disadvantages ofDecentralization

Lower-level managersmay make decisionswithout seeing the

“big picture.”

Lower-level managersmay make decisionswithout seeing the

“big picture.”

May be a lack ofcoordination among

autonomousmanagers.

May be a lack ofcoordination among

autonomousmanagers.

Lower-level manager’sobjectives may not

be those of theorganization.

Lower-level manager’sobjectives may not

be those of theorganization. May be difficult to

spread innovative ideasin the organization.

May be difficult tospread innovative ideas

in the organization.

LO 1

11-4


Decentralization and Segment Reporting

A segmentsegment is any part or activity of an organization about which a manager

seeks cost, revenue, or profit data. A segment

can be . . .

Quick MartQuick Mart

An Individual Store

A Service Centre

A Sales Territory

LO 1

11-5


Superior Foods: Geographic Regions

Superior Foods Corporation could segment its business by geographic regions.

Superior Foods Corporation$500,000,000

Central$75,000,000

Atlantic$300,000,000

Prairie$70,000,000

West Coast$55,000,000

Nova Scotia$45,000,000

New Brunswick$85,0000,000

Prince Edward Island$50,000,000

Newfoundland$120,000,000

LO 1

11-6


Superior Foods: Customer Channel

Convenience Stores$80,000,000

Supermarket Chain A$85,000,000

Supermarket Chain B$65,000,000

Supermarket Chain C$90,000,000

Supermarket Chain D$40,000,000

Supermarket Chains$280,000,000

W holesale Distributors$100,000,000

Drugstores$40,000,000

Superior Foods Corporation$500,000,000

Superior Foods Corporation could segment its business by customer channel.

LO 1

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.

Traceable fixed costs should be separated from common fixed costs to enable the

calculation of a segment margin.

LO 1

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 No computer division means . . .division means . . .

No computerNo computerdivision manager.division manager.

LO 1

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 No computer division but . . .division but . . .

We still have aWe still have acompany president.company president.

LO 1

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.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.

TimeTime

Pro

fits

Pro

fits

LO 1

11-12


Traceable and Common Costs

FixedFixedCostsCosts

TraceableTraceable CommonCommon

Don’t allocateDon’t allocatecommon costs to common costs to

segments.segments.

LO 1

11-13


Activity-Based Costing

9-inch 12-inch 18-inch TotalWarehouse sq. ft. 1,000 4,000 5,000 10,000 Lease price per sq. ft. 4$ 4$ 4$ 4$ Total lease cost 4,000$ 16,000$ 20,000$ 40,000$

Pipe Products

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.

LO 1

11-14


Levels of Segmented Statements

Let’s look more closely at the Television Division’s income statement.

Let’s look more closely at the Television Division’s income statement.

Webber, Inc. has two divisions.

Com puter Division Television Division

W ebber, Inc.

LO 1

11-15



Our approach to segment reporting uses the contribution format.

Income StatementContribution Margin Format

Television DivisionSales 300,000$ Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin 60,000$

Cost of goodssold consists of

variable manufacturing

costs.

Cost of goodssold consists of

variable manufacturing

costs.

Fixed andvariable costsare listed in

separatesections.

Fixed andvariable costsare listed in

separatesections.

LO 1

11-16



Segment marginis Television’s

contributionto profits.

Segment marginis Television’s

contributionto profits.

Our approach to segment reporting uses the contribution format.

Income StatementContribution Margin Format

Television DivisionSales 300,000$ Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin 60,000$

Contribution marginis computed by

taking sales minus variable costs.

Contribution marginis computed by

taking sales minus variable costs.

LO 1

11-17



Income StatementCompany Television Computer

Sales 500,000$ 300,000$ 200,000$ Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 60,000$ 40,000$

Common costsNet operating income

LO 1

11-18



Income StatementCompany Television Computer

Sales 500,000$ 300,000$ 200,000$ Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 60,000$ 40,000$

Common costs 25,000 Net operating income 75,000$

Common costs should not be allocated to the

divisions. These costs would remain even if one

of the divisions were eliminated.

Common costs should not be allocated to the

divisions. These costs would remain even if one

of the divisions were eliminated.

LO 1

11-19



As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into

smaller smaller segments.

Let’s see how this works using the Webber, Inc.

example!

LO 1

11-20



ProductProductLinesLines

Webber’s Television Division

Regular Big Screen

TelevisionDivision

LO 1

11-21



We obtained the following information fromthe Regular and Big Screen segments.

Income StatementTelevision

Division Regular Big ScreenSales 200,000$ 100,000$ Variable costs 95,000 55,000 CM 105,000 45,000 Traceable FC 45,000 35,000 Product line margin 60,000$ 10,000$

Common costsDivisional margin

LO 1

11-22


Income StatementTelevision

Division Regular Big ScreenSales 300,000$ 200,000$ 100,000$ Variable costs 150,000 95,000 55,000 CM 150,000 105,000 45,000 Traceable FC 80,000 45,000 35,000 Product line margin 70,000 60,000$ 10,000$

Common costs 10,000 Divisional margin 60,000$


Fixed costs directly tracedto the Television Division

$80,000 + $10,000 = $90,000

Fixed costs directly tracedto the Television Division

$80,000 + $10,000 = $90,000

LO 1

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.

1. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports.

2. 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.

LO 1

11-24


Some ProblemsSome Problems

Omission of some

costs in the

assignment process.

Use of inappropriate

methods for allocating

costs among segments.

Assignment to segments

of costs that are

really common costs of

the entire organization.

LO 1

Hindrances to Proper Cost Assignment

11-25


Omission of Costs

Costs assigned to a segment should include all costs attributable to that segment from the

company’s entire value chainvalue chain.

Product Customer R&D Design Manufacturing Marketing Distribution Service

Business FunctionsBusiness FunctionsMaking Up TheMaking Up The

Value ChainValue Chain

LO 1

11-26


Inappropriate Methods of Allocating Costs Among Segments

Segment1

Segment3

Segment4

Inappropriateallocation base

Segment2

Failure to tracecosts directly

LO 1

11-27


Arbitrarily Dividing Common Costs and Segments

Segment1

Segment3

Segment4

Segment2

Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the

common costs” for two reasons:

1. This practice may make a profitable business segment appear to be unprofitable.

2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control.

LO 1

11-28


Income StatementHaglund's Lakeshore Bar Restaurant

Sales 800,000$ 100,000$ 700,000$ Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 Segment margin 244,000 14,000$ 230,000$

Common costs 200,000 Profit 44,000$

Quick Check

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.

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.

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. $20,000b. $30,000c. $40,000d. $50,000

LO 1

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. $20,000b. $30,000c. $40,000d. $50,000

The bar would be allocated 1/10 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?

LO 1

11-34



Sales 800,000$ 100,000$ 700,000$ Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 Segment margin 244,000 14,000 230,000 Common costs 200,000 20,000 180,000 Profit 44,000$ (6,000)$ 50,000$

Allocations of Common Costs

Hurray, now everything adds up!!!

LO 1

11-35


Quick Check

Should the bar be eliminated?a. Yesb. No

LO 1

11-36


Should the bar be eliminated?a. Yesb. No

Quick Check


Sales 700,000$ 700,000$ Variable costs 250,000 250,000 CM 450,000 450,000 Traceable FC 220,000 220,000 Segment margin 230,000 230,000 Common costs 200,000 200,000 Profit 30,000$ 30,000$

The profit was $44,000 before eliminating the bar. If we eliminate

the bar, profit drops to $30,000!

LO 1

11-37


Cost, Profit, and Investments centres

Responsibilitycentre

Responsibilitycentre

CostcentreCost

centreProfitcentreProfitcentre

Investmentcentre

Investmentcentre

Cost, profit,and investmentcentres are allknown asresponsibilitycentres.

LO 2

11-38


Cost centre

A segment whose manager has control

over costs, but not over revenues

or investment funds.

LO 2

11-39


Profit centre

A segment whose manager has control over both costs and

revenues, but no control over

investment funds.

Revenues

Sales

Interest

Other

Costs

Mfg. costs

Commissions

Salaries

Other

LO 2

11-40


Investment centre

A segment whose manager has control

over costs, revenues, and investments in

operating assets.

Corporate Headquarters

LO 2

11-41


Responsibility centres

Salty SnacksProduct M anger

Bottling P lantM anager

W arehouseM anager

DistributionM anager

BeveragesProduct M anager

ConfectionsProduct M anager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Cost Centres

Investment Centres

Superior Foods Corporation provides an example of the various kinds of responsibility centres that exist in an

organization.LO 2

11-42





W arehouseM anager









President and CEO


organization.

Profit Centres

LO 2

11-43





W arehouseM anager









President and CEO

Cost Centres


organization.LO 2

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.

LO 3

11-45


Three Primary Approaches

There are three primary approaches to setting

transfer prices:

1. Negotiated transfer prices;

2. Transfers at the cost to the selling division; and

3. Transfers at market price.

LO 3

11-46


Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions.

Advantages of negotiated transfer prices:

1. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization.

2. 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.

Upper limit is determined by the buying division.

Lower limit is determined by the selling division.

Range of Acceptable Transfer Prices

LO 3

11-47


Harrison Ltd – An Example

Cumberland Beverages:Ginger beer production capactiy per month 10,000 barrelsVariable cost per barrel of ginger beer $ 8 per barrelFixed costs per month $ 70,000Selling price of Imperial Beverages ginger beer on the outside market $ 20 per barrel

Pizza Place:Purchase price of regular brand of ginger beer $ 18 per barrelMonthly comsumption of ginger beer 2,000 barrels

Assume the information as shown with respect to Cumberland Beverages and Pizza Place

(both companies are owned by Harrison Ltd).

LO 3

11-48



The selling division’s (Cumberland Beverages) lowest acceptable transfer price is calculated as:

Variable cost Total contribution margin on lost salesper unit Number of units transferred

Transfer Price +

Transfer Price Cost of buying from outside supplier

The buying division’s (Pizza Place) highest acceptable transfer price is calculated as:

Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

Transfer Price Profit to be earned per unit sold (not including the transfer price)

If an outside supplier does not exist, the highest acceptable transfer price is calculated as:

LO 3

11-49



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:

$02,000

= $8Transfer Price +$8

Selling division’s lowest possible transfer price:

Transfer Price Cost of buying from outside supplier = $18Buying division’s highest possible transfer price:

Therefore, the range of acceptable transfer price is $8 – $18.

LO 3

11-50



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:

( $20 - $8) × 2,0002,000




Therefore, there is no range of acceptable transfer prices.

LO 3

11-51



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:


Therefore, the range of acceptable transfer price is $14 – $18.


( $20 - $8) × 1,0002,000


LO 3

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.

Given the disputes that often accompany the negotiation process, most companies

rely on some other means of setting transfer prices.

LO 3

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:

1. Using full cost as a transfer price and can lead to suboptimization.

2. The selling division will never show a profit on any internal transfer.

3. Cost-based transfer prices do not provide incentives to control costs.

LO 3

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.

1. 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.

2. A market price approach does not work well when the selling division has idle capacity.

LO 3

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.LO 3

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

LO 3

11-57


Return on Investment (ROI) Formula

ROI = ROI = Operating incomeOperating incomeAverage operating assets Average operating assets

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Income before interestand taxes (EBIT)

Income before interestand taxes (EBIT)

LO 4

11-58


Net Book Value vs. Gross Cost

Most companies use the net book value of depreciable assets to calculate average

operating assets.

Acquisition costLess: Accumulated depreciationNet book value

LO 4

11-59


Understanding ROI

ROI = Operating income

Average operating assets

Margin = Operating income

Sales

Turnover = SalesAverage operating

assets ROI = Margin Turnover

LO 4

11-60


Increasing ROI

There are three ways to increase ROI . . .There are three ways to increase ROI . . .

IncreaseIncreaseSalesSales

ReduceReduceOperatingOperatingExpensesExpenses ReduceReduce

OperatingOperatingAssetsAssets

LO 4

11-61


Increasing ROI – An Example

Regal Company reports the following:Regal Company reports the following:

Operating income $ 30,000Operating income $ 30,000

Average operating assets $ 200,000Average operating assets $ 200,000

Sales $ 500,000Sales $ 500,000

Operating expenses $ 470,000Operating expenses $ 470,000

ROI = ROI = Margin Margin Turnover Turnover

Operating income Sales

Sales Average operating assets×ROI =

What is Regal Company’s ROI?

LO 4

11-62


Increasing ROI – An Example

$30,000 $500,000

× $500,000$200,000

ROI =

6% 6% 2.5 = 15% 2.5 = 15%ROI =




LO 4

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.

Let’s calculate the new ROI.Let’s calculate the new ROI.

LO 4

11-64


Increasing Sales Without an Increase in Operating Assets

$42,000 $600,000

× $600,000$200,000

ROI =

7% 7% 3.0 = 21% 3.0 = 21%ROI =

ROI increased from 15% to 21%.ROI increased from 15% to 21%.




LO 4

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.





Sales $ 500,000Sales $ 500,000


LO 4

11-66


Decreasing Operating Expenses with no Change in Sales or Operating Assets

$40,000 $500,000

× $500,000$200,000

ROI =

8% 8% 2.5 = 20% 2.5 = 20%ROI =

ROI increased from 15% to 20%.ROI increased from 15% to 20%.




LO 4

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.





Sales $ 500,000Sales $ 500,000


LO 4

11-68


Decreasing Operating Assets with no Change in Sales or Operating Expenses

$30,000 $500,000

× $500,000$180,000

ROI =

6% 6% 2.78 = 16.7% 2.78 = 16.7%ROI =

ROI increased from 15% to 16.7%.ROI increased from 15% to 16.7%.




LO 4

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.





Sales $ 535,000Sales $ 535,000


LO 4

11-70


Investing in Operating Assets to Increase Sales

$50,000 $535,000

× $535,000$230,000

ROI =

9.35% 9.35% 2.33 = 21.8% 2.33 = 21.8%ROI =

ROI increased from 15% to 21.8%.ROI increased from 15% to 21.8%.




LO 4

11-71


Criticisms of ROI

In the absence of the balancedscorecard, management may

not know how to increase ROI.

Managers often inherit manycommitted costs over which

they have no control.

Managers evaluated on ROImay reject profitable

investment opportunities.

LO 4

11-72


Residual Income - Another Measure of Performance

Operating incomeabove some minimum

return on operatingassets

LO 5

11-73


Calculating Residual Income

Residual income

=Operating

income–

Average operating

assets

Minimum

required rate of return( )

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

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.

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

11-75


Residual Income – An Example

Operating assets 100,000$ Required rate of return × 20%Minimum required return 20,000$

Operating assets 100,000$ Required rate of return × 20%Minimum required return 20,000$

Actual income 30,000$ Minimum required return (20,000) Residual income 10,000$

Actual income 30,000$ Minimum required return (20,000) Residual income 10,000$

LO 5

11-76


Motivation and Residual Income

Residual income encourages managers to make profitable investments that would

be rejected by managers using ROI.

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%

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%

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. Yesb. No

LO 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. Yesb. No

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. Yesb. No

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. Yesb. No

ROI = $18,000 / $100,000 = 18%

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. $240,000b. $ 45,000c. $ 15,000d. $ 51,000

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. $240,000b. $ 45,000c. $ 15,000d. $ 51,000

Operating income $60,000Required 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. Yesb. No

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. Yesb. No

Operating income $78,000Required return (15% of $400,000) (60,000)Residual income $18,000

Yields an increase of $3,000 in the residual income.

LO 5

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.

LO 5

11-88


Zephyr, Inc. – Continued

Retail WholesaleOperating assets 100,000$ 1,000,000$ Required rate of return × 20% 20%Minimum required return 20,000$ 200,000$

Retail WholesaleActual income 30,000$ 220,000$ Minimum required return (20,000) (200,000) Residual income 10,000$ 20,000$



Recall the following information for the Retail Division of Zephyr, Inc.

Assume the following information for the Wholesale

Division of Zephyr, Inc.

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.

LO 5

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.

RI does not incorporate important leading non-financial indicators.

LO 5

11-91


The Balanced Scorecard

Management translates its strategy into performance measures that employees

understand and accept.

Management translates its strategy into performance measures that employees

understand and accept.

Performancemeasures

Customers

Learningand growth

Internalbusiness

processes

Financial

LO 6

11-92


The Balanced Scorecard: From Strategy to Performance Measures

Exhibit11-4

FinancialHas our financial

performance improved?

CustomerDo customers recognize that

we are delivering more value?

Internal Business ProcessesHave we improved key business processes so that we can deliver

more value to customers?

Learning and GrowthAre we maintaining our ability

to change and improve?

Performance Measures

What are ourfinancial goals?

What customers dowe want to serve andhow are we going towin and retain them?

What internal busi-ness processes arecritical to providing

value to customers?

Vision and

Strategy

LO 6

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.

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.

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

11-94


The Balanced Scorecard for Individuals

A personal scorecard should contain measures that can beinfluenced by the individual being evaluated and that

support the measures in the overall balanced scorecard.

A personal scorecard should contain measures that can beinfluenced by the individual being evaluated and that

support the measures in the overall balanced scorecard.

The entire organization should have an overall

balanced scorecard.

Each individual should have a personal

balanced scorecard.

LO 6

11-95


The balanced scorecard lays out concrete actions to attain desired outcomes.

A balanced scorecard should have measuresthat are linked together on a cause-and-effect basis.

If we improveone performance

measure . . .

Another desiredperformance measure

will improve.

The Balanced Scorecard

Then

LO 6

11-96


The Balanced Scorecardand Compensation

Incentive compensation should be linked to balanced scorecard

performance measures.

LO 6

11-97


The Balanced ScorecardJaguar Example

Employee skills in installing options

Number ofoptions available

Time toinstall option

Customer satisfactionwith options

Number of cars sold

Contribution per car

Profit

Learningand Growth

Internal Business

Processes

Customer

Financial

LO 6

11-98







Number of cars sold


Profit

Increase Options Time

Decreases

Strategies

Satisfaction Increases

Increase Skills

Results

LO 6

11-99






Number of cars sold


Profit


ResultsCars sold Increase


LO 6

11-100






Number of cars sold


ProfitResults


TimeDecreases

ContributionIncreases


LO 6

11-101







Number of cars sold


ProfitResults

ContributionIncreases

ProfitsIncrease

If numberof cars sold

and contributionper car increase,

profits increase.

Cars Sold Increases

LO 6

11-102


Advantages of Graphic Feedback

When interpreting its performance, Jaguar will look forcontinual improvement. It is easier to spot trends or

unusual performance if these data are presented graphically.

Time to Install an Option

0

5

10

15

20

25

30

35

1 2 3 4 5 6 7 8 9 10

Week

Tim

e to

Inst

all i

n M

inu

tes

LO 6

11-103


Process time is the only value-added time.

Delivery Performance Measures

Wait TimeProcess Time + Inspection Time

+ Move Time + Queue Time

Delivery Cycle Time

Order Received

ProductionStarted

Goods Shipped

Throughput Time

LO 6

11-104


Delivery Performance Measures

ManufacturingCycle

Efficiency

Value-added time

Manufacturing cycle time=

Wait TimeProcess Time + Inspection Time

+ Move Time + Queue Time

Delivery Cycle Time

Order Received

ProductionStarted

Goods Shipped

Throughput Time

LO 6

11-105


Quick Check

A TQM team at Narton Corp has recorded the following average times for production:

Wait 3.0 days Move 0.5 days Inspection 0.4 days Queue 9.3 days Process 0.2 days

What is the throughput time?

a. 10.4 daysb. 0.2 daysc. 4.1 daysd. 13.4 days





LO 6

11-106










Quick Check

Throughput time = Process + Inspection + Move + Queue = 0.2 days + 0.4 days + 0.5 days + 9.3 days = 10.4 days

LO 6

11-107


Quick Check



What is the Manufacturing Cycle Efficiency?

a. 50.0%b. 1.9%c. 52.0%d. 5.1%




a. 50.0%b. 1.9%c. 52.0%d. 5.1%

LO 6

11-108





a. 50.0%b. 1.9%c. 52.0%d. 5.1%




a. 50.0%b. 1.9%c. 52.0%d. 5.1%

Quick Check

MCE = Value-added time ÷ Throughput time

= Process time ÷ Throughput time

= 0.2 days ÷ 10.4 days = 1.9%

LO 6

11-109


Quick Check



What is the delivery cycle time? a. 0.5 daysb. 0.7 daysc. 13.4 daysd. 10.4 days




LO 6

11-110








Quick Check

Delivery cycle time = Wait time + Throughput time = 3.0 days + 10.4 days = 13.4 days

LO 6

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?

Which customers should be targeted and how will

they be attracted and retained at a profit?

LO 6

11-112


Quality of Conformance

When the overwhelming majority of products produced conform to design

specifications and are free from defects.

LO 7

11-113


Prevention and Appraisal Costs

Prevention Costs

Support activities whose purpose is to

reduce the number of defects

Appraisal Costs

Incurred to identify defective products

before the products are shipped

LO 7

11-114


Internal and External Failure Costs

Internal Failure Costs

Incurred as a result of identifying defects

before they are shipped

External Failure Costs

Incurred as a result of defective products being delivered to

customers

LO 7

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

LO 7

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.

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.

Amount Percent* Amount Percent*Prevention costs:

Systems development 400,000$ 0.80% 270,000$ 0.54%Quality training 210,000 0.42% 130,000 0.26%Supervision of prevention activities 70,000 0.14% 40,000 0.08%Quality improvement 320,000 0.64% 210,000 0.42%

Total prevention cost 1,000,000 2.00% 650,000 1.30%

Appraisal costs:Inspection 600,000 1.20% 560,000 1.12%Reliability testing 580,000 1.16% 420,000 0.84%Supervision of testing and inspection 120,000 0.24% 80,000 0.16%Depreciation of test equipment 200,000 0.40% 140,000 0.28%

Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%

Internal failure costs:Net cost of scrap 900,000 1.80% 750,000 1.50%Rework labor and overhead 1,430,000 2.86% 810,000 1.62%Downtime due to defects in quality 170,000 0.34% 100,000 0.20%Disposal of defective products 500,000 1.00% 340,000 0.68%

Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%

External failure costs:Warranty repairs 400,000 0.80% 900,000 1.80%Warranty replacements 870,000 1.74% 2,300,000 4.60%Allowances 130,000 0.26% 630,000 1.26%Cost of field servicing 600,000 1.20% 1,320,000 2.64%

Total external failure cost 2,000,000 4.00% 5,150,000 10.30%Total quality cost 7,500,000$ 15.00% 9,000,000$ 18.00%

* As a percentage of total sales. In each year sales totaled $50,000,000.

Year 2 Year 1

Quality Cost ReportFor Years 1 and 2

LO 7

11-118


Quality Cost Reports in Graphic Form

$10

9

8

7

6

5

4

3

2

1Appraisal

0Prevention Prevention

1 2Year

Qu

alit

y C

ost

(in

mil

lio

ns)

Appraisal

Internal Failure

External Failure

Internal Failure

External Failure

20

18

16

14

12

10

8

6

4

2Appraisal

0Prevention Prevention

1 2Year

Qu

alit

y C

ost

as

a P

erce

nta

ge

of

Sal

es

Appraisal

Internal Failure

External Failure

Internal Failure

External Failure

Quality reports

can also be

prepared in

graphic form.

LO 7

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.

Help managers see whether their quality

costs are poorly distributed.

LO 7

11-120


Limitations of Quality Cost Information

Simply measuring quality cost problems does not solve quality problems.

Results usually lag behind quality

improvement programs.

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:

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.

3. The intended level of quality is being achieved on a sustained basis.

LO 7

11-122


Profitability Analysis

Appendix 11A

LO 8

11-123


Consider the following example for CardCo:Budget Actual

Sales in unitsDeluxe cards 14,000 17,000Standard cards 6,000 5,000

Price per unitDeluxe cards $18 $16Standard cards $ 9 $10

Market volumeDeluxe cards 75,000 85,000Standard cards 95,000 90,000

Variable cost per unitDeluxe cards $ 8 $ 8Standard cards $ 3 $ 3

LO 8

Sales Variance Analysis

11-124


Revenue: Deluxe (17,000x16) 272,000$ Standard (5,000x10) 50,000

322,000 Variable expenses: Deluxe (17,000x8) 136,000 Standard (5,000x3) 15,000

151,000 Contribution margin 171,000$

Actual Results Flexible Budget Master Budget

Actual results are based on the actualactual quantity sold

multiplied by the actual actual selling price or

variable cost

CardCo Actual and Budgeted Results

LO 8


11-125


Revenue: Deluxe (17,000x16) 272,000$ (17,000x18) 306,000$ Standard (5,000x10) 50,000 (5,000x9) 45,000

322,000 351,000 Variable expenses: Deluxe (17,000x8) 136,000 (17,000x8) 136,000 Standard (5,000x3) 15,000 (5,000x3) 15,000

151,000 151,000 Contribution margin 171,000$ 200,000$


Flexible budget results are based on the actualactual quantity

sold multiplied by the budgetedbudgeted selling price

orvariable cost


LO 8


11-126


Revenue: Deluxe (17,000x16) 272,000$ (17,000x18) 306,000$ (14,000x18) 252,000$ Standard (5,000x10) 50,000 (5,000x9) 45,000 (6,000x9) 54,000

322,000 351,000 306,000 Variable expenses: Deluxe (17,000x8) 136,000 (17,000x8) 136,000 (14,000x8) 112,000 Standard (5,000x3) 15,000 (5,000x3) 15,000 (6,000x3) 18,000

151,000 151,000 130,000 Contribution margin 171,000$ 200,000$ 176,000$


Master budget results are based on the budgetedbudgeted quantity sold

multiplied by the budgetedbudgeted selling price

orvariable cost


LO 8


11-127






Sales Price Variance$29,000 U


LO 8


11-128






orSales 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

$29,000U


LO 8


11-129






Sales Volume Variance$24,000 F


LO 8


11-130







orSales 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

$24,000F

LO 8


11-131


The Sales VolumeVolume Variance can further be broken down into the: Market VolumeVolume Variance

=

Market ShareShare Variance

=

Budgeted CM per

unit

Actual market volume

Budget market volume

–{ } ×

Budgeted CM per

unit×

Actual market share

–Expected

market share }{

×Expected

market share %

Actual sales

quantity–[ ]

LO 8


11-132


For CardCo, the Sales VolumeVolume Variance of $24,000 F breakdown further as follows: Market VolumeVolume VarianceDeluxe = (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 F16,772 F Market ShareShare VarianceDeluxe = [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 F7,228 F

Sales VolumeVolume Variance = (1) + (2) = 24,000 F

LO 8


11-133


The Sales VolumeVolume Variance can also be broken down into the: Sales MixMix Variance

=

Sales QuantityQuantity Variance

=

Actual sales quantity

Actual sales quantity at

expected sales mix

Budgeted CM per unit

–{ }×

Actual sales quantity at

expected sales mix

– Anticipated sales quantity} Budgeted CM

per unit×{

LO 8


11-134


For CardCo, the Sales VolumeVolume Variance of $24,000F is made up of: Sales MixMix VarianceDeluxe = [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 F6,400 F Sales QuantityQuantity VarianceDeluxe = [(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) 17,600F17,600F

Sales VolumeVolume Variance = (1) + (2) = 24,000F

LO 8


11-135


Marketing Expense

Appendix 11B

LO 9

11-136


Marketing Strategy

Transport Warehousing

SellingAdvertising

Credit

LO 9

Costs Factors to Consider in a Marketing Strategy

11-137


Order Getting and Order Filling

A d vertis in g S e llin g C om m iss ion s Trave l

O rd er G e tt in g

W areh ou s in g Tran sp orta tion P ack in g C red it

O rd er F illin g

More Discretionary

LO 9

11-138


End of Chapter 11

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